Low interest rates are often a cure. Now they’re also a symptom.

Mark Makela/Reuters/File
Consumer spending has held steady in the United States, despite signs that a global recession may be on the horizon. A strong job market has bolstered the confidence of many consumers at places like this Prussia, Pennsylvania, shopping mall seen in December 2018.
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Recession alarm bells are ringing around the world. From Europe to Asia and Latin America, signs of economic weakness have emerged or worsened recently.

For decades, an inverted yield curve, when shorter-term bonds yield a higher interest rate than long-term ones, has been seen as a likely recession indicator. Perhaps, in this era of ultra-low interest rates, an inversion in the United States this week isn’t the danger signal that it used to be.

Why We Wrote This

Warning signs of recession often spur quick-fix policy solutions to jump-start the economy. But perhaps a look at the endemic circumstances that have brought the world to this point is in order.

Still, it’s a fragile time, with some large economies such as Germany and Britain possibly in a recession or near it. One safety valve would be for the U.S. and China to resolve their trade war. Another, beyond mere central bank stimulus efforts, could be infrastructure investment that helps for the long run as well as right now.

“I think there are huge distortions in the distribution of income that explain the low interest rates and weak [consumer] demand” globally, says economist Michael Pettis in Beijing. One distortion is high income-inequality worldwide, he says. The second is some nations’ focus on exports, which also leaves consumers with less money to spend.

Recession indicators are blinking worldwide, with financial markets rattled this week by bad news from all corners: Germany, China, Argentina, and even the United States, where bond interest rates “inverted” in what many see as a signal of economic trouble ahead.

But the worry runs deeper than that uncertainty. 

For decades, an inverted yield curve, when shorter-term bonds yield a higher interest rate than long-term ones, has been seen as a likely recession indicator. What’s different this time is that interest rates on all U.S. Treasury debts are so low that there’s little room for the Federal Reserve to deploy interest rate cuts to stave off a recession.

Why We Wrote This

Warning signs of recession often spur quick-fix policy solutions to jump-start the economy. But perhaps a look at the endemic circumstances that have brought the world to this point is in order.

“Monetary policy I think is impotent” in the current environment, says Gary Shilling, who heads an economic forecasting firm in Springfield, New Jersey.

Ultra-low interest rates have become a feature of the world economy since the Great Recession. It’s a conundrum that few view as benign, and the coming year could test whether the global economy can weather hard times amid financial conditions for which there is little precedent.

In much of Europe, for example, interest rates on public debt have actually been negative for several years – forcing savers to pay a fee to lend (or store) their money. Recession or not, policymakers seem engaged in a kind of perpetual war to keep economic growth afloat.

“Some of the recession fears are a little bit overblown in my view, but that’s not to say that we’re complacent about the risks,” says Tim Quinlan, a senior economist at Wells Fargo Securities in Charlotte, North Carolina. “Perhaps the overlooked risk – and nowhere is this more pronounced than in the United States – is that the ability of government to have a robust response either through fiscal spending or a central bank ... is limited.”

Susan Walsh/AP/File
U.S. President Donald Trump shakes hands with Chinese President Xi Jinping during a meeting on the sidelines of the June 2019 G-20 summit in Osaka, Japan. China and the United States have been locked in a trade war that is battering exporters on either side of the Pacific and threatening to tip the global economy into recession.

And that challenge leads back to the conundrum: Why have interest rates become so unusually and persistently low in major economies worldwide, rain or shine? Economists aren’t sure, but some say restoring more normalcy in global finance may hinge on addressing deeper structural challenges, from high debt levels and imbalanced trade to wide inequality of incomes.

The hopeful view is that recession can be averted, or be mitigated where it crops up. Perhaps, in this era of ultra-low interest rates, the inverted yield curve isn’t quite the danger signal that it used to be, Mr. Quinlan and others suggest.

Red flag or “silly talk”?

Recessions often happen partly because central banks tighten monetary policy too much, boosting short-term interest rates. Meanwhile long-term rates decline as real-world investors see warning clouds and buy bonds. The result is an inversion of bond rates for a time, before central banks start slashing their short-term lending rates to offset a downturn.

On Wednesday, the U.S. bond market inverted with the 2-year Treasury note yielding more than the 10-year Treasury note. Economists are closely watching how long that situation will last. The past three times the bond market endured a sustained inversion, recession followed within about a year.

Yet global economic data lately haven’t been entirely bad, especially in the linchpin U.S. economy. And the Federal Reserve has recently reversed its monetary stance, cutting its short-term lending rate in July for the first time since the Great Recession. More rate cuts are expected to follow.

“The bond market is distorted by what’s happening outside of the U.S.,” Mohamed El-Erian, chief economic adviser at the insurance firm Allianz, said in a CNBC interview this week. He dismissed concerns about a U.S. recession as “silly talk.”

But it’s a fragile time at best. Nations worldwide are worried about the fallout from unresolved trade tensions between the U.S. and China. And a number of nations already appear to be possibly in a recession or near it. 

  • In Europe, the export-oriented German economy shrank 0.1% in this year’s second quarter. Growth was almost nonexistent in debt-troubled Italy. Russia is tottering. And the British economy contracted by 0.2% amid worries about its looming breakup with the European Union.
  • In Latin America, Mexico and Brazil are struggling. Argentina is in a full-scale crisis as a projected populist swing in coming elections raises the prospect of a default on debts.
  • In Asia, China may turn to stimulus policies to sustain growth, although its economy isn’t yet near a formal recession. The economy of trade-reliant Singapore contracted in the second quarter. South Korea has cooled dramatically.

Can the slide be reversed?

One key to turning all this around, many say, is for the U.S. and China to find a positive resolution to their trade differences. President Donald Trump this week announced a postponement of a planned expansion of tariffs against Chinese imports, so that toys, clothing, and cellphones would remain unaffected through this holiday season. But the uncertainty remains whether the two sides will reset trade relations, or increasingly decouple. 

Ralph Orlowski/Reuters/File
Employees of German car manufacturer Porsche work on a Porsche 911 at the Porsche factory in Stuttgart-Zuffenhausen, Germany, Feb. 19, 2019. The export-oriented German economy shrank 0.1 percent in this year’s second quarter.

The other obvious steps would include central banks easing monetary conditions, or governments using fiscal policy, such as new spending or tax cuts to spur more consumer and business activity.

The bandwidth in many nations is limited. The U.S. has already enacted a big tax cut under President Trump, for example. But that doesn’t mean there’s no room to act. 

Mr. El-Erian and others say this moment – with low government borrowing costs and the economy needing a boost – could be a perfect time for infrastructure spending, which can help in both the short and long term.

That idea connects back to the larger conundrum. 

Ultimately, the lesson may be that getting out of the cycle of abnormally low or even negative interest rates is about more than just stimulus. It’s about how to create lasting healthy progress for the world economy rather than a bandages-and-duct-tape kind of growth.

“If the US borrows money to invest in infrastructure, education, etc., or to redistribute wealth in ways that increase economic efficiency, and if that causes the total value of goods and services to rise by that amount, then there is indeed no limit to the ability of the U.S. to borrow,” says economist Michael Pettis, a professor of finance at Peking University, in an email interview. 

But if a nation is perpetually adding to its debts without boosting its gross domestic product (its ability to finance those debts), then there are limits to borrowing, he argues. That’s the case even if the central bank is willing to keep printing money, since the value of that money will decline unless it’s backed by the nation’s real productive capacity.

A broader challenge

As Professor Pettis sees it, the world of low rates has been enabled by more than just rising public debts and unconventional central bank policies.

“I think there are huge distortions in the distribution of income that explain the low interest rates and weak [consumer] demand,” he says. “The first is high levels of income inequality in all the major economies. The second is what are effectively ‘mercantilist’ policies in ... countries like Germany, Japan, China, etc., in which hidden transfers from the household sectors [are subsidizing exports, and] leaving the household share of GDP relatively low.”

Inequality and trade imbalances have gained attention as global economic concerns in recent years. Professor Pettis thinks those two are linked in the way they’re affecting global economics. He argues the two distortions have a parallel effect: They both transfer income from ordinary households – people who spend most of their earnings – to lower-consuming sectors (the rich, businesses, or local governments).

Financially healthier households, by contrast, could actually fuel solid growth, as rising consumption gives the impetus and confidence for more investment by businesses. 

Some other analysts see similar concerns. 

“If you look around the world, we have basically the same structural problems. We’re extremely over indebted. The debt is delivering diminishing returns,” says Lacy Hunt, an economist at Hoisington Investment Management in Austin, Texas. “Manufacturing sectors around the world I think are already in recession.” 

No one is discussing how to reduce debt levels as a share of advanced economies, he adds. And with a negative interest rate, “the economy may respond transitorily,” but Mr. Hunt argues a decline in savings “quickly controls the situation” for the worse.

Mr. Shilling, in New Jersey, worries that a recession may already be underway even in the U.S., given the way official data can be shaky during turning points in the economy. While most economists disagree, forecasts for growth have been declining globally in recent months, and many forecasters see a strong likelihood of recession in either 2020 or 2021. 

Longer term, Mr. Shilling is hopeful that the low-rate, low-growth conundrum will end. Perhaps more people staying in the workforce past their traditional retirement age will help the economy grow.

“I’m not as convinced as many,” he says, “that we’re in a slow growth environment forever.”

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