Terra Firma

What drives markets in the end are fundamentals, and few variables are as important as the real interest rate – the return after inflation on relatively risk-less assets. It determines one part of the return on savings, and it feeds through into the relative price of debt versus equity. For the first half of this d vecade – after the crash of 2000 – real rates have been close to zero (and even at times below zero). As a result there has been a boom in consumer spending, a dash-for-debt, and a rapid increase in asset prices, notably housing. The growth of private equity and infrastructure funds is also partly explained by this phenomenon of low interest rates.

Now that era appears to be coming to an end – with major implications for financial markets, some of which are already spreading out from the US sub-prime market.

Why real interest rates were so low in the first half of this decade

When historians look back on the first half of this decade, they will seek explanations for why interest rates have been so low. The premature declaration of the death of inflation may be one factor, as might excess savings in the Middle East and China, but looming over the period is the 2000 crash in financial markets with the bursting of the dot-com bubble, and the reaction of policy-makers. The irrational exuberance of the 1990s gave way to the prospect of a global recession, and the policy response was to sharply lower interest rates and to run bigger government deficits (through lower taxes, in the US, and higher public expenditure, in the UK).

A classic Keynesian boost to spending followed, and it was indeed very successful in staving off the threatened recession. And, contrary to previous such experiments (notably in the 1970s), it did not bring forward inflation. It seemed that for once governments and consumers could indeed spend their way out of recession.

What resulted from zero real interest rates

What followed was a textbook response by both consumers and financial markets. Consumers engaged in a massive spending spree, using their plastic credit cards with a previously unknown enthusiasm. And it helped that there were both new things to spend their money on, new ways to do this, and for very separate reasons, lots of cheap imports available.

The coming of budget flights and the turning of all those new technologies developed in the 1980s and 1990s into consumer products such as iPods, digital cameras and the like created new opportunities for spending. The Internet provided a more efficient way of shopping, and the growth of Chinese and other low-cost exporters kept a lid on inflation – as did large-scale immigration of cheaper labour.

Cheap money, low returns on savings and the economic growth (which was the counterpart to higher spending) created its own virtual (or vicious depending on the time perspective) spiral. It seemed as if the economy was in a ‘Goldilocks’ phase: optimism about economic growth meant that people assumed that they would be richer in the future, and hence had less reason to save. And indeed, to the extent that they thought they were saving for their old age, it was in their houses. In the UK especially, house ownership comprises a significant proportion of household wealth. Cheap mortgages meant the real costs of house ownership had fallen. Hence higher prices could be afforded – as long as the interest rates stayed low. There followed an enormous house price bubble.

The dash-for-debt in financial markets

It took some time for financial markets to react, and at first it was in the traditional areas, such as the re-pricing of bonds. However, as the low real interest rates persisted, some came to believe that they were permanent – that the combination of the death of inflation, the surpluses of China and the Middle East, and financial liberalisation had together changed the paradigm. This meant that debt might be cheap for ever.

Such a fundamental change in the relative price of debt encouraged borrowing in financial markets on an altogether unprecedented scale. Debt markets provided almost unlimited sources of finance for acquisitions, and the private equity firms were not slow to grasp the opportunity. Eventually almost anything could be bought on the basis of debt. Banks and other financial institutions fell over each other to channel the excess liquidity in international markets into the new champions of the financial markets – private equity and hedge funds. Even governments got in on the act, with the Chinese investing directly in Blackstone and a number of Middle Eastern rulers creating their own investment funds.

As with all such major movements in financial markets, excess tended to follow rational decisions. As the initial returns looked high, other less well-informed players jumped in, anxious to join in the feast. Pension funds, whose equity-based portfolios had been battered in the 2000 crash, focused on ‘alternative assets’ and private equity became a larger part of their investment portfolios. Not surprisingly, whilst some private equity investors did very well, there developed a long tail of under-performers.

The financial markets themselves differentiated the products. Specialist infrastructure funds emerged, focused on transport and utilities. These funds had a particular rationale. Not only was debt cheap, but regulated utilities had very considerable protections which in effect passed a large amount of risk (including inflation) through to customers. They were, it was argued, particularly suitable for high gearing. In this category, water companies and airports have been the major targets, to the extent that many (if not most) are now highly geared.

On the back of these more sophisticated vehicles, there has been a boom – perhaps even another ‘irrational exuberance’ – in plain old-fashioned lending, notably in mortgages and consumer credit. The mystique of ever more complex financial instruments which gave the illusion that risk had been dissipated has underpinned the mortgage lending, and it is not surprising that the sub-prime market has been the first to experience the consequences. Whilst some may fool themselves that risk can be magicked away through financial alchemy, it never is – and even if diversification mitigates exposure, diversification cannot abolish systemic risk. Banks periodically act like lemmings and, like lemmings, their history is littered with over-optimistic lending. There is no good reason to suppose they have, or will ever, learn the lessons of that chequered history.

What will happen as real rates return to normal?

In the long run, it is hard to imagine that real interest rates can remain at, or return to, near zero. There is a strong tendency to revert to the mean – and historically that mean is probably around 2%. So markets may have to get used to the idea that having lived with very low interest rates – and adjusted to them by borrowing and raising the price of assets – they now need to cope with the reverse. The period 2000-05 may turn out to be the historical exception, not the rule.
For consumers, it could be very painful. In the end, houses have to be afforded – the owners need to pay the interest and the next generation will have to be able to afford to buy them. If the real interest rate goes up, then prices fall – unless incomes rise to compensate or there is scarcity. A correction looks inevitable, and just as rising house prices have led to higher spending and lower saving, the reverse could occur – perhaps even undermining economic growth. Rising interest rates take up more of household budgets, while falling house prices make people more pessimistic about the future and they consequently spend less and save more.

In financial markets, the rise in the cost of debt might make a number of highly geared structures look very vulnerable, for they have little by way of an equity cushion to absorb the shocks. The delusion that somehow equity risk might have gone away may well come home to haunt some of the players.

In the long run it is good news for investors. A higher real interest rate means a higher return to investors. But the transition could be painful. Markets rarely correct for changes in the fundamentals in a smooth and measured way. And since there are ever more complex and sophisticated financial instruments in play, which many fail to fully understand, it could be a rough ride – even an old-fashioned credit crunch – but ultimately risk will not prove to have gone away, and there will be losers as well as gainers.


Dieter Helm, Professor of Energy Policy, University of Oxford & Fellow in Economics, New College, Oxford

Dieter Helm is an economist, specialising in utilities, infrastructure, regulation and the environment, and concentrates on the energy, water and transport sectors in Britain and Europe.

© Dieter Helm