Low interest rates are a 700-year legacy

This article appeared originally in Gulf News: link to original article

The seeds for ultra-low and negative interest rates were sowed 700 years ago, according to a working paper by the economist Paul Shmelzing. We are, therefore, exactly where we are supposed to be. How so?

According to the author, global interest rates, which he traced back to 1311, have been trending downwards over the years despite increases over different periods in the past seven centuries. The author also predicts that negative interest rates may be here to stay, and they may sooner or later be the new normal.

Put differently, the financial crises, which the world was faced with throughout the period of the study, were cyclical downturns that transitioned interest rates to lower levels. Global interest rates were on their way there, anyway.

Such historic financial crises include the “Tulip Mania” bubble in the 17th century, which was the result of an unexplainable frenzy to buy tulip bulbs, bidding prices up for them. Another financial crisis was in the unwinding of “Mississippi Company” in the 18th century, acquired by a bank established by economist John Law in France.

The bank introduced paper money for the first time to salvage the French government from stagnant growth and a growing national debt, post the Spanish Succession War. Other more recent financial crises include the Great Depression of the 1920s-30s, the recession in early 1980s, and the Asian financial crisis of 1997.

Mired in the negative

Paul’s analysis indicate that average long-term global interest rates have been negative all along. This was, though, more of an implicit trend rather than an explicit one. Subsequently, current negative rates, introduced after the 2008 financial crisis, are a tangible culmination of a negative trajectory that has been 700 years in the making.

While the above mentioned financial crises exacerbated those long-term negative global interest rates, there is one main underlying factor that has been driving this downward trend.

This pertains to shifts in saving rates and consumption, which can be the result of nature- and human-induced events. An increase in savings’ rate means money flowing into bonds, which naturally pushes interest rates lower. The opposite happens when consumption increases, and savings drop.

Unforeseen events

For instance, the Black Death in the 14th century was detrimental in wiping out a significant percentage of the global workforce, which nudged surviving individuals to increase their consumption and spending. Think today of coronavirus, and the impact that it could have on global economic growth and whether or not it could produce another drag or stagnation, similar to that witnessed on the back of the 2008 financial crisis.

Human intervention

Human-induced factors include changes in taxation that would directly impact consumption. Other human-induced factors are the above cited financial crises, which most times, if not all, are consequences of human behaviour in financial markets.

Shmelzing forecasts that between now and 2040, short- and long-term interest rates would have plunged into negative terrain for good. What does that mean for central banks and for monetary policies?

Monetary policies will need to get more creative. Quantitative Easing (QE) was one example of central banks being creative. The struggle for central banks nowadays is not with ultra-low or negative interest rates, but on how to come up with new ways to manage monetary policies, and thus liquidity in their economies.

Given that low interest rates are usually associated with inflation, missing inflation targets by central banks have been nothing but frustrating, especially when not even QE has done the trick.

Moving forward, central banks could look into ways to influence long-term interest rates, rather than short-term ones, by targeting their yields. This seems to be the most recent innovation pioneered in Japan, but its effectiveness is yet to be tested across the board.

Even though yield targeting for long-term maturities can provide one solution, more solutions will be needed as ultra-low and negative interest rates become the new normal, which is happening.

In conclusion, the trajectory of global interest rates was ultimately headed to today’s new era of ultra-low and negative interest rates. The world will need to come up with innovative monetary tools to deal with that and future financial crises, both nature- and human-induced ones.

The last thought that I want to leave you with: What can countries with pegged currencies do about ultra-low and negative interest rates?