Low Interest Rates, Labour Productivity Stir Global Economic Instability – IMF

Unconventional monetary policies, seen as a panacea at the height of the Great Recession in 2009, have backfired viciously by now, revealing the corruptive effects of cheap credit in the form of shrinking profitability, stagnant growth, and the accelerating erosion of labour productivity.

Kristian Rouz – The International Monetary Fund (IMF) warned that extended periods of ultra-loose central bank monetary conditions and low labour productivity have long-lasting negative effects to the quality and stability of the international financial sector and broader economy. Low base borrowing costs affect the profitability of commercial lenders, which in turn might start charging their customers for banking services in order to support their capitalisation and sustainability.

Meanwhile, low labour productivity across the advanced economies produces increased economic volatility and affects the salaries and wages, as well as the overall quality of life, in many nations across the globe.

In their recent study, the IMF found that low interest rates, a characteristic of central bank policies across the advanced economies from the US to the Eurozone to Japan, amongst others, might force commercial lenders to change their approach to doing business. In the past decade, low central bank interest rates have prevented commercial banks from extracting larger business revenues, resulting in a creeping erosion of the sustainability of banking sectors in many nations.

Subsequently, the costs of the zero and negative interest rate policies (ZIRP and NIRP) might be passed on by commercial banks to their customers. As evidenced by the recent Italian banking crisis, many banks, not limited to those in Italy, are struggling to sustain acceptable levels of capitalisation. The era of free banking for average customers, both private and institutional, might be coming to its end, unless central bank interest rates go up in the near future.

Many bank customers in the advanced economies, according to the IMF observations, have preferred saving their money amidst the economic turmoil of the past decade, whilst the levels of investment have remained weak, despite central bank stimulus efforts in the form of ZIRP and NIRP. Most prominently, such trends were obvious in the Eurozone and Japan, where levels of economic growth have been hampered by lack of business spending.

“Smaller, deposit-funded and less diversified banks would be hurt most, which could increase the pressure to consolidate. As banks reach for yield at home and abroad, new financial stability challenges may arise in their home and host markets. These hypotheses are supported by the experience of Japanese banks,” the IMF said.

Currently, base borrowing costs set by the Bank of England (BOE) are 0.25pc, their lowest level since the institution was established in the 17th century. In Japan, central bank rates are negative, at —0.1 – the monetary authorities believed such measures would discourage saving and promote spending and investment, yet, the effects of the unconventional monetary policies have been all but negligible and the Japanese economy is still growing slow. The European Central Bank (ECB) has been practicing ZIRP and bond-buying for years trying to overcome the destructive consequences of the debt crisis earlier this decade, but growth is still weak.

“Prudential frameworks would need to provide incentives to ensure longer-term stability instead of falling prey to demands for deregulation to ease the short-term pain,” the IMF observed.

Indeed, whilst the regulators across the world have been tightening banking and financial sector surveillance in the past decade, whilst keeping rates low, commercial banks were bleeding off their earnings. Whilst in the US, the central bank and the government have pledged to normalise the situation by deregulating the overall economy and raising borrowing costs, in other parts of the world central bank approach to policies remains unchanged.

This means, many European and Japanese banks could start looking for ways to extract new sources of revenue, and their customers are first in line.
Another challenge to the global economy, the IMF said, is low labour productivity, which impairs the profitability of enterprises both in and outside of the financial sector, on the one hand, and affects worker compensation, on the other. IMF head Christine Lagarde said government investment in human capital could help ease the deflationary pressures on worker compensation.

“Another decade of weak productivity growth would seriously undermine the rise in global living standards. Slower growth could also jeopardise the financial and social stability of some countries by making it more difficult to reduce excessive inequality and sustain private debt and public obligations.” Lagarde said.

Better education and innovation, Lagarde pointed out, could help prevent further erosion of labour productivity.

Cheap credit and low labour efficiency are thus the two main challenges to global economy. Currently, across many advanced economies, consumer debt is skyrocketing out of control, the demand-side is worn out by the high levels of household debt and low wages, and the supply-side is struggling amidst shrinking revenues.

Normalisation in monetary conditions with interest rate hikes, like in the US, might be an option. Yet, the complexity of the issues the global economy is facing suggests the necessity of structural economic reforms across multiple disentangled jurisdictions, which is not deemed a viable scenario. Therefore, further deterioration in the wealth of nations seems imminent.

“We at the IMF therefore believe that all governments should do more to unleash entrepreneurial energy. They can achieve this by removing unnecessary barriers to competition, cutting red tape, investing more in education, and providing tax incentives for research and development,” Lagarde said.