Growth on credit

It’s enough to take your breath away. The global economy is facing an unusually high number of risks by historical comparison. However, the markets seem unaffected as they continue to reach new heights. Moreover, according to the IMF’s latest report, the upturn covers almost every region in the world. The German Council of Economic Experts even sees signs of overheating in Germany, says Dr. Klaus Wiener, Chief Economist of the GDV.

As welcome as the current situation appears, it also raises the question of what is driving this surprisingly strong upturn. One source is energy prices, which have fallen dramatically since 2014 and boosted the economies of oil-importing countries with the same vigour as an extensive stimulus package. The recovery of lost ground following the biggest crisis in recent economic history is another contributory factor. Uncertainty made investors extremely cautious well into the post-crisis years.

Capital market rates have fallen to extreme lows
There is yet another growth driver, one which outstrips all the others: interest rates, also known as the biggest monetary policy experiment in recent history. The major central banks in the West responded to the national debt and financial crisis with an extremely loose monetary policy. As a result, capital market rates have also fallen to extreme lows and settled there. Ten years after the onset of the crisis, real interest rates remain at rock bottom. Take the US, where the economy has been growing for nine years and is now at full capacity, while the real money market interest rate is very much in negative territory at just above minus 1.0 percent, in spite of four key interest rate increases.

It’s even more extreme in Europe. As the key interest rate is still at zero, the real money market interest rate is minus 1.8 percent. If you factor in the European Central Bank’s (ECB) bond purchasing programme and calculate the real interest rate on the basis of the shadow rate, it is actually well below that figure. Against this backdrop, the galloping growth in the Eurozone is hardly surprising, especially in Germany where the crisis has long since been consigned to the past.

The GIIPS countries saw long-term real interest rates fall
The interest rate-driven boom is reminiscent of the convergence spell prior to and after the introduction of the single European currency. That is not a fond memory: real interest rates plummeted in those countries that subsequently fell into crisis. The GIIPS countries (Greece, Italy, Ireland, Portugal and Spain) saw long-term real interest rates fall by an average of about 6.5 percentage points from 1995 to the end of 1998. This unleashed an economic boom that was even stronger than the one we are currently experiencing.

In Spain, average annual growth measured by real GDP development was 3.6 percent between 1999 and 2008. In Greece it was 3.5 percent and in Ireland growth even reached 5.4 percent. The boom in those countries was driven by interest rate-dependent components of demand, particularly construction. For example, 700,000 new apartments were built in Spain during that boom, more than in France and Germany combined.

During that growth spell, structural challenges including a lack of innovativeness, low productivity growth and poor international competitiveness in terms of price were entirely overlooked due to the surging economy. These fundamental deficits really needed to be addressed following the monetary union. However, the opportunity presented by the favourable interest rate environment just fell by the wayside.

It is unlikely that the interest rate situation will change abruptly
Coming back to the current situation, it is unlikely that the interest rate situation will change abruptly. At the same time, it’s inconceivable that rates will simply stay this low; recent comments by Jens Weidmann, President of the Deutsche Bundesbank also support this position. Once interest rates start to rise again, if not before, it will become clear that most of the current growth is premature: growth on credit.

An interest rate hike, which could well be pronounced according to a recent study by the Bank of England, could therefore trigger a much stronger economic backlash than would be the case if monetary policy were to remain in crisis mode for a shorter duration. The current low interest environment must not go on too long or else growth may get too far ahead of itself. The reduction in ECB bond purchases at the start of 2018 is a small initial step in that direction. Nonetheless, the monetary policy change still needs to come quicker than currently scheduled to maintain stability in economic growth.