The Consequences of Interest Rate Suppression
Alasdair Macleod

Decades of interest rate suppression have resulted in debt traps in both public and private sectors which will destroy faith in fiat currencies. This leads to higher, far higher interest rates and the escape into gold is only just starting.

Throughout European history, there has been a dislike of interest rates. For the last two millennia this was reflected in Christian (and Muslim) bans on usury. But interest is charged by a lender for good reason. A lender is ceding possession of money or credit to another, losing the facility to turn them into goods for his or her own consumption. That is worth compensation, and economists call it time-preference. And then there’s the risk that the borrower might default on the obligation to repay. That’s worth something as well. The fact of the matter is that the compensation a lender of money is due can only be decided on a case-by-case basis between lender and borrower.

The idea that this is something that should be controlled by a central bank is therefore fundamentally flawed. Not only are central banks wholly unsuited to the task by its very nature, but they act for governments in two important respects. They provide the interest rate background for the pricing of government debt. And in order to ensure tax revenues are consistently beneficial to the government, they attempt to manage economic activity in the private sector.

Consequently, central banks are under political pressure to suppress interest rates at all times. It leads to the most important distortion of all in a modern economy by encouraging the creation of debt for reasons other than its use for productive purposes. The greater the suppression, the greater the distortion becomes. We might be aware of zombie corporations which without continuing cheap debt would not survive, but the problem goes far deeper, distorting the entire economic system of production.

It also leads to a transfer of wealth from saver to borrower, which handily for the suppressing central bank cannot be quantified. And the chief beneficiary of this wealth transfer is the government.

Interest rate suppression tends to disrupt the balance between immediate consumption and savings, because savers are discouraged. Reduce the level of savings and you increase immediate consumption. Increase immediate consumption, and you increase the general level of prices. We can see that interest rate suppression begins to have unintended consequences. But perhaps the most acute problem today is in government debt.

Government debt increases as a consequence of interest rate suppression. That is the consequence of a central bank pursuing the two objectives referred to above. From a government’s point of view, so long as interest rates are suppressed, it becomes free to borrow increasing quantities because the cost of borrowing is suppressed and the funding of ever greater budget deficits is facilitated.

This creates another distortion. The funding of these deficits comes at a time of a diminishing propensity to save, due to the suppression of interest rates. Government debt becomes increasingly funded by the creation of new credit, rather than tapping into the savings pool, which is the recycling of existing credit. Inevitably, this dilution of the currency leads to a falling purchasing power of the unit in which all credit is denominated. And a declining purchasing power leads to a tendency for interest rates to rise as faith in the currency’s value declines.

Out of interest rate suppression, subsequent rises in interest rates become inevitable.

Another far larger and ultimately destructive problem arises, which we must take an effort to understand. In a model free market economy, there is a balance between savings and consumption reflected in productive debt. But for each unit of debt, there is a corresponding credit. And being transferable and therefore capable of being valued, credit is wealth. Therefore, in our free market model, there is a balance maintained between the productive capacity of an economy and the wealth of economic actors. But government spending is unproductive and therefore not part of this balance.

Government spending is unproductive because it takes income and profits from production which would otherwise be reinvested in production and the consumption of it, to redistribute them in a manner dictated not by genuine economic demand but by political priorities. If this destruction of productive activity is kept within reasonable bounds and governments always balanced their budgets, there is enough dynamism in free markets to absorb the economic cost. This was broadly the situation in the nineteenth century until the First World War. It changed during the twentieth century as socialism spread. Government debt began to expand at an ever-faster pace as well.

Following the abandonment of Bretton Woods, the last fig-leaf of discipline on government finances was removed. The financialisation of markets in the mid-eighties diverted economic resources from production in favour of debt creation for non-productive purposes. And because debt is matched by credit which in turn is valued as wealth, financialised economies became debt-driven instead of production driven. And the lower interest rates went, the greater the value of this credit and the wealthier we became.

Both borrowing governments and borrowing consumers, the two most obvious categories of unproductive debt utilisation, tend to tolerate a certain level of interest cost. The neatest example is in the housing market, where buyers think in terms of mortgage affordability rather than price. Suppress interest rates, and larger mortgages become affordable.

This means that a lower interest rate simply leads to increased borrowing. It fed into a debt bubble and therefore a wealth bubble which only stopped inflating when interest rates hit the zero bound, with some even going negative — the ultimate suppression. They could be suppressed no more. But debt has continued to grow to pay for budget deficits and higher interest costs post-covid; only its value as wealth is declining. For example, the US Treasury 10-year note has declined in value by over 30% since mid-2020.

The debt trap outcome

The Fed was forced to raise interest rates when the inflationary consequences of the wealth bubble began to undermine the dollar’s purchasing power. In terms of time preference, higher rates compensate holders of dollars for the loss of purchasing power and to dissuade them from selling them. In previous interest rate cycles, the creditworthiness of dollar debt didn’t become destabilised, admittedly with a bit of help from the authorities. But the debt problem has become too great today, with the government itself firmly ensnared in a debt trap.

Foreign holders of US Government debt will be nervous of interest not being paid but continuing to roll up. It is no longer a simple time preference issue but has become one of likely default. For this reason, inflation watchers are monitoring the wrong metric. They should ask themselves what level of interest will compensate lenders to the US Government for an increasing risk of default.

Answer that question realistically, and you realise that there is no level of interest rate which will compensate a holder of US Government debt for the risk. That is the essence of a debt trap.

The US Government has the solution in its own hands. It must stop running budget deficits and maintain sufficient surplus to stabilise the situation. This action must be implemented soonest. Do this, and existing debt will maintain credibility and therefore preserve the confidence of its holders.

Unfortunately, the political class has no intention of addressing this problem. Unless it does, it is absolutely certain that interest rates will continue to rise, even beyond the highest levels in the dollar’s history as lenders refuse to cover lending risk and even try to sell their existing exposure. In the parlance of the market, US bonds will rapidly become offered only.

All those borrowers in America’s private sector tricked into taking on debt at suppressed interest rates will have a similar problem to that of their government. And foreign governments who have also been duped by their central banks’ suppression policies face the same fate, along with their hapless citizens.

At this point in time, with no governments seemingly aware of their debt traps and even their central bank agents being hardly attuned to the danger, the dollar-based fiat currency system is heading for a collapse in the value of all credit. And those who are increasingly aware of the problem are foreign holders of dollars and dollar denominated debt.

That’s why they are buying gold and will progressively refuse to buy more dollar debt. It is the monetary escape from the loss of faith in dollar credit.

 

 

Alasdair became a stockbroker in 1970 and a Member of the London Stock Exchange in 1974. His experience encompasses equity and bond markets, fund management, corporate finance and investment strategy. After 27 years in the City, Alasdair moved to Guernsey. He worked as a consultant at many offshore institutions and was an Executive Director at an offshore bank in Guernsey and Jersey.

 

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