Most of the world is enjoying a strong economic rebound, with corporate profits, trade and output roaring ahead. But it is vital to make a distinction between short-term buoyancy (which many pessimists under-estimate) and the long-term structural problems at the heart of the global economy. The latter are worse than most people realise.
Bill Gross, the fund manager who runs America’s Pimco, the influential bond markets investor, puts his finger on a key problem. Credit remains too cheap, promoting excessive leverage and the misallocation of capital on a giant scale. Central bankers have lowered the cost of money for 30 years now. Some of this was legitimate: inflation fell substantially, while the variability of prices declined, reducing uncertainty and cutting nominal interest rates as well as the real cost of money. So far, so good: but Gross is spot on when he argues that what we are seeing today is very different.
The present ultra-low yields cannot be justified. They are merely providing fuel for leverage, propping-up asset-based economies, unsustainable wealth creation and above all a misplaced belief in large and perpetual capital gains. As Gross points out, real 10-year US interest rates (with inflation stripped out) have fallen from over five per cent in the early 1980s to under one per cent in recent months. Because of the way government bond yields are used to calculate discount rates and plugged into asset valuation models, this collapse in real yields may be responsible for 3,000–4,000 Dow points (in other words, up to a third of the index’s value) as well as two to three per cent annual appreciation in bonds over those three decades. Of course, a good chunk of this readjustment was good news, the result of better economic policies – but a decent part, at least in recent years, can only be described as absurd overshooting.
The problem is that yields have fallen so much that even the most determined followers of bubblenomics within the central banking fraternity can no longer push them down any further – mathematical reality has kicked in. There is now a negative real yield on five-year Treasury Inflation Protected Securities, which is senseless. Average five-year real yields on Aaa sovereigns over the past century suggests that investors ought to be demanding and receiving around 1.5 per cent in real terms instead of the present -0.1 per cent. Investors are paying the government to lend it money, thus subsidising the US national debt. In a way, this is tantamount to a secret default, a haircut by any other name.
Followers of the Austrian school of economics have long argued that artificially low interest rates send out flawed signals to investors, causing them to borrow and invest too much in things such as overpriced housing. Recessions occur when people finally realise their mistake and always involves capital destruction and reallocation. There was a good exposition of that view in a BBC Radio Four documentary on Monday (Yo Hayek!, available on the BBC website) presented by Jamie Whyte, of Oliver Wyman, a consulting firm.
Manipulating the price of credit – be it by low Bank base rates, excessive quantitative easing (as in the US) or mass purchases of government bonds by Asian central banks – always ends in tears. At some point, the bond markets will readjust – let us hope the global economy is able to cope when the day of reckoning finally arrives.
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