When interest rates decline and stabilise, financial-market participants tend to take on greater leverage and risk. The challenge for regulators, then, is to prevent those risks from becoming systemic and causing a broader economic crisis.
Capital markets believe that interest rates are indeed on a downward path, for three reasons. First, inflation is moderating in the United States, the United Kingdom, and Europe, and there is even evidence of deflation in China. Second, global economic growth is projected to remain low over the next decade, with growth in advanced economies over the next five years falling to its lowest level in four decades. Moreover, China’s contribution to global demand is set to abate, owing to unfavourable demographic trends such as a shrinking working-age population.
Lastly, many expect artificial intelligence to boost productivity, which could lead to job losses and slack in labour markets. That would cap wage inflation and strengthen expectations of lower interest rates over the long term.
Of course, other factors may still lead to upward pressure on interest rates. Deglobalisation and the return of protectionist trade barriers could push up the prices of many goods and services; and many central banks may be inclined to keep interest rates high to deter governments (especially G7 members) from increasing their borrowing and increasing their fiscal deficits. Finally, though inflation has fallen far from its pandemic peak, it remains sticky above the 2% target in the US, the UK, and Europe.
As matters currently stand, financial-market forecasters are projecting two rate cuts this year in both the UK and the EU. When rates do finally start moving down, investors will reallocate capital, which will have major implications for already elevated asset prices. With the Dow Jones Index and the FTSE 100 (UK) hitting new highs in recent weeks, moral hazard is a pertinent concern. After all, when borrowing costs fall and become more predictable, governments, corporations, and households tend to borrow more. Between 2010 and 2022, when US interest rates were effectively zero, US corporate debt rose 70%, reaching $94 trillion.
Public debt has been on an even more worrying trajectory. In the US, the nonpartisan Congressional Budget Office projects that federal debt will grow from 99% of GDP at the end of 2024 to 116% – a new record – by the end of 2034. This raises concerns beyond fiscal sustainability, because growing government debt issuances may “crowd out” private-sector borrowing and raise everyone else’s borrowing costs.
Lower, stable interest rates also raise the risk of asset bubbles, by creating a “wall of money” in the financial system. As retail and institutional investors borrow more and seek higher yields, they will place ever-riskier bets on speculative assets such as venture capital and cryptocurrencies. And when more cash chases relatively fewer investment opportunities, the result is asset-price inflation. That is why the S&P 500 quadrupled between 2009 and 2021, when interest rates were near zero.
History is littered with examples of higher leverage leading to asset bubbles, and then to full-blown economic crises. This was what led to the 1929 Wall Street crash and Great Depression; Japan’s crisis in the 1990s; the dot-com collapse in 2000; and the 2008 global financial crisis.
In the current context, two areas of regulatory concern are worth mentioning. First, multi-manager hedge funds today are larger, more systemically important, and possibly more leveraged than the funds of 20 years ago. Should a major hedge fund fail, it could have far greater spillover effects than in the past.
Second, the growth of the private credit market in recent years warrants closer scrutiny, since it is well known that leverage has been migrating away from the banking system, where regulators still have direct oversight. Consider, for example, that approximately 69% of mortgages and 70% of leveraged loans in the US are being originated outside of the banking system.
Regulators can take three pre-emptive steps to address these risks. First, they can limit risk-taking by retail investors with collateral requirements on leverage to discourage borrowing and excessive speculation. Second, they can curb institutional risk-taking in the regulated financial system by requiring global systemically important financial institutions to hold more capital against speculative investments. While capital requirements were tightened after the 2008 crisis, we may now need to go further to curb bubbles. There is also an opportunity to update accounting rules to reflect financial realities (for example, replacing held-to-maturity accounting with mark-to-market accounting for banks).
Third, regulators can impose stricter rules on the unregulated (“shadow banking”) segments of the financial system. For example, hedge funds could be classified as “dealers” of government securities, which would subject them to more oversight and transparency rules. This change would echo new rules unveiled by Gary Gensler, the chair of the US Securities and Exchange Commission, in January.
On a more general note, regulators need models that better reflect and replicate the effects of the whole financial sector – both the regulated and unregulated parts – on the real economy. The 2008 crisis showed what excessive risk-taking in financial markets can do to growth and prosperity. A loss of GDP is felt widely across society – whether in the form of rising unemployment or lower tax revenues to fund public goods such as health care and education – and it also harms future generations by undercutting investment in innovation.
The moral hazard of lower interest rates could turn out to be enormously consequential. The fate of the economy – not only of capital markets – is in regulators’ hands. They would do well to get ahead of the next speculative cycle while they still can.
Dambisa Moyo, an international economist, is the author of four New York Times bestselling books, including Edge of Chaos: Why Democracy Is Failing to Deliver Economic Growth – and How to Fix It. This content is © Project Syndicate, 2024, and is here with permission.
59 Comments
I think Demograhics are going to cause huge changes to the western world and china, the aging population will need a different risk profile so the cost of capital is going to be higher for risk , Unless central banks print we may see a higher interest period for some decades
As you age your risk appetite diminishes. The boomers were a relatively large generation, with a greater ability to invest given the economic times they worked in. So the successive, smaller generations with less surplus capital to invest will likely shrink the pool of investment funds.
"You mean, what does the money get invested into? Fixed interest lower risk loans, bonds, that sort of thing."
So you're saying the aging population buy "fixed interest lower risk loans, bonds, that sort of thing" and the institutions then likewise buy "fixed interest lower risk loans, bonds, that sort of thing" so they can pay the aging population a low yield return?
Is that how it actually works, Pa1nter? Seems that something is wrong with that logic.
I'm not following your argument there. I'll try flesh it out:
As you age, your investment appetite for risk reduces.
This is due to the reduced ability to re-save a life's savings when you're in your 60s/70s etc, and also older people's circumstances often have them needing to access their funds more available (as opposed to being tied up in bankrolling some 10+ year venture).
So, instead of putting funds in a high risk, high return investment, they will instead invest in something lower yielding, but with a higher degree of security.
"I'm not following your argument there."
Indeed you are not. I'll leave you with real world experience.
Way back in the 90s I set up two "call centers" to handle responses from the people seeking low risk returns - mostly older people. The call centers would fully manage the fund raising from the very beginning to the end of fund raising process. The process started with someone saying, "We need 100 million to fund a project". The projects could be anything. Some were building projects that most would consider high risk. The products were configured and defined, with the risks underwritten (insured) in various ways. Once the advertising was placed - frequently in low-cost print media where we knew these older, low-risk investors would see them - the call centers went into overdrive collecting money. Minimum investments were usually 10k. Average amounts typically around 100k but often more. Campaigns usually only lasted for two weeks before the 100 million was raised. At that time the fund (or whatever the investment product was called) was closed and the amount raised passed onto whoever requested it.
So when you said, "You also have the potential for a loss of investment liquidity as boomers shift their funds into more conservative assets.", I was pretty sure you really hadn't thought through what you said. (And your subsequent answers make it clear you still don't get it.) Because that is NOT what happens at all. Never has, never will.
Worth pointing out at this stage what IT GUY said:
"the aging population will need a different risk profile so the cost of capital is going to be higher for risk"
But will it? Will the cost of capital be higher for risk?
If we take what Pa1nter said is correct - that the aging generation will put their money into low yielding (but supposedly safe) assets - wouldn't that actually increase the spread between what money can be borrowed at and what it can be lent at? I.e. lots of money happy with very low yields while demand still exists at higher rates?
Wouldn't that situation actually result in a surplus of capital and the cost of capital actually falling further for the same level of risk?
(I've highlighted falling further as this is what has been happening for the last 100+ years.)
No. What I am saying is that for the same risk they'll be little change. (And the cost of capital may actually be slightly less over time.)
That's completely different to what you and IT Guy said.
IT GUY;
I think Demograhics are going to cause huge changes to the western world and china, the aging population will need a different risk profile so the cost of capital is going to be higher for risk , Unless central banks print we may see a higher interest period for some decades
Your response:
You also have the potential for a loss of investment liquidity as boomers shift their funds into more conservative assets.
Sorry. Not engaging further.
What I am saying is that for the same risk they'll be little change. (And the cost of capital may actually be slightly less over time.)
That's completely different to what you and IT Guy said.
Yes, what you are saying is quite different from what we are saying.
Perhaps your first salvo should have been "wait, what do we mean by risk here".
Re ... "So the successive, smaller generations with less surplus capital to invest will likely shrink the pool of investment funds."
What of inheritances? Are you saying governments will start heavily taxing inheritances thereby removing money from the system? Are you saying the money supply will shrink?
Or that the wealth will become more concentrated in the hands of a far fewer number? And those few will ensure the velocity of the money supply will shrink?
Sorry, still not following your logic.
The logic is we had all these boomers, who were numerous, and relatively affluent. Their appetite and ability to chase risk were the investment dollars funding much of the almost exponential growth in technology over the previous decades.
We are unlikely to see the same level of investment in such endeavours in the following decades.
Inheritances are definitely a thing, but are unlikely to be diverted towards the same sorts of high risk moonshot ventures at the same volume as in the past.
The wealth will highly become more concentrated as successive generations' wealth is more weighted towards inheritance, rather than a value accumulated over a working life. Not that that was the gist of what I was trying to convey.
Depends on their age and circumstances.
- some people will live in inherited property.
- some people will use the inheritance to supplement their relatively lower disposable incomes (generation vs generation).
- with longer life expectancies and higher aged care costs, some will inherit less, when they're older themselves, and also be more inclined towards lower risk investments.
1/3 or so of people are likely to inherit bugger all, or maybe even some extra debt.
I don't have a clear breakdown of the constitution of everyone else (i.e. expected age of average benefactor and their personal circumstances). I am only speaking to observed trends and demographics.
Maybe to help me, what are the factors that would make us believe investment funds for higher risk activities would remain constant (or even increase) in the future?
This week's lottery was 50 million. How many people would be thrilled to win just $100k? Almost all I suspect.
Let's pretend that I won a share of that first prize, some $7 million. What would I do with it? Or you?
Would you put the whole $7 million in a low risk, low return fund? Perhaps you would?
With even the most basic financial advice you'd be advised to tier it. Say $500k in a few low risk, low return funds. And then maybe $1m steps up the risk profiles until it was all invested.
Sure, not many will be inheriting $7m. Maybe just $100k?
Perhaps they repay their mortgage? The money goes to a bank who can now relend it.
Perhaps they take out a low risk, low return term deposit? The money goes to a bank who can now relend it, and most likely at a far higher risk weighting as that's where the bank makes their profits. (And as per the winner of the lottery above, they'll almost certainly tier it through the risk profiles.
Perhaps they buy a new car? The money goes to the plethora of people involved in selling and making cars and the raw materials they come from. And those people will spend it.
I could go on and on. But rest assured - most people will spend the money. Very, very little will end up doing absolutely nothing.
But I digress - So let's go back to what you originally said:
"So the successive, smaller generations with less surplus capital to invest will likely shrink the pool of investment funds."
Please do explain why you believe the pool of investment funds will likely shrink?
(There are ways it can. But 'successive, smaller generations' are not one of those ways.)
The lesson is: don't feed the sealions
Perhaps they repay their mortgage? The money goes to a bank who can now relend it.
The money (credit) is extinguished together with the loan contract.
Banks don't take deposits and they never lend money. They are in the business of purchasing securities. When one gets a bank loan, the loan contract is a promissory note. The bank purchases that contract from the borrower. Now the bank owes the borrower money and it creates a record of the money it owes, which we call deposits - source.
LOL. I knew that using "relend" was a dangerous thing to do and I'd get pulled up by people with a greater knowledge of banking.
But, please, I was trying to help someone understand the money-go-round. (Oh dear. I'll get pulled up for that one too.) But saying "relend" is far, far shorter than describing what actually happens ... Maybe something like, "the repayment cancels a security (or part thereof), thereby allowing the bank, given the central bank constructs they must (should) work within, to purchase another equivalent security or spread the capacity to purchase further securities throughout the most profitable risk profiles available to them at that time." Wow. A mouthful and still not the full story. Can I use 'relend' in the future? Or will I get pulled up every time I try to K.I.S.S.?
I'd suggest taking care following Pa1nter. He's awash with folksy wisdom that is frequently wrong.
In this particular instance his - and now your - personal view are contrary to what we're actually seeing happen.
Liam Dann actually has a article in the NZ Herald that relates to exactly this issue.
Will ‘stingy’ Baby Boomers help push interest rates lower? – Liam Dann
It's paywalled but here's a snippet.
Economists (the boffins, not the magazine) had assumed that, in retirement, Boomers would be unleashing their wealth on the world
The Economist cites the classic model – called the “life-cycle hypothesis” – that economists use to plot spending patterns based on demographics.
Developed in the 1950s, it assumes that individuals plan their spending across their lifetimes. They take on debt when they are young, assuming future income will enable them to pay it off. Then they save during middle age to maintain their lifestyles when they retire.
In short, as The Economist puts it, “in old age, they spend more than they earn, funding their lifestyles by selling capital (such as houses) and eating into savings”.
Based on that theory, there have been all sorts of concerns and articles written about a wave of Boomer wealth being unleashed. These have included the prospect of mass selloffs of large suburban homes and rising levels of consumption pushing up inflation and driving up global interest rates.
But new research suggests it isn’t happening and the traditional model is breaking down.
Boomers are still saving.
They aren’t selling their homes or unlocking capital with reverse mortgages at anything like the levels predicted a decade or so ago.
Many are choosing not to retire and to keep working into their late 60s and early 70s.
Their spending and saving behaviour suggests they still live with the burden of financial stress. Or that they feel they do... which might be more to the point.
There’s no doubt inflation has been tough for many older people on fixed incomes. Through the first phase of the pandemic, young people were able to leverage the tight labour market and their job mobility to boost their incomes.
But that phase didn’t last.
Higher interest rates pose less of a problem for older generations; in fact, they boost savings. And the biggest economic risk in a recession is losing your job.
That, too, affects age groups disproportionately. The unemployment rate, at 4.3 per cent, still sits well below the historical average of 5.5 per cent.
But youth unemployment figures typically run at three times the average, according to Stats NZ.
Data out this week from credit agency Centrix paints a stark picture of the generational differences in this tough economy.
“The cost-of-living crisis has not impacted everyone equally, as evidenced by consumer arrears, which are a sign of financial stress,” Centrix managing director Keith McLaughlin said.
A clear divide had emerged since 2022, “a tale of two economies”, he said.
Consumers under 25 were among those hardest hit, as they were more likely to experience cashflow problems and had limited savings to rely on.
But consumers aged 40-49 were increasingly experiencing debt stress, with many having home loan commitments and grappling with higher mortgage rates.
“In contrast, consumers aged 50 and above are faring better, with lower levels of arrears since 2020,” he said.
...
Older generations are not only handling the economic downturn better than younger ones, but it looks like we might actually be in better shape than we were before Covid hit.
Just an aside, that opening sentence is far from correct. Many economists - myself included - never believed "Boomers would be unleashing their wealth on the world". We predicted exactly what we are seeing now. We also predicted - and as this article points out - that the OCR would become less and less effective as a tool for controlling inflation, and a more inter-generationally unfair tool to be using to boot.
It's election year in some countries. Maybe some economies aren't as healthy as they would have us believe.
https://www.zerohedge.com/markets/inside-most-ridiculous-jobs-report-years
Chris,
I stand by my remark. Very low rates will always create moral hazard and it seems somewhat perverse to consider ways of minimising that through much increased regulation, rather than avoiding the issue by not setting rates too low in the first place. We are supposed to learn from our mistakes, not just keep repeating them and then trying-almost certainly with only limited success-to deal with the resultant fallout.
The natural limits of risk vs leverage have already been reached - that is, the ability of the average consumer to pay for their basic needs. Their consumption underpins corporate revenues, affordable interest repayments, and susequent valuations. The average consumer may be screwed, but so is the average corporate; the ultimate parasites detroyed their hosts' ability to support them.
Yeah. It's kind of funny how people forget the interconnection of everything and think they can just keep taking from and endless mountain of debt and when the peasants run out of debt someone else will spend instead.
We are at the point it needs to unravel itself. Which is going to be very interesting to what happens.
The ai thing is similar. So the elite use AI to automate their businesses and cut out the cost of human labour.... but if nobody is paying the workers anymore or lending to them.. who buys the stuff they make.
Crazy world.
It's more of a pyramid than a ponzi.
Although it's initial design assumed more of a funnel shape, because when they rolled it out we had a birth rate that allowed natural population growth, and recipients of super died 10 years earlier.
Basically, there is no provision for future demographic trends. As our birth rate further declines, and lifespans and medical technology increases, the system probably can't exist at all anymore.
If technology manages to supplant most human labour, negating the shortage of the workforce/tax base, most of us probably won't own that technological capital, so will probably be wards of the state or something.
Imagine an economy where there are many good investment ideas, and entrepreneurs are competing for debt and equity. On average, they are able to generate high returns for their investors.
That would result in a high cost of capital, and also that would be a way of rationing the capital to ensure that it went to the most productive ideas.
If existing repayments on debt are no longer able to keep up with the new, higher cost of capital then that investment is no longer productive enough.
I think this is generally a good rule on which to base an economy for productive industries. Problem is, some unproductive industries like investment property want to be seen as a business and get those tax breaks, but also don't want to benchmark their productivity against the market.
Home ownership also gets caught up though, as they borrow from the same pool. Successful economies, including NZ in the past, have got around this by government support e.g. state homes, state advances, lower interest debt.
With Deglobalization and the rebuilding of the manufacturing capacity of the Western World - this means more expensive products. Then the widespread remilitarizing of the West.......Big demands coming, on ever more scarcer resources.
Interest rates are NOT coming down in any significant way and the risk is much, much more to the Upside.
Still more poison being tipped into the NZ Housing Ponzi well!
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