Negative real interest rates, credit crunches and capital flight

Here's some quick research I've done on real interest rates around the world:

The source for this information are two charts published weekly in The Economist (dated 19 September 2008), under the section "Economic and Financial Indicators" (click here, scroll down on the right hand side, and click on Output, prices and jobs for inflation figures. Then click on Trade, exchange rates, budget balances and interest rates for 10 year bond rates).

As you can see from this quick bit of table-creation from Openoffice.org, there are quite a number of countries around the world who are running negative real interest rates.

Negative Real Interest rates occur when the inflation rate exceeds interest rates. In this situation, money loses its value - not just when it is in people's wallets but also in their savings accounts. Anyone who has money stashed away in a savings account is essentially losing wealth, since inflation exceeds the interest paid on these accounts. As a result, money is quickly used either to purchase goods and services or invested in anything that will exceed the inflation rate. This may be shares, or it may be property, or it may be flowers - whatever the market sees as potentially exceeding the inflation rate.

In this scenario, of course, a self-fulfilling cycle begins. Since inflation punishes liquidity, money is used in such a way as to devalue it. Thus inflation begets inflation. Moreover, since investments that exceed inflation become more and more valuable, a "bubble" begins to form. Thus inflation-beating investments beget inflation-beating investments. The end result is an eventual popping of the inflation-beating investment, an increase in liquidity and a drop in inflation - until the cycle begins anew.

This is pretty much what has happened to the US since 2003. As I mentioned before, real interest rates in the US were negative between late 2002 and the end of 2005. This situation has been repeated since 2007 Q3 and continues today. It was during that 2002-2005 period that the housing bubble began to grow. The growth in housing prices exceeded the inflation rate, causing the market to invest in it and inflate it - an inflation-beating investment begetting inflation-beating investments. Now that this bubble has collapsed there has been a rush back to liquidity.

The danger that now exists for the US - and in all places where negative real interest rates are being experienced - is that an economic recovery is now highly dependent upon the creation of new investment bubbles. Since US interest rates have been driven down so low, even those who have rushed to liquefy their investments have placed their money in loss-making accounts - inflation is still eating away at people's bank accounts. The difference, of course, is that bank accounts (and treasury bonds and other "safe" investments) are not declining nearly as fast as shares and property prices.

One of the end results of negative real interest rates - when they have been going on too long - is capital flight. Capital flight is pretty much what I have already described above (people liquefying their investments and putting money into bonds) but is felt in the value of national currency. In other words, capital flight is when investors not only liquefy shares and other assets, but also end up selling the currency and buying another currency that is more attractive.

This process is what hit Asia in 1997 and also created the Russian financial crisis in 1998. In both of these cases, investors not only liquefied their investments but also sold off the currency to invest in something safer (which turned out to be the US Dollar, mainly). In both cases, these nations did not just suffer credit crunches, but also quickly depreciating currencies. In the end they were left with ruined financial sectors and substantial levels of inflation caused by increased import costs. The current accounts of these nations also flipped from deficits to surpluses, since imported goods became expensive and exported goods became more attractive to overseas buyers.

It is important to note that bubbles and busts and credit crunches can still occur when real interest rates are positive. However, since bonds and bank accounts compete more effectively with inflation-beating investments, the bubbles and busts are reduced to "peaks and troughs" - what is know today as the business cycle. The higher real interest rates are, the safer an economy is from internal imbalances like the formation of investment bubbles. But since the world economy is so powerfully linked, "contagion" can still spread from one economy to the next, even if that economy has been running positive real interest rates.

I have spoken before about the potential of a damaging fall in the value of the US Dollar. At the present moment, the credit crunch in the US has led to a liquefying of investments and zero bond yields. Yet America's negative real interest rates, if they remain, will eventually lead overseas investors to ditch the dollar in favour of other currencies (such as the Euro and the Yen). At that point the credit crunch would develop into capital flight and lead not only to a financial crash comparable to the great depression but also damaging levels of inflation (caused by dollar devaluation) that would outstrip any deflationary effects caused by the credit crunch.

If the United States of America were any other nation, the IMF would probably be advising them to make policy changes based upon the Washington Consensus. I see little choice in doing anything else. Central Banks (like the European Central Bank and the Bank of Japan) could use their vast financial power to rebalance any runs on the US Dollar, but I seriously wonder whether such a process would be workable over the long term. Financial austerity is the key to rebalancing the US economy, and I would think that any intervention on behalf of non-American central banks to prop up the Dollar would have to come at a price - that being austerity measures (policy changes based upon the Washington Consensus) forced upon the US by foreigners. Thus foreign central banks would be able to provide the US with financial help in the same way as the IMF and the World Bank would be.

There is a question, however, as to just how much foreign central banks could possibly prop up the dollar without harming themselves. The US is too big an economy to fail, yet it may be too big to help if and when any capital flight takes place. Moreover, with the international community also suffering financially from America's economic meltdown, it may end up being a case of nations looking after themselves first and foremost.

The onus is therefore upon the US to solve its own problems. The Washington Consensus is a good place to start. From this policy should come positive real interest rates, fiscal responsibility and better regulations for the financial market. Moreover, in the face of capital flight, the Federal Reserve has no choice but to raise interest rates to control any resulting inflation.

The alternative to this would be a continuation of negative real interest rates and either the creation of another damaging investment bubble and/or eventual capital flight. This process would ruin the US economy for years to come and bring untold harm upon the international financial system.


Unknown said...

Now I am not an economist, but the linkage of consumer prices and interest rates makes sense to me for a domestic investor but not so much for a foreign investor.

For a foreign investor it seems a relevant question is what is the net return after also accounting for the rise (or fall) of the dollar.


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