Are central bankers tinkering with interest rates too much?

The coronavirus outbreak is bringing fears for the world’s economic health – not just its physical health. The global economy was in difficult shape to begin with, due to international trade wars and rising global debt, but now, to a great degree, economic activity has come to a full stop.

Spending has plummeted, and businesses have closed, with the knock-on effect of pushing unemployment through the roof. Factories are shuttered, so production has fallen along with demand. The world’s financial markets are spiraling downwards: The S&P has fallen 20 percent since the beginning of the quarter; the Dow Jones is down more than 23 percent; the NASDAQ lost over 1,300 points in three months.

We’re rapidly approaching the point where there’s nothing to buy, and no one has any money to buy it with.

Central bankers like Jerome Powell, head of the Federal Reserve; Andrew Bailey, head of the Bank of England, central bank of the UK; and Christine Lagarde, head of the EU’s European Central Bank (ECB), face a Herculean task to keep their economies right-side up.

They need to deal with the short-term economic spiral as markets, cities, and entire sectors shut down. And on another level, they also need to prevent long-term economic decline that can result from fears of volatile markets, the destruction of numerous SMEs and even larger corporations, and unemployment stretching into a long-term problem as businesses fail to get back on their feet.

We’re seeing central bankers primarily respond by tinkering with interest rates and quantitative easing (QE) plans:

• The Federal Reserve led the way, cutting interest rates to almost 0 percent, promising to buy unlimited amounts of treasury bonds and mortgage-backed securities as needed, and agreeing to buy some corporate and municipal debt.
• The Bank of England suddenly cut interest rates to 0.25 percent, then cut them again to 0.1 percent, alongside a promise to buy £200 billion in government bonds.
• The ECB didn’t cut interest rates, presumably because they are already at -0.5 percent. This initially provoked a volatile few days for the euro, but it stabilized, and the eurozone has rallied, thanks to the ECB’s announcement of a €750 billion QE stimulus package.

The danger is that rate cuts and QE plans may be entirely the wrong approach. Here’s why.

Adjusting interest rates could be actively damaging

Interest rates cuts have long been the tool of choice for central banks, but that doesn’t mean they’re the right tool.

Artificially lowering interest rates essentially incentivizes debt and discourages fiscal responsibility at times when businesses and individuals need to focus on being frugal and sustainable. As a generation saw huge amounts wiped off their pensions, they learned to stop saving and embrace the debt. Businesses and whole governments took the same approach, borrowing more and more in order to invest in their own expansion.

While this creates an image of a healthy economy, it’s just a dangerous mirage. Much of the developed world now inhabits an unsteady bubble of personal debt, corporate debt, and government debt, encouraged by the consistently low interest rates, leaving no one able to bear a recession when interest rates have nowhere to go but up.

As Peter Schiff, CEO of Euro Pacific Capital, puts it, the current crisis isn’t caused by COVID-19, but by the unsustainable bubble of debt. “Too many analysts are focusing on the pin that burst the bubble, but the problem is really the bubble not the pin,” he notes. Indeed, many pundits had long predicted a recession in early 2020 – it’s easy to argue that if it hadn’t been sparked by coronavirus, it would have been sparked by something else.

In this context, cutting interest rates is simply not helpful and is actively damaging. These steps only increase the amount of debt borne by central banks, inflate the bubble further, and make the situation worse. The recent Federal Reserve interest rate cut didn’t help stabilize the markets much, showing that investors no longer have much faith in rate cuts.

What are we seeking to incentivize, anyway? Does society really benefit by people having the discretionary income to spend more time in stores and restaurants? The nature of the current situation calls for a specific type of austerity.

On the other hand, it’s true that raising interest rates now would be similarly catastrophic. What businesses need right now is enough cash to stay afloat until after the initial crisis has passed.

Central banks can be more creative when pressed

Alongside the interest rate cuts and QE measures, we are seeing some more creative moves. The Federal Reserve agreed to buy some corporate and municipal debt, which is, admittedly, another QE measure but also a way of promising cash to large corporations. However, they are only offering this to corporations above a certain scale, which could be problematic because there are so many companies that don’t pass the bar.

The Federal Reserve also moved to make it easier for banks to give loans to small businesses, expanding SBA loans and opening a lending facility that will allow it to buy securities backed by student, auto, credit card, and SBA business loans. But this might not be enough to keep small businesses afloat, and the plan to support SMBs is vague and has no start date. Plus, as mentioned above, such measures only encourage the debt bubble to increase.

We are seeing more creative measures from other central bankers.

In the UK, a £350 billion stimulus package includes a government guarantee to pay workers’ wages at 80 percent of their pre-corona amount, as well as a £9 billion package to support the self-employed. While the package also involves quantitative easing and the offer of government-backed loans to small businesses, which perpetuates the debt cycle, these steps should help ensure that businesses still exist post-corona and people still have jobs, so the economy can pick up again in a more natural way.

Denmark’s ambitious 90-day Temporary Compensation Scheme, moreover, is particularly compelling. Essentially a variant of unemployment insurance, this is “a temporary program of public furlough assistance that allows firms to place workers on paid leaves of absence,” as MIT Assistant Professor of Finance Daniel Greenwald describes it.

Greenwald sees this as a great option for the U.S., since “The businesses would be required to maintain each worker’s health coverage during the furlough, and return them to employment afterwards.” Plus, no incentivized debt and no unnecessary spreading of COVID-19 infection.

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As a whole, though, the EU has its hands full. The ECB’s €750 billion emergency fund focused on QE measures, promising to buy government bonds to shore up the sovereign and corporate debt that threatens to cripple some economies. The ECB is also offering €3 trillion of liquidity through refinancing operations at -0.75 percent. These steps will probably have disastrous long-term effects on eurozone inflation, but it’s difficult to see what else the ECB could have done when Italy and Spain are on their economic knees.

A cure that’s worse than the malady

While the recession we’re entering was precipitated by the coronavirus, it was probably inevitable even without the health scare and its domino effect. Interest rate cuts and QE measures are the first weapon of choice for central banks, but they are arguably the true cause of any ongoing economic woes.

Central banks that focus on measures to keep workers in jobs and businesses solvent are taking the right steps to deal with the short-term trauma of corona-induced slowdown, but they may not be able to prevent the long-term fallout of years of a fiscal policy that kept rates low, debt high, and savings non-existent.