ZERO INTEREST RATES ARE WORKING

Bash the Central Banks is a common theme that goes on all the time across various discussion forums and from Economists of different Hades and hues. However the fact is that most of them would not have their jobs and the companies that they work for might have gone down under if the Global Central Banks led by the US FED had not resorted to unconventional monetary measures. The big risk from these measures was that they would lead to an inflation spiral which has not happened in a world that has been deleveraging from very high levels.

The big area in which the zero rate policies as well as QE’s have worked is in reducing the Fiscal Positions of various countries and Governments. For example the borrowing cost for Germany is almost zero today. The 10 year bond trades at 0.1%. The reduction in borrowing costs from over 4% in 2008 to almost zero today has resulted in huge savings in interest payouts and Germany reported the first fiscal surplus last year after 1969. As a result DEBT/GDP for Germany declined from around 75% to 72% last year and will keep on dropping for the next several years. Then comes the story of the countries like Spain, France etc who have been exceeding the deficit targets continuously. If the borrowing costs were not as low the deficits would have been even higher and could have led to another sovereign debt crisis situation as we saw in 2012. Slowly over the next couple of years even these countries will have more advantage of lower borrowing costs which can potentially improve the fiscal positions of these countries too. If we take the example of Spain, it reported a Fiscal Deficit of 4.8% last year and projected to be 3.6% this year. Its 10 yr borrowing costs today are around 1.15%, imagine what the deficit would have been if it had to borrow at the panic levels of rates reached in July 2012 of 7.5%. Many of these European countries have a Debt to GDP of between 90 to 100%. A 1% additional cost of borrowing adds 1% to the overall debt over one year. ECB has bailed out many of these countries from doom.

Similarly for the USA given the fact that low interest rates have also been combined with a recovery of sorts, a combination of higher government revenues and lower borrowing costs led to the Fiscal Deficit being $ 439 billion last year which was at 2.5% of GDP and the lowest since 2007. If recovery continues and borrowing costs remain low then overall deficit will be under control. Spending hikes and tax concessions to boost the economy will lead to an uptick this year as well as going forward. For example due to additional spending and tax breaks the deficit is projected to expand to $ 616 bn this year and be at 2.9% of GDP. This could help sustain growth pickup. If borrowing costs remain low the overall deficit will be more under control and help the fiscal stimulus work. Remember Fiscal Deficit in the USA shot up to $ 1.4 Trillion in 2009.

Low interest rates induced by Central Bankers will help those countries that undertake structural reforms more durably than those which do not. However they are helping all of them as of today and helping hide the structural issues in many of these economies. It is buying time for various governments to act. The key is to see if many will and therefore prevent another crisis a few years down the line.

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