It’s hard to know if debt refinancing at today’s rates is a gross distortion of reality or the shape of things to come
Are interest rate cycles a thing of the past? Have we entered an age of permanently cheap capital? It is astonishing to be asking these questions, but these are extraordinary times. For construction and real estate developers – and investors – it would be helpful to know whether low borrowing rates are a cruel fantasy with imminent expiry or something closer to a settled equilibrium. Is debt refinancing at today’s rates a gross distortion of reality or the shape of things to come?
There are at least three versions of the thesis that we are living in an age of low interest rates. The first is the ‘ice age’ thesis, long expounded by Albert Edwards, the ultra- bearish global strategist at French bank Société Générale. He has argued for many years now that the world is rushing inexorably into a financial ice age, with the developed world following Japan into an era of collapsing bond yields and equity prices. He predicted back in January that yields on US government debt would slide below zero during the next recession. Central bankers are cast as hapless bystanders in this scenario.
The second version is the ‘collapsed roof’ thesis: that interest rates cannot increase because the global debt burden would become intolerable. Interest rates can move only in a very tight, low, range because debt-income ratios are so high. The inference here is that central banks have engaged in financial repression, seeking to prevent an increase in interest rates to an extent that would likely plunge the world economy into recession or depression. This leaves two big questions: do central banks genuinely set interest rates, and how likely is it that they will avoid policy mistakes?
The third version is the idea that central banks have led us towards a socialist utopia, which embraces the radical notion that governments should not have to pay interest on any of their borrowings. This thesis has revived in the context of the popularity of modern monetary theory. Wealth-holders (including pension funds) should be content to hold government bonds solely for their utility as liquid (readily tradable) assets. Therefore governments should borrow freely in order to provide job guarantees, renew the infrastructure, protect the environment and keep everyone safe. That line item for debt service would be so much better deployed elsewhere.
The ice age thesis asserts that the journey towards deflation and negative interest rates is an incomplete adjustment to a new, if unstable equilibrium. The collapsed roof thesis asserts that the new equilibrium is already here and central banks are constrained by it. The socialist utopia thesis is that the existing policy framework is fundamentally flawed and should be abandoned in favour of a new and better equilibrium. What these three theses have in common is a failure to acknowledge that there is an external corrective force, whether of mean reversion or of broader normalisation, which will bring the reign of very low nominal interest rates to an end.
There are two powerful corrective forces that threaten to overturn the era of low inflation and low nominal interest rates. At Economic Perspectives we have showcased each of them in recent seminars: Blowing up the Box on 26 June, and The Coming Collapse of Corporate Credit on 10 October.
‘Blowing up the box’ refers to the obsolescence of the macro policy framework, or box, that has prevailed in advanced western economies for the past 35 years. This box, designed to lock in low inflation, uphold fiscal discipline and rebuﬀ political interference, is now in mortal danger, charged with inadvertently crystallising and compounding relative economic advantage and disadvantage over the past decade (see figure 1). We stand at the threshold of a policy revolution that will blow up the box, overriding the primacy of the inflation objective and abandoning fiscal orthodoxy into the bargain.
As political economy overrides the ‘new normal’, the policy box is set to explode, bringing a reordering of policy priorities. Central banks will probably be reassigned to the defence of sovereign credit in the context of ambitious public spending programmes and the continued repression of nominal interest rates. In practice, the inflation objective will be jettisoned, and the inflation rate will find a new level, paving the way to significantly higher nominal borrowing costs.