The Merchants of Menace and the potential debt disaster: What happens when interest rates are maintained artificially low over an extended period of time? It may appear to be an academic question. However, if the accurate answer is “the 2008 global financial crisis,” you should sit up and take notice. Especially given where interest rates are at the moment, which is the most out of whack in investing history.

Despite the fact that savings accounts are close to zero, inflation is around 5%, and mortgages are available at half that amount, the Bank of England’s rates are not moving quickly. This is an odd combo.

In the eurozone, the situation is similar, but the central bank is refusing to budge on interest rates at all.

And in the United States, many are worried about the likelihood of a restrictive monetary policy that will do nothing to reduce inflation.

But all of this debate about inflation and interest rates is only one side of the issue – the financial and monetary side, to be precise.

Today, I’d want to discuss the actual economy. What happens to the actual economy when interest rates remain artificially low for an extended period of time?

To answer this issue, you must first grasp that there are only a finite number of genuine resources in the real world. The most obvious limits are space, personnel, and physical resources like as metal and oil.

This is in stark contrast to the monetary system, which governments can manipulate spectacularly, well beyond the limits of rationale or truth.

Limitless sums of money can be printed, interest rates can go below zero, and central banks can absorb an infinite amount of debt. Governments can deduct zeros from bank notes and bank accounts, or they can create an altogether new currency.

But let’s go back to business. The scarcity constraint, as economists refer to it, indicates that the key economic concern is how to optimally distribute resources to suit human demands. In other words, who should make what, where, how, and with what.

The capital structure is an important component of this. Should farmers raise a variety of crops and livestock or specialise in one? Is it appropriate for the country to specialise and trade? Should a car firm strive to construct a car on its own or outsource the design, assembly, and other parts? What combination of humans and machines should be employed to complete the task? What should the locations of the factories be? What size should they be? How many different types of cars should be produced? Should our milk be used to produce butter or cheese, or should it simply be sold as milk? Should we buy bread from a bakery, our local supermarket, or prepare it ourselves at home?

How affluent we become and how high our standard of living is determined by how well we answer these issues. And the structure of our living standards is also determined by how we respond to these questions. I don’t think Japanese people desire to live like English people, and vice versa…

Who makes these judgments in today’s economy? Who chooses where, how, and by whom it is produced?

The government, in a socialist or communist economy, makes the decisions. You go where you’re told, do what you’re told, in the way you’re told, with what you’re given, and you receive what you’re given in the end.

Individuals making individual decisions about their own individual lives, on the other hand, are how these decisions are determined in a capitalist society.

Isn’t it easy to see why economists like government planning? Capitalism appears to be absolute anarchy.

The thing is because the value is determined by the beholder, capitalism is the best approach to make economic judgments. Governments just do not understand what their constituents want well enough to make sound allocation judgments.

Despite realising that this applies to most aspects of our economy, particularly after the disasters of Communism, we have been stuck with a particular sort of central planning. Central banks, to be specific.

Which brings us back to our earlier discussion of low-interest rates.

Capital allocation decisions are the type of decisions that macroeconomists, such as central bankers, who focus on aggregates such as GDP, do not consider. As a result, they overlook the impact that interest rates have on the real economy. The capital misallocations are caused by low-interest rates.

Conveniently, a group of economists known as “the Austrian School of Economics” provided an answer to this topic several decades ago.

Regrettably, hardly one in governments or central banks is paying attention to them any longer.

In short, Austrians believe that artificially low-interest rates stimulate capital overinvestment. That is a fancy way of stating a larger plant, more machinery, and a more complex manufacturing process.

When interest rates are low due to high savings rates, such an investment is advantageous. This is due to the fact that savings signal an increase in future consumption, which can be supplied in the future by the increased production enabled by higher investment in productive capacity.

However, when central banks artificially decrease interest rates by generating money rather than actual savings, the economy is duped into believing that there will be greater consumption in the future. However, because printed money is not the same as genuine savings when future consumption fails to materialise, the investments are deemed ineffective. Bankruptcies and a recession result.

This is how central bank interest rate manipulation creates the business cycle, rather than reducing it, as news readers would have you believe.

However, there are numerous more consequences of artificially low interest rates. Housing bubbles and banking crises are the most obvious examples.

Just as price limits on energy led to a succession of energy business bankruptcies in the UK’s energy industry, so may the central bank’s interest rate policy lead to bank failures. It causes lending excesses, followed by lending contractions.

This is fundamental supply and demand economics. When you impose a price limitation, you get both surpluses and shortages. In the world of debt and lending, this manifests as loan booms and bank busts.

It’s even easier to understand housing bubbles. Loan affordability is the most important factor driving housing demand. And the major factor impacting loan affordability is the central bank-controlled interest rate.

This manipulation has now reached an astounding mismatch. While inflation is at 5%, Lloyds is giving the lowest ever 10-year fixed mortgage rate of 1.66 per cent. This is totally insane. Your mortgage is being paid off three times over by inflation!

Of course, this is an extreme case, but it reflects the craziness that is the mortgage industry in the United Kingdom, the United States, Europe, and others.

But not so fast…

Remember that scarcity is the main lesson of economics. Governments have the ability to tinker with money, inflation, and interest rates. However, they are unable to suspend reality.

As a result, home values are skyrocketing.

Some of this overstated demand eventually leads to a building boom. That’s exactly what happened in Ireland and Spain in the run-up to 2008, when entire housing estates were exposed as bad investments – and it’s exactly what the Austrian school says will happen as a result of low-interest rates.

The key, however, is growing prices, because physical reality cannot be suspended, only monetary reality.

With an annualised growth rate of more than 11% in January, UK house prices had their best start to the year since 2005.

Do you recall what happened after 2005?

Let me give you one additional ramification of artificially low-interest rates. They keep zombie businesses afloat. Zombies are companies that cannot afford to pay their debts but can find lenders to keep their loans rolling over.

A zombie company going bankrupt is a frightening prospect right now. However, consider the alternative.

These businesses are depleting resources by producing and selling items that do not generate a profit for the corporation. And profit indicates that what is produced is worth more than what was expended to produce it.

Profit, in other terms, indicates the creation of value. If you’re losing money, it’s a sign that you’re squandering resources that could be better used elsewhere.

This is why socialism failed: planners were unable to determine whether economic activity met its intended objective of providing value for customers. They didn’t know whether to create butter or cheese with the resources available since there is no way to tell in an economy without prices, profit, and loss.

Failure is critical in a capitalist society because it permits resources to be reallocated from activities that use resources but destroy value to those that produce value. And the profit motive is the regulating mechanism that ensures we are continually attempting to maximise the gain from the resources we use.

When artificially low lending rates keep zombie enterprises from failing, they generate waste. And it may appear that a large number of corporate failures would be disastrous. In the short run, it would be.

However, in the long run, it is precisely this reallocation of resources that raises our living standards. Otherwise, we’d still be shoeing horses with blacksmiths, developing images with Kodak film, and driving electric automobiles with coal…

Instead, we recognised that the resources being used in those economic activities were being squandered and might be better utilised. We’ve recognised it for the most part…

Where may this all take us?

Stagflation is the ultimate manifestation of monetary interference colliding with real-world limits. Rising costs and a stagnant economy produce items that people don’t want…or at prices they don’t want.

Then central bankers must make a decision. They have the ability to hike interest rates, which will ruin the zombified economy. Alternatively, they can allow inflation to run high and perpetuate stagflation.

In the past, interest rate hikes every few years have unintentionally triggered debt problems. All the way up to the point where even governments are impossibly overindebted. Then they start choosing the latter and don’t even try to control inflation for fear of bankrupting their companies.

The important question is whether we’ve arrived there. Will central bankers cause a debt catastrophe or allow for stagflation?

Of fact, there are two investments that benefit from either outcome. The first is gold, which is both an inanimate item and thus not vulnerable to the machinations of monetary maniacs (in the long term), and a monetary metal on which societies rely when their government-controlled money fails.

The second is gold’s more youthful and vibrant relative.

Nick Hubble
Editor, Fortune & Freedom

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