Could interest rates ever be too high?

I’m passionate about monetary policy and particularly the negative societal impact of low-interest rates. I disagree with the mainstream economic theory that interest rates should be lowered to stimulate economic activity. This short-term thinking underestimates the long-term negative consequences of inflation and artificially reducing people’s time preference, the interest rate. Given my disdain for artificially low-interest policies, I can be perceived as dogmatic. Targeting this dogmatism, I was posed with a good question by a detractor, “could interest rates ever be too high and what are the consequences?” Although rare, we could imagine a world where central bank rates are too high. Since this is a hypothetical scenario, sadly, I’ll make economist-style assumptions.

High rates required to encourage deposits

Let us define the scenario as central bank rates being permanently high and stable such that commercial banks have no incentive to make use of central bank liquidity tools. i.e. The rates demanded by the central bank are higher than those demanded in the real economy. Banks have to offer consumers, households and corporates interest rates that are high enough to encourage deposits at their bank. But, by definition, these rates are lower than those offered by the central bank. Remember, we’re talking about deposits here, not loans where consumers pay the interest rates. High-interest rates on deposits are good for consumers because they can earn returns merely by depositing their capital in the bank.

Once banks have a reasonably large number and amount of deposits at reasonably stable interest rates they have pretty low-risk liabilities. Unless the bank conducts business poorly and mismanages its balance sheet, it is unlikely that depositors will suddenly withdraw their deposits all at once (bank run). On the other side of the balance sheet, banks have large cash assets, which they can make use of in the real economy.

Banks want to offer low-interest rates

While depositors enjoy high-interest rates, banks would rather pay as low-interest rates as possible. Banks have to manage their need for deposits, which are the lifeblood of the business, with the desire to pay low-interest rates because they would prefer to pay less than more. I.e. deposit rates will only be as high as they need to be to encourage savers to deposit their funds in the bank, and no higher.

Banks use the deposits to make loans in the real economy to consumers, households and corporates who require funding. Through using low-risk deposits to make higher risk loans banks increase the risk on their balance sheet. Banks are compensated for the balance sheet risk by the interest rate spread between the deposits and loans. I.e. interest rates on loans will usually be higher than interest rates on deposits. The longer time horizon of loans and the risk that the consumers aren’t able to repay warrants a higher interest rate on loans.

Judicious but competitive lending

In our scenario, banks know that central bank liquidity is expensive so they don’t want to make use of it very often. They are encouraged to price real economic credit and duration risk effectively. In other words, lending will be judicious. This does not imply that lending will cease. If a bank is unwilling to make a loan to a trustworthy/creditworthy consumer this provides a market opportunity for another lender to step in and provide the loan.

Informal lenders, micro-finance institutions, community trusts, building societies and stokvels serve a critical purpose here. Often these types of informal institutions are better able to price credit risk for smaller and poorer customers and thus are more willing to lend. Corner stores in a rural area, for example, know their customer base very well and they aren’t going to run away with deposits like VBS bank did in South Africa. The real trust between the individual in a small community and a corner store creates the perfect opportunity for micro-finance. Large banks from urban areas aren’t able to price the risk within rural communities nearly as well as microlenders who know their customers. If these urban banks are run in a prudent manner, they are generally less willing to offer loans in rural areas.

So yes, loan rates will be higher in this scenario, but competition will force their rates as low as possible. Yes, there will probably be less loan growth but loan growth will definitely exist. Loans will just be biased towards much more productive activities.

Higher rates encourage production over consumption

Rather than take out expensive high-interest loans, people are encouraged to save to achieve their goals. Well-priced and high-interest deposits makes saving attractive and easier. Higher interest rates also lengthen people’s time-horizons. For example, rather than impulsively purchasing a new pair of shoes because my credit card says I have enough credit, I have to wait and save. Waiting reduces impulsive purchases because I often realise that I don’t need the shoes. This does not imply that there won’t be any consumption. People still need to consume and various people have a penchant for shoes… But, at the margin, consumption will fall, saving with increase and investment into more productive activities will be favoured. Rather than purchase the shoes, I might realise that paying for my children’s education is more important.

Longer-term decisions are better quality decisions

This dynamic is not just a pipe-dream. An interest rate is a reflection of my preference for consumption between today and tomorrow. When the interest rate is higher, my preference for consumption today decreases relative to tomorrow. i.e. higher interest rates increase the importance of the future. When people think about their future, they inherently start taking wiser, more meaningful decisions that are more likely to favour education over purchasing shoes, for example.

Turkey highlights the perils of credit-induced growth

At times it may appear that a savings/deposit based high-interest rate economy doesn’t allow the same degree of investment as a credit based low-interest rate economy. This is a fallacy. A credit-based economy can appear to achieve much higher rates of growth in the short term because a sudden rise in debt and consumption can drive economic growth higher. However, in the future, the debts need to be paid, usually at much higher interest rates due to the inflation created by the credit expansion. Turkey’s current economic crisis provides just one example of this complex dynamic. In the 2011-2015 period Turkey was the poster child of Emerging Markets but this is because it was using low-interest rates and debt to drive economic activity rather than real savings and investment. Eventually, the external imbalances, capital consumption and inflation came home to roost, which wreaked havoc in the economy in 2018.

Savings rather than credit induced growth reduces the possibility of very volatile credit-cycle induced economic growth. Dramatically higher economic growth rates should not be suddenly expected.  Steady rates of growth should be expected. Over time, savings will increase, capital will accumulate, productivity will rise and economic growth rates will increase.

Interest rates can never be too high

In reality, the situation of interest rates being too high can never actually exist. Too high central bank rates would merely imply that the central bank is no longer a relevant institution in the day-to-day running of commercial banks. The free market would price credit risk as effectively as possible and would do so and independently of the central bank.

If the interest rates were too high and everyone was just putting their money in short-term deposits then competition would arise between banks, corporates and or consumers to lend out idle capital and make profits. Alternatively, if investment opportunities were limited, banks would swiftly realise they’ve got too many deposits and would immediately reduce the interest rates they offer on short-term deposits. Competition would force interest rates lower, where appropriate.

What would it take to get here?

Unfortunately, it not quite as easy to get to this world of naturally floating interest rates as we would like. Falling interest rates encourage debt growth which is why, after a 30-year trend lower in global interest rates since the 1980’s, many economies around the globe are saturated with debt. Rising rates are positive for savers, depositors and the economy at large, but they are painful for debt holders. If the debt holders cannot make profits above the more naturally determined rate of interest, then defaults could take place as interest rates adjust. Optically, this wouldn’t appear to be a positive development in the short-term, which is why it would be rash to suddenly allow interest rates to shift higher overnight. However, we must remember that defaults only take place within businesses that cannot earn profits above the natural rate of interest – these companies should not have been in business in the first place.  So yes, short-term frictions should be expected but over time capital will be allocated far for efficiently and productively. In time the positive impacts, which I’ve mentioned above, would overcome the negative short-term implications from debt defaults.

Low-interest rates are inequality enhancing

In the real world, central bank rates are usually lower than those required to encourage depositors. Low central bank rates create a moral hazard for banks whereby they care much less about managing the level of deposits and much more about making loans. If the commercial banks run into liquidity constraints they can usually ask the central bank to step in. Banks love it when central bank rates are low – they are able to charge higher rates in the real economy but finance at cheaper central bank rates. In reality, banks still try to price credit risk reasonably effectively because they’d like to make as much money out of consumers as possible. The central bank backstop of cheap funding and lower rates just implies that banks don’t have to price credit risk quite as judiciously as they’d have to under a scenario of freer, less central bank controlled, banking. Banks benefit from being the intermediary between central bank rates and consumer rates, not average consumers because banks have an opportunity to arbitrage the credit risk.

Banks borrow as cheaply as possible and lend out at the highest rates possible. Think about it…interest rates on high credit risk loans are still pretty high… It’s the perceived lower credit risk customers who benefit from lower interest rates. Big companies, wealthy individuals and government all have much lower credit risk profiles than your average man on the street. If central banks rates are low, commercial banks are very willing to offer these types of institutions much lower interest rates. Your average man on the street doesn’t benefit nearly to the same degree. Through this mechanism, we can see one of the ways in which inflationary monetary policy, through low-interest rates, is inequality enhancing. This mechanism is insidious because it contradicts the mainstream economic narrative that stimulatory monetary policies could assist poorer people through stimulating economic activity. But this mainstream narrative needs to be challenged due to the incredibly negative impact on people who are less wealthy, less financially astute and less politically connected.

 


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