Of monetary economics, zero interest rates and Islamic finance


THE INTEREST rate is the compensation paid for the use of money. In neo-classical economics, the prevailing rate of interest is the rate that balances aggregate savings and investment.

Like all other goods and services that have an equilibrium price balancing demand and supply, the interest rate is the equilibrium price of money.

Since interest rates, being a price, is negatively correlated with the demand for capital, falling interest rates ought to see increased demand for capital to be invested.

Current reality defies this logic. Nominal interest rates in much of the developed world is at or near zero. In Germany, Switzerland and Japan bond yields are negative even out to 10 years and beyond.

An estimated US$15 trillion (RM63 trillion) worth of outstanding bonds are yielding negative rates. An NBER paper argues that real interest rates for low-risk assets that fluctuated around 2% for almost a century has now fallen, particularly in advance economies.

There now appears to a clear dichotomy, whereas rates are near zero or negative in the advanced economies, second-tier nations like Russia and China have rates in the 5% to 7% range. Yet others, like Turkey, still have double-digit rates.

That interest rates in the advanced nations would be similar is to be expected given the extensive capital flows. Free capital flows will arbitrage rate differentials among countries of similar risk profile.

That also implies that domestic monetary policy independence is largely a fiction in the absence of some capital controls.

So, if the uniformly low-interest rates in the first world is a consequence of financial market integration, the cause, however, is the addiction to monetary looseness, particularly of the US.

Even if it was the political expediency for growth that necessitated the constant monetary stimulus, it was the central banks that were behind the rate cuts.

Not surprisingly, the US, the world’s biggest debtor nation and the biggest potential beneficiary, was the initiator of these cuts.

The Greenspan years being the most notorious. The near absence of inflation which used to be the control against monetary looseness enabled the sustained rate cuts.

Yet again, another lynchpin of monetary economics, the trade-off between monetary expansion and inflation appears to have crumbled.

The near-zero interest rates have created a bond market bubble, fuelled stratospheric stock valuation and created a massive build-up in private and public sector debt.

More importantly, as with all misaligned policies that lead to perverse incentives, companies have been incentivised to borrow in order to repurchase their stocks and payout higher dividends.

The objective being to alter their capital structure through leverage and thereby increase firm value. From a macroeconomic viewpoint, such activity effectively hollows out corporations and results in a negative externality to society.

Pension fund and insurance industries that need positive yields to meet their future obligations are being decimated. Policy induced distortions and the resulting cracks are beginning to show.

Despite these costs, the expected economic relationships have not held up. The demand for capital and investment which is supposed to increase with falling interest rates, has not happened.

Much like the body getting desensitised to a medicine with extended use, investments now seem desensitised to rate decreases.

Monetary policy is now clearly pushing on a string. For governments with huge debt obligations, this is not necessarily bad as they certainly have the incentive to keep interest rates artificially low through financial repression.

There are two ways to think about this. The pessimistic view would have it that the seeds of the next crisis have been sown and we are being set up for a fall. The monetary lever is now unusable and public debt leaves little wiggle room with fiscal policy.

The optimistic view would argue that we are now in a new normal where even without the friction of interest rates, economies need not skid.

Thus, life goes on as normal in Germany, Switzerland and Japan even with zero and negative interest rates.

All of these begs the question of how really important are interest rates? The perception created in monetary economics that interest rates are at the core of everything may not be true anymore.

Critics of Islamic finance who fail to see how an interest-free system could work, ought to take note of contemporary realities.

In many ways, an unintended consequence of the monetary looseness may be the vindication of Islamic finance as a sustainable alternative.

Prof Dr Obiyathulla Ismath Bacha is the professor of finance at the International Centre for Education in Islamic Finance. The views expressed are of the writer and do not necessarily reflect the stand of the newspaper’s owners and editorial board.