Low interest rates cast a long shadow

When the financial crisis of 2008/9 threatened the stability of the financial markets, triggering a worldwide plunge in economic output and mass lay-offs, the major central banks responded by slashing interest rates. Eight years ago, the key interest rate in the eurozone was still 4.25%. From autumn 2008, it slid to just 1% in the space of 12 months. It has now reached zero. At that time, no one predicted that this would mark the beginning of a new era in monetary policy. Previously, economic crises had always been followed by an upswing justifying higher central bank interest rates. Not so this time, however: the inflation rate remained too low and interest rates continued to dwindle. The longer interest rates languish at these low levels, however, the greater the fallout and the stronger the redistributive effects.

What began with interest rate cuts in autumn 2008 turned out in the following years to be the biggest monetary policy experiment undertaken in the history of the European Central Bank (ECB). In the subsequent months, the key rate was further reduced several times and various measures were launched to assure the liquidity of commercial banks and to set up the “quantitative easing” programme. In July 2012, ECB President Mario Draghi pledged in a much-cited speech that he would “do whatever it takes to save the euro”. This allayed fears that several states would leave the currency union and the risk premiums on government bonds of peripheral eurozone countries also fell considerably. In autumn 2012, the ECB Governing Council additionally announced a comprehensive programme for purchasing government bonds of euro countries, known as the OMT programme (outright monetary transactions). Although the announcement was never implemented, it sparked fierce controversy. Since 10 March 2016, the key interest rate in the Eurozone has remained at zero. In other words, the ECB lends commercial banks as much short-term money as they want – at no cost. According to an ECB decision of March 2016, a 0.4% penalty is charged on money deposited with the ECB. Every month, the central banks of the eurozone additionally purchase bonds worth around €80 billion. The plan is to continue buying up bonds until March 2017 at least. At the same time, the ECB also resolved to supply commercial banks with low-interest liquidity for a term of four years. As a result, German bonds with a term to maturity of up to eight years generated negative interest at the end of March 2016. A hitherto seemingly unshakable principle has thus been reversed: creditors are no longer always rewarded for lending money. Borrowers need not always pay to take out a loan. On the contrary: they themselves are being paid for taking out loans, thus more or less compelling them to do so.

Since this is a monetary policy experiment, no empirical data is available to the central banks. Comprehensive scientific surveys have only been conducted in recent years. What is undisputed is that declining interest rates are leading to a redistribution of wealth, regardless of the cause of the decline. In theory, a distinction is made between the various possible ways in which low interest rates can encourage or reduce inequality. Conceivable effects include redistribution between states, financial market investors, companies and private households. In the case of private households, low interest rates can lead to a distortion and redistribution of income, assets and future consumption. However, it is very difficult to document and appraise such redistributive effects on the basis of data, as the effect of monetary policy is frequently very indirect. What‘s more, long-term trends are also involved and there are no cases for comparison. By way of example, no one knows how income and assets would have developed since the financial crisis of 2008/9 without the intervention of the ECB.

One party in particular clearly profits from the low interest rates: the state. Approximately four-fifths of all government bonds in Germany earned negative interest in mid-April 2016. Whoever lends the government one hundred euros today will receive less than a hundred in ten years’ time, adjusted for inflation. The low interest burden which has prevailed for several years now is one of the reasons for the good budgetary situation (see Fig. 2). In other words, wealth is redistributed between the state and the owners of government bonds with the result that private savers with life insurance policies or company pension schemes, for instance, lose out.

Finance ministers in other eurozone countries benefit from an even greater interest rate advantage. The reason is that the differences in interest rates (spreads) between government bonds issued by states with a high credit rating and those with a low credit rating have also declined. This also explains why countries with a lower credit rating such as Spain and Italy are often accused of profiting disproportionately from the ECB policy. Although countries with a high credit rating such as Germany, Austria and the Netherlands also benefit from lower interest rates, they are also liable for the risks assumed by the central bank as a result of purchasing higher-risk securities. Redistribution mechanisms consequently also operate between eurozone countries. Since low interest rates can reduce the pressure to introduce reforms, they could even prove injurious to the national budget in the longer term. For instance, if much-needed structural labour market reforms are not undertaken, the long-term burden for the tax system could prove greater than the short-term relief afforded by lower interest charges.

The impact of central bank policy can vary depending on the composition of household income from different sources. An expansionary monetary policy often goes hand in hand with rising asset prices. The mere announcement of further reductions in interest rates or purchases of securities by the ECB frequently leads to rising stock and bond prices. The effect of loose monetary policy on the real economy often only emerges much further down the line. In the short term, people who derive a significant portion of their income from capital invested in stocks and fixed-interest securities, for example, will therefore profit more from price rises in these two asset classes than wage or salary earners without any noteworthy investment income. However, the net effect is difficult to gauge, as our globalised financial markets are also driven by more remote developments such as the fears of a Chinese hard landing in January 2016. Many other sectors profit to varying degrees from low interest rates. Wages and salaries do not develop uniformly, which can have a redistributive effect on household incomes. Conversely, however, an expansionary monetary policy can also soften an economic downturn and thus significantly reduce the growing disparity between incomes. This is because low-income households tend to be among the first to be hit by unemployment during a downturn. Since the ECB’s monetary policy measures have presumably saved jobs which would otherwise have been axed, earners of low wages are likely to have profited most. However, it is not the European Central Bank‘s expansionary response in times of crisis that is at issue. It is the extent and, above all, duration of its programmes to which critics take exception. The economic stimuli created by opening the monetary floodgates increasingly appear to be fizzling out, with the result that the equalising effect of low unemployment now appears negligible. Besides, if loose monetary policy reduces the pressure to reform, unemployment will climb back up to its original high in the long term.

An extensive redistribution is also taking place between private borrowers and creditors. Households which are prepared to take out a loan and borrow money can enjoy the benefit of low interest rates. Creditors, on the other hand, are left out in the cold. Mortgages account for a large portion of private borrowing, but the interest rates for mortgages are usually fixed for a longer period of time so that changes in the interest rate do not take creditors and borrowers unawares during the term of the loan. Instead, they predominantly affect new business or long-term loans. The longer interest rates remain low, however, the stronger the redistributive effect will become. According to a study by the Cologne Institute for Economic Research (IW), the lower interest income clearly outweighs the lower interest charges across all income groups. If the population is classified in so-called wealth deciles, only the least wealthy 10% profit on balance, according to the IW, for they are frequently highly indebted (see Fig. 4). The wealthiest 10% have the least to lose in relation to their overall wealth. Corporate assets account for a major portion of the total wealth in this wealth class and more investment options are available to them. Another form of redistribution takes place between older and younger people, as younger people tend on average to be more frequently indebted due to purchasing a property, for example.

What this wealth consists of also determines who wins and who loses out. Inflation is not an issue in the Eurozone at present, partly due to the development of energy prices. Should inflation increase in future, however, as a result of the vast increase in the money supply, the value of wealth would decrease in real terms. The disparity could increase, as people with low earnings tend to keep most of their wealth in cash and other assets whose value is eroded by inflation. Monetary policy that brings about an unexpected change in the level of inflation not only impacts existing wealth and the debt burden of borrowers as described above, but may also have a major redistributive effect on old-age pension schemes. This is because most savings targets are fixed in nominal terms, meaning that the savings rate must be adjusted accordingly to ensure that the target can still be achieved despite changes in interest rates and inflation. The Cologne Institute for Economic Research has Calculated that a German household with average net income and savings will have to forgo consumer goods worth €12,000 over the entire savings period in order to offset the disadvantages of a ten-year period of low interest rates in their provision for old age. Quite apart from this, wealthier savers can usually make use of more options to transfer their savings to investment classes with higher yields. As a rule, such options are not available to less affluent people who generally rely on standard products such as savings accounts and life insurance. Where life insurance is concerned, German lawmakers responded to low interest rates by introducing, among other things, an obligatory additional interest reserve. This will help to stabilise the financial strength of insurance companies and ultimately benefit all customers. At the same time, however, the new ruling will also come at the price of redistributive effects between existing and new customers. Henceforth, insurers will additionally have to ensure that earnings are fairly divided between new and long-standing customers.