Low Interest Rates Are Not Enough: El-Erian

Welcome to what could be called "GGIRC," the great global interest rate convergence – whereby interest rates steadily converge to zero in many countries around the world, both advanced (other than the crisis European economies) and emerging (other than the persistent financial basket cases).


In theory this is a good thing for a global economy.

After all, major economic areas, particularly Europe and to a lesser extent the United States, are challenged by too little growth, too much debt and too high a joblessness rate(especially among the young and the long-term unemployed).

Even more dynamic economies, from Brazil to China, are slowing.

According to text book economics, lower interest rates have beneficial flow and stock effects.

They make it cheaper to fund investment and consumption; and they make it easier for companies, governments and individuals to carry a given stock of already-accumulated debt.

In practice, however, the situation is much more complicated and not so benign.

GGIRC is not happening for good reasons.

As such, the effects are slow to materialize. And, unless quickly accompanied by other policy initiatives, the consequences will be at best mixed and, probably, net negative.

Three major factors are behind GGIRC.

First and foremost, hyper activist central banks that are using traditional (price) and unconventional (quantity) measures to force interest rates down.

Just look at the series of actions by America’s Federal Reserve — from flooring policy rates at almost zero for an exceptionally long time (and also pre-committing to keeping them there until the end of December 2014) to purchasing an enormous amount of U.S. Treasury and mortgage securities in a further attempt to drive borrowing costs down.

Second, individuals and institutions are piling into government securities to protect against principal loss in an increasingly uncertain and worrisome global economy and an ever-deepening European crisis.

This is most pronounced for Germany, Switzerland and the United States, where inflows of capital have led to negative nominal rates for short-dated securities (i.e., investors willingly accepting marginally less money on maturity than they invest).

Third, global investors are spreading GGIRC through "the global carry trade". This search for relatively safe yield is driving the flow of money into the local bond markets of countries such as Brazil, Mexico and South Africa.

Yet GGIRC is not fueling an economic boom driven by labor hiring and investment in plant and equipment.

Lower Borrowing Costs Are Not Enough

Simply put, lower borrowing costs are not enough to convince companies to expand given the list of domestic, regional and global uncertainties; indeed, many of these companies are far from credit rationed as they sit on huge cash balances.

And they only help at the margin the highly-indebted consumers.

This limited scope for benefits comes with the growing reality of collateral damage and unintended consequences.

Today’s market-based economies, and the accompanying institutional setup, do not function well at such artificially repressed interest rates.

Certain segments, from pension funds and life insurance companies to money market funds, are particularly challenged.

They have no choice but to shrink the scale and scope of financial services they offer to individuals and institutions.

Then there are some emerging countries that could well be de-stabilized by some of the activities encouraged by artificially-repressed interest rates.

It is only a matter of time until they are challenged by asset market bubbles (including in housing) and irresponsible lending by institutions subject to weak market and regulatory supervision.

This is not to say that GGIRC is a bad thing. It need not be.

But it will be if not quickly accompanied by major policy actions that address the causes of today’s global economic malaise.

What the world economy needs today is a coordinated set of measures to promote growth, allocate financial losses, match healthy balance sheet with those that are challenged and reforming, and improve the functioning of the labor and housing markets.

For this to materialize, highly polarized and dysfunctional politics needs to give way to more strategic and constructive interactions across party lines and social segments.

There is little to suggest that this will happen any time soon absent yet another major financial crisis.

In the meantime, GGIRC may well morph from being seen as part of the solution to inadvertently becoming part of the problem.