(July 25, 2012) — There is a serious disconnect between the theorized benefits of low interest rates and what is actually happening in the world economy today, argues Pacific Investment Management Company (PIMCO) CEO and co-CIO Mohamed El-Erian.
While rock bottom interest rates worldwide should foster economic growth, what El-Erian calls the “GGIRC”—or the great global interest rate convergence—is currently having little positive economic effect and could eventually become a problem. The discrepancy between theory and reality, he asserts, stems from the underlying reasons for how the low interest rates have come about and from their unintended consequences.
“According to textbook 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,” El-Erian contends. “In practice, however, the situation is much more complicated and not so benign.”
El-Erian points to three principal factors behind the GGIRC. The first is aggressive action by central banks, like the US Federal Reserve, the European Central Bank, and most recently the Bank of England, to bring down interest rates. The second is a global flight to quality among investors desperate to avoid major investment losses. This motivation is so pronounced, he notes, that short-dated securities issued by Germany, Switzerland, and the United States have negative nominal rates, meaning investors are willing to accept a marginal loss on their principal if it will be protected. The third factor is the “global carry trade,” meaning that investors are pushing yields down in countries such as Brazil, Mexico, and South Africa as they search for relatively safe returns.
Yet despite low interest rates, global economic growth remains anemic. The “GGIRC is not fueling an economic boom driven by labor hiring and investment in plant and equipment,” writes El-Erian. “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.”
As institutional investors understand well, there is also a damaging side to low interest rates. “Certain segments, from pension funds and life insurance companies to money market funds, are particularly challenged,” El-Erian explains. “They have no choice but to shrink the scale and scope of financial services they offer to individuals and institutions.”
Consequently, policymakers need to reassess the costs and benefits of low interest rates and determine a new course of action to stimulate the economy. “In the meantime,” he concludes, “GGIRC may well morph from being seen as part of the solution to inadvertently becoming part of the problem.”
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