It makes sense when economic activity is depressed for central banks to ease monetary policy to boost investment and so create the jobs. But Chris Hamman, head of fixed interest at Sanlam Investment Management (SIM), argues that lowering interest rates even further is "tantamount to pushing on a piece of string".
Very low interest rates do affect the economy, he concedes, but in a different way to what people expect - the public sector is the main beneficiary and this comes at the expense of long-term economic performance.
The idea that lower interest rates will stimulate investment rests on two important assumptions, he explains. Firstly, that interest rates will remain low for a prolonged period, and secondly, that projects will generate sufficiently positive cash flows to meet financial obligations towards funders. Neither holds up.
SA 10-year government bonds are at 6,5%, roughly at their lowest level since the late 1960s. With inflation having averaged 5,3% over the past decade one can question whether this is sustainable.
"Investors in the real economy are investing over the lifetime of a project, 20 years or more, so they have to believe the current very low level of interest rates is sustainable or it will not trigger investment," says Hamman.
The cash flow assumption is equally troublesome. In lowering interest rates to multigenerational lows like in SA, or multicentury lows like in the US, the monetary authority is signalling that the economic outlook is bleak and profit expectations ought to be scaled right back.
"Rational investors will not fund projects when the potential returns are declining amid lower interest rates and, at the same time, the riskiness is rising amid increased economic uncertainty," says Hamman.
Faced with the alternative of risk-free government bonds, investors all over the world have been channelling their investments into sovereigns bonds. This is helping governments to finance debt at levels last seen during the 1940s.
US gross government debt breached 100% of GDP by end-2011 - a level last seen at the end of World War 2. In Japan, the UK and Italy, gross government debt in 2011 amounted to 230% of GDP, 82% of GDP and 120% of GDP respectively.
Given the size of this debt mountain, governments will at some point need to run primary budget surpluses to achieve a return to fiscal sustainability, notes SIM economist Arthur Kamp. This implies less spending and/or higher taxes - neither of which are politically palatable, especially at a time of low real GDP growth.
"Hence, governments will need to live with debt, which means they have a clear incentive to keep borrowing costs low and to channel available savings towards the purchase of government securities," says Kamp.
This strategy - dubbed financial repression - enables governments to finance their deficits and minimise their debt costs and so delay the implementation of fiscal austerity measures. Unfortunately, the cost is that of a declining long-run potential growth rate.
Of course, if a government uses the debt it raises to invest in infrastructure this would raise the long-run potential of the economy, Hamman concedes, but he argues that most SA government spending is not on infrastructure but on wages. Essentially, SA is borrowing to pay wages and the interest on existing debt.
The bottom line is that the very easy monetary policy being practised by the UK, the US and even SA is likely to have a limited effect on boosting growth while leaving these economies at the mercy of fickle foreign investors.
The lesson is that SA should be putting far less faith in fiscal and monetary policy to stimulate growth and much more weight on industrial, trade and labour policy.
FM
