TheMarketForIdeas

The financial crisis of 2007 was the result of a constant accumulation of risks facilitated by the gradual lowering of interest rates. This decrease allowed the emergence of an allocation of resources incongruous with the economic reality, decisively affecting the complementarity of production processes. As a viable example, the Federal Reserve, led at the time by Alan Greenspan, decided that between December 2000 and June 2003, the federal funds rate would be reduced from 6.5% to 1%. Immediately after that, in June 2004, the federal rate was increased by 0.25%, to curb the rise in inflation in the real estate market. But a constant decrease in the interest rate was reflected in specific, interest-sensitive sectors, such as real estate. This increase in investment appetite in the real estate sector was also due to legislative provisions, such as the Housing and Urban Development Act, which obliges GSEs such as Fannie Mae and Freddie Mac to have at least 30% of their loan purchases directly linked to affordable housing, which would stimulate mortgage lending in communities with limited resources. This phenomenon was also precipitated by the appearance of the Community Reinvestment Act, all of which facilitated a loosening of lending standards. At the same time, to support these mortgage practices, mortgage-backed assets appeared and implicitly the development of the shadow banking system. As these investments were interest-sensitive, with the increase in inflation in the real estate sector, a tightening of monetary policy affected the profitability of these investments and hence the ability to repay, effects that have also translated into the shadow banking system, repo markets and, finally, international markets. The detailed processes that led to the outbreak of the financial crisis are not the subject of this article, but their brief presentation was necessary to continue the presentation of the phenomenon of economic zombification. 

Perverse incentives 

The rethinking of monetary policy was necessary due to the appearance of zero lower bound at nominal interest rates, but also to the impairment of the transmission mechanisms of the monetary policy, which affects the ability of a central bank to act directly on real economic variables.

As the pre-crisis heterogeneous real resources were redirected to the real estate sector, the emergence of the financial crisis invariably led to an accelerated consumption of capital, which affected the level of liquidity in the financial-banking sector, of which the shadow banking system was composed, but also the aggregate demand, using a Keynesian terminology. Initially, the central banks sought to control short-term interest rates adjusting the supply of bank reserves through repurchase agreements or open market operations, using, in this direction, government bonds. Post-2007, with the onset of the financial crisis, monetary policy had to be rethought. This rethinking was necessary due to the appearance of zero lower bound at nominal interest rates, but also to the impairment of the transmission mechanisms of the monetary policy, which affects the ability of a central bank to act directly on real economic variables. At this point, in order to ensure the necessary liquidity in the banking system and stabilize the markets, it was decided to introduce unconventional monetary programs, which may consist in the introduction of negative interest rates or the emergence of a fiscal role played by central banks. These are not the only unconventional mechanisms, but in the following lines we will focus mainly on the fiscal role played by post-crisis central banks.

Although these unconventional programs were designed to recapitalize commercial banks, to ensure financial stability or to avoid entering a deflationary spiral, the collateral negative effects of these programs have not been carefully analyzed. In the following, I will demonstrate how these programs negatively affect the function of price discovery, especially in the bond and stock market, how they actively participate in keeping alive an outdated structure of production, which does not allow economic readjustment, and how they facilitate the emergence of the phenomenon of economic zombification.

Central banks are becoming the main mechanisms for price control, their activity being much more relevant to the expectations of economic agents than the real fundamentals of the economy. The balance sheet of a central bank becomes the main monetary policy instrument, having the direct capacity to influence real economic variables, even if the interest rate would not be changed.

Given that the transmission mechanisms of monetary policy have stopped working justly, and interbank markets have ceased intermediating the transfer of banking reserves, banks preferring to accumulate them in order to protect against adverse shocks, central banks have decided to assume a fiscal role for the restoration of interbank markets, but also to stimulate economic recovery, and these processes are carried out through the direct purchasing of government bonds and mortgage-backed assets. In other words, the aim is to inject liquidity into those segments of the financial market seriously affected by the financial crisis. They aimed to reduce the long-term interest rate of bonds and MBS, by reducing the relative spread between the yield of these bonds and risk-free rates, participating in changing the composition of portfolios held by economic agents. Basically, they sought to diversify portfolios and expand investment spending in sectors severely affected by capital consumption. These bond and MBS acquisitions were financed by the ex-nihilo creation of reserves, which facilitated the growth of the balance sheets to an unprecedented level. 

Undead markets 

The more stringent the activity of the central bank, the more markets become distorted, prices not reflecting the real fundamentals of companies or states. Thus, there is a moral hazard, in which economic agents no longer have the ability to identify a real investment opportunity or a congruent price, this hazard being translated into an artificial increase in market valuation, a high degree of indebtedness, but also at distorted prices that no longer reflect the economic reality, hence the value-gaps.

Currently, the European Central Bank holds over 35% of the euro area debt in its own balance sheet, the Federal Reserve has an increasing influence in the bond and stock markets, hence the ability to engage in a monetary process through which it will aim to control the yield curve, and the Bank of Japan has become one of the main shareholders in 49.7% of Nikkei 225 listed companies. From these figures, we understand that central banks are becoming the main mechanisms for price control, their activity being much more relevant to the expectations of economic agents than the real fundamentals of the economy. The balance sheet of a central bank becomes the main monetary policy instrument, having the direct capacity to influence real economic variables, even if the interest rate would not be changed. But the problem lies in the lack of a distinction between fiscal policy and monetary policy, the central bank's balance sheet facilitating the fiscalization of the monetary policy. In other words, the central bank becomes active in operations that fall under the jurisdiction of the government, operations related to the arbitrary support of some sectors, the possibility of bail-outs, taking risks in its own balance sheet and so on. These policies are invasive and have a distributional impact. Why? When a central bank makes the decision to become active in a particular sector, such as the financial sector, it offers indirect advantages only to that sector. In other words, these fiscal transactions are not neutral, but any process of easing financing conditions applies only to certain sectors or assets. Through this balance sheet, the central bank enters the sphere of both indirect lending of certain sectors, especially when I emphasize that the balance sheet has the capacity for indefinite expansion, and also in the sphere of indirect advantages. These indirect advantages imply that only certain companies benefit from bail-outs or yield control. This fiscal role requires arbitrary sectorial support. But the problem lies in the lack of cognitive capacity of monetary decision-makers to understand social preferences, these allocative decisions being taken on political considerations. Through these fiscal transactions, some sectors obtained certain advantages, and these advantages allowed the resumption of economic activity in related and complementary sectors. This effect has led to extensive redirections of resources to the main beneficiary sectors, with shortages appearing in other sectors. In this way, as the central bank “cannot solve structural problems in the economy” (Cecchetti, 2012), it can only affect the price system, but also create non-functional markets. But these fiscal transactions “are eroding market disciplines as companies are rewarded simply for being in major market indexes, rather than for having new business strategies or offering more dividends” (Tomita, 2019). The more stringent the activity of the central bank, the more markets become distorted, prices not reflecting the real fundamentals of companies or states. Thus, there is a moral hazard, in which economic agents no longer have the ability to identify a real investment opportunity or a congruent price, this hazard being translated into an artificial increase in market valuation, a high degree of indebtedness, but also at distorted prices that no longer reflect the economic reality, hence the value-gaps.

As mature companies have gained advantages from these fiscal transactions, their market value and implicitly the collateral held will increase, which allows them easy access to finance. But at the same time, small and medium-sized companies were affected by the lack of economic readjustment, the lack of complementarity of the capital structure and implicitly the lack of a real aggregate demand, given the accelerated consumption of capital.

At the same time, by using the balance sheet, we reach the dynamic inflation, the Cantillon effect. Since monetary transactions have a distributional character, we understand that money is not neutral, neither in the short term, nor in the long term, these transactions having non-linear effects on the potential development of markets. Thus, as the balance sheet is directed towards the acquisition of government bonds and mortgage-backed securities, these sectors obtain preferential advantages without demonstrating a productive capacity – “the first beneficiaries receive this new quantity of money, which allows them to offer more money in the market in exchange for goods and services they wish to purchase” (Moreira et al., 2016). In other words, as central banks act directly on the yield of these bonds, and these transactions are accompanied by negative nominal interest rates, states can borrow at zero or even negative costs, which means they can avoid implementing structural reforms and continue to engage in populist spending. 

Winners and losers 

As mature companies have gained advantages from these fiscal transactions, their market value and implicitly the collateral held will increase, which allows them easy access to finance. But at the same time, small and medium-sized companies were affected by the lack of economic readjustment, the lack of complementarity of the capital structure and implicitly the lack of a real aggregate demand, given the accelerated consumption of capital.

Concomitantly, the capital structure affected by the financial crisis continued to be supported through the balance sheet’s expansion. As, immediately after the financial crisis, there was a need for a readjustment of the production structure that would become congruent with social preferences, the implementation of a massive balance sheet and negative interest rates accelerated capital consumption. The direct acquisition of MBS and bonds from financial-banking companies allowed them to avoid economic adjustment and to be able to engage, using the new liquidity, in relatively different transactions, with central banks now assuming higher risks. At the same time, the imposition of negative rates facilitates the artificial support of non-productive companies, hence the negative interest rates “[...] has been associated with rising market concentration, reduced business dynamism, a widening productivity gap between industry leaders and followers and lower productivity growth” (Liu et al., 2019). As mature companies have gained advantages from these fiscal transactions, their market value and implicitly the collateral held will increase, which allows them easy access to finance. But at the same time, small and medium-sized companies were affected by the lack of economic readjustment, the lack of complementarity of the capital structure and implicitly the lack of a real aggregate demand, given the accelerated consumption of capital. The lack of aggregate demand is inherently linked to the maintenance of the obsolete capital structure, facilitated by the existence of negative interest rates, affecting their innovative capacity, but also their marginal productivity.

Thus, over-indebtedness facilitated by falling yields and implicitly by the negative interest rates, excess liquidity and capital consumption, without taking into account the lack of a rational entrepreneurial calculation, will represent disinflationary effects, which will lead to the appearance of a vicious circle, in which inflation expectations fall, forcing a new financial repression, repression that will participate in a new consumption of capital. At the same time, we will see the loss of central bank independence. As the inflation rate reflected by the Consumer Price Index remains low, there will be political pressure on central banks for the arbitrary use of the balance sheets in the direction of political or social programs without a real analysis of costs and benefits. But, although inflation expectations in the Consumer Price Index remain low, inflation is on an upward trend in the financial sector and bond yields. Inflation can be found in the SP500 and in certain ratios, such as the price-per-earnings ratio, which increased steadily from QE1, when it reached 13.47, to 21.46, in Q1 2018. The same increase can be observed in the case of EV/EBITDA, being in a constant increase, from 7.79, at the time of the launch of the first quantitative easing program, to 11.21, in May 2017.

But, since states with structural problems have every interest in issuing bonds, especially in a negative yield regime, we will see the perpetuation of populist spending, which will further delay the implementation of structural reforms necessary for real economic adjustment.

In the case of government bonds, although the deficit in the eurozone increased by 2.3 trillion euros, the fundamentals of the states remained weak. Thus, in the first three months of 2019, six states with a government debt relative to gross domestic product of more than 100% had negative yields on bonds. For example, Italy - 134% debt / -0.349% yield, Portugal – 123% | -0.697% or Belgium-105.1% | -0.809%. At this point, it should be pointed out that when the ECB initiates ex-nihilo deposits and government bonds get a risk-free status, we are witnessing a moral hazard. In other words, government bonds can be used as collateral to obtain loans from the European Central Bank, in the form of a reserve agreement type, ECB “[…] accepts the bond and initiates a collateralized loan with very short term maturity of up to a month” (Bagus, 2012, p. 88), which implies an increase in the deposits of a commercial bank within the ECB. But, since states with structural problems have every interest in issuing bonds, especially in a negative yield regime, we will see the perpetuation of populist spending, which will further delay the implementation of structural reforms necessary for real economic adjustment. Thus, these deficit states will gain a relative advantage, allowing them to “enjoy the old, lower prices” (Ibid., p. 116). As such, “[…] later receivers of new money see their buying prices increase before incomes start to increase” (Ibidem). 

Paved with good intentions 

This is a dynamic inflation, given that this yield was caused by massive bond purchases made by the ECB through its balance sheet. This yield is a direct cause of purchasing programs, with no real demand for them on secondary markets. Thus, with the implementation of negative interest rates, European governments managed to save more than 1.15 trillion euros (Greive & Hildebrand, 2018), with the balance sheet of the European Central Bank reaching 40% of European gross domestic product. This means that the ECB has two options, either to continue the acquisition programs to keep yields low, leading to even greater capital misallocation and stagnation, or to normalize monetary policy, with related high balance sheet losses and economic readjustment. This second situation will readjust the production structure and prevent the emergence of economic zombification. In the context of a liquidity excess, we will see a decreasing return of fiscal operations led by central banks, low demand being inherently linked to the lack of viable investment opportunities, given the lack of structural reforms. In other words, in a negative interest regime, we will see resource allocations in non-productive sectors, the price system being negatively affected.

With the implementation of negative interest rates, European governments managed to save more than 1.15 trillion euros, with the balance sheet of the European Central Bank reaching 40% of European gross domestic product.

And this support of non-productive sectors invariably leads us to lower marginal productivity. Although the main stock indices increased due to dynamic inflation and acquisition programs, unprofitable companies managed to continue their activity, competing with healthy companies for real complementary resources, the latter being drastically affected. These unprofitable companies, usually large companies with valuable collateral, had no incentive to participate in improving the services offered, given the possibility of attracting financing at a preferential cost. Thus, in the euro area, “over the period 2008-2016 labor productivity growth dropped to an average of 0.5% from about 1.5% during the period 2000-2007” (European Commission, 2018, p. 7). As the ability to bring added value in the real economy stagnates, we observe “a decline in the rate of technical progress, an increase in input misallocation, a decrease in business dynamism and highly regulated product and labor markets” (European Central Bank, 2017, pp. 55-64).

Another explanation for the phenomenon of economic zombification would be related to the banking system. The implementation of negative interest rates in the euro area led to losses of about 8 billion euros annually, representing 0.4% or 40 base points of the accumulated deposits of 2 trillion euros. At the same time, even the continued growth of the liquidity cover ratio, which is around 146%, starting with 2014, when it was worth 115%, puts additional pressure on the banking system in the euro area. In 2018 (European Banking study, 2019), return on equity had the value of 7.2%, below the cost of equity, which was around 8%. Since RoE is negative, investors no longer make decisions after in-depth analyses of the fundamentals, but become risk-on and risk-off traders. At the same time, CIR (cost-income ratio) is around 66%, about the same value that it had in 2014. Negative interest rates continue to put pressure on the banking system, on the decrease in profit margin, which can mean a decrease in lending capacity and even retrenchment. At the same time, as commercial banks continue to be the main sources of financing in the euro area, unlike the United States, the continuation of the negative interest rate policy can “erode financial stability” (Arteta et al., 2016). Which means that “[...] from a financial stability perspective, lower margins imply ceteris paribus a weaker ability of banks to build up capital through retained earnings, decreasing their shock-absorbing capacity” (Klein, 2020), invariably leading to an eviction effect for small and medium-sized companies, those already affected by artificial competition for real resources.

In the euro area, “over the period 2008-2016 labor productivity growth dropped to an average of 0.5% from about 1.5% during the period 2000-2007”.

Thus, the banking system suffers, and these negative effects of low interest rates will put even more pressure on it. This phenomenon could also be observed in the first three months of 2019, when the main 50 listed European commercial banks had a negative total shareholder return (European Banking study, 2019), which decreases confidence in the ability of the banking system to have organic capital growth, with the financing of the real economy being drastically affected. 

Conclusion 

After this brief review, we noticed the main negative effects of unconventional monetary policies, which delayed the economic recovery. Although this was the main goal pursued, monetary decision-makers did not take into account the distortion of the structure of relative prices, which provides relevant indications on economic development and implicitly for the rational allocation of resources, but neither accelerated consumption of capital due to the Cantillon effect. Small and medium-sized companies suffer from the lack of viable investment opportunities, and this phenomenon is closely linked to the perpetuation of the outdated capital structure, but also to the distributional aspect of the fiscal policies led by central banks. They have assumed a fiscal role, by keeping unprofitable companies and sectors alive, through indirect lending or bail-outs. The only viable solution is the normalization of the balance sheet of central banks and hence the permissiveness of economic readjustment, the only one that can remove the economy from the state of zombification in which it is currently. This is unlikely given the extraordinary measures being normalized to attend to the economic issues caused by the public policy responses to the coronavirus pandemic. Rather, the distortions will grow even stronger, as will the incentives of its beneficiaries to lobby for their continuation.

References 

Arteta, C., Kose, M. A., Stocker, M. & Taskin, T. 2016. “Negative interest rate policies: Sources and implications”. Policy Research. Working Paper, no. 7791. World Bank, Washington DC.

Bagus, P. 2012. “The tragedy of the EURO”, 2^nd edition. Ludwig von Mises Institute, Auburn, AL.

Cecchetti, S. 2012. “Inside the Risky Bets of Central Banks”. The Wall Street Journal, December 12.

“European Banking Study. Navigating the road ahead – Market trends & strategic options for European banks”. 2019. ZEB Munchen.

European Central Bank. 2017. “The slowdown in euro area productivity in a global context”. ECB Economic Bulletin, Issue 3.

European Commission. 2018. “Labour market and wage developments in Europe”. Annual review 2018. Brussels, Belgium.

Greive, M. & Hildebrand, J. 2018. “Draghi’s low euro-zone interest rates save Germany billions”. Handelsblatt Today. https://www.handelsblatt.com/today/finance/money-for-nothing-draghis-low-euro-zone-interest-rates-save-germany-billions/23581942.html.

Klein, M. 2020. “Implications of negative interest rates for the net interest margin and lending of euro area banks”. Bank of International Settlements. Working Paper, no. 848.

Liu, E., Mian, A. & Sufi, A. 2019. “Low interest rates, market power and productivity growth”. NBER Working Paper, no. 25505.

Moreira, T., B., Tabak, B., M., Mendonca, M., J. & Sachsida, A. 2016. “An evaluation of the non-neutrality of money”. PLoS One, 11(3): e0145710.

Tomita, M. 2019, April 17. “Bank of Japan to be top shareholder of Japan stocks”. Nikkei Asian Review. https://asia.nikkei.com/Business/Markets/Bank-of-Japan-to-be-top-shareholder-of-Japan-stocks.