The world economy is a ticking time bomb. At some point, the bomb will go off, paradigms will shift, and epic fortunes will be lost and made.
This isn’t a pessimistic doomsday forecast by some sort of permabear; it’s the unavoidable economic truth.
Artificially low-interest rates have been used almost non-stop as an easy economic Band-Aid by the world’s government banks. Unfortunately, massive systemic risk has been built into these falling rates that threaten the entire world economic regime – and it’s only getting worse.
To understand the risk, we need to look at one of the most fundamental mechanisms that run markets: pricing.
NOTE: This article will cover some basic theory. It’s critical to understand economic and financial theory – especially beginner concepts like those discussed in this article. Without understanding these basics, everything you do is just a roll of the dice.
How Prices Work and Why They Matter
Prices are the mechanism by which the invisible hand of the market communicates with us and shows us where to allocate our resources.
If we ignore prices, there will be consequences.
Usually, those negative consequences show themselves in the way of either a shortage of goods and services or with goods and services being wasted.
Imagine a barber deciding to only charge $0.01 per haircut. Will this increase business? Probably in the short run. But eventually, he’ll pay the price because he won’t be able to survive while operating at a loss.
Imagine Wal-Mart decides to sell cans of beans at $500 per can. Think they’ll sell many cans? Probably not – ignoring the prices will just leave cans on the shelves.
Price strategies definitely do exist for individual market actors, but centralized price controls generally don’t achieve the desired goal – and almost always have extreme negative unintended consequences. This is basic economics.
For example, just look at rent control. Economists know that rent control – when a government essentially bans landlords from raising rents beyond a certain level – leads to rent being more expensive over time for a drastically lower quality rental property.
The government is artificially manipulating the price of rent – and there are immediately massive issues with the supply of quality living space. This is economically unavoidable.
Prices matter. If you ignore prices, you cause major negative consequences – eventually. People will either not invest what they should invest in an asset – or they’ll invest too much. Either way, there is economic destruction.
Artificial Interest Rates and Malinvestment
Without getting too bogged down in the mechanics, the Federal Reserve has the ability to greatly impact the interest rates in the United States by changing the federal funds rate – which is the rate banks loan money to each other on a short-term basis.
The Fed doesn’t do this purely through some sort of free-market mechanism – they are instead using their banking power and privilege to change the rates. So when the Fed changes interest rates, they’re essentially utilizing government-caused price controls.
Remember earlier when we talked about how ignoring prices will lead to either too much or too little of something? Ignoring the price of money – ie, manipulating the cost of credit – also leads to the same destructive results.
Interest rates are the price of borrowing money. That’s what interest is – it’s a price you pay in order to borrow money. Because of this, interest rate manipulation has the same outcome as price controls.
When interest rates are artificially low, that leads to investments that don’t make sense. However, because capital is so cheap, people will still make the investment – eventually leading to a horrible bust.
Artificially Low-Interest Rates Lead to Risky Investments
The history of manipulated interest rates shows a history of bubbles that eventually burst in fantastic fashion. When interest rates are low, they provide financial organizations an incentive to fund more and more risky investments since the threshold for what works is simply lower.
For example, if an investment fund knew it could only borrow at 8% above inflation, it likely wouldn’t take a massive gamble on quite as many opportunities – if the cost of capital is higher, one typically protects it more.
Lower interest rates lead to riskier investments. Riskier investments eventually start to go bust. Eventually, it seems obvious when the bubble explodes.
The history of markets confirms this again and again. The phenomenon also plays out in study after study.
For example, an MIT study published in 2018 explained the following:
“Using simple randomized experiments of investment decision making, we show that allocations to the risky asset are significantly higher when interest rates are low, holding fixed the excess returns of the risky asset. We find consistent results in different settings, and in diverse subject pools including MTurk workers and HBS MBAs.”
This phenomenon is shown throughout history, in experiments, and can be seen playing out almost in real-time on CNBC. The lower the rates, the more people are taking big gambles to make money with risky real estate investments, business decisions, and personal financial decisions.
All the risk begins to pile higher and higher. It becomes a house of cards. And, eventually, something knocks over the house.
The freer the market, the more the market is able to efficiently price everything within the market. While definitely not perfect – we’re dealing with human beings here, after all – it’s still an incredibly powerful system able to calculate far beyond what anyone could intentionally calculate. An artificially low-interest rate is where someone violates the market – IE, utilizes force. An artificially low interest-rate is when the price of lending lower than it naturally would be.
There’s a reason people won’t lend money at a certain price. It’s too risky for too little reward. There’s a reason the price must be forced to be lower – the risk is being either fully or partially ignored. Structurally ignoring risk is a really bad idea.
(Recent) Historical Examples of Malinvestment
Because of artificially low-interest rates, debt has been skyrocketing for years. Risky businesses, risky real estate deals, massive personal consumption – these have all been made possible by extremely low rates.
More specifically, we can look just through the last few decades and see quite a few jarring examples of massive economic destruction caused by manipulated prices.
- The 2000s U.S. Housing Bubble. The Fed lowered interest rates on an unprecedented level as a response to the Dot Com bubble bursting – this led to a debt bubble that, when it blew up, nearly took out the entire world economic system.
- The 1980s Japanese Stocks and Land Bubble. In the late 80s, the Japanese central bank kept an extremely loose monetary policy rolling for far longer than it should have, leading to extremely inflated stock and real estate prices. The central bank finally started to tighten up the policy, and after several tightening measures popped the bubble. Japanese stocks still haven’t even come anywhere near its highs of the late 80s – after 30 years.
- The Global Corporate Debt Bubble. This one is scary because it’s going on right now – and without massive federal intervention, it would likely pop. It still might pop. The NY Times has a useful article explaining that the bubble is caused by artificially low-interest rates, just like we’re discussing here. I’m not a fan of the author at all, but this is something that people from all political walks should be openly discussing.
- The U.S. Student Loan Bubble. Student loans are hit with artificially low-interest rates – but also suffer from other forms of artificial price manipulation. It’s bizarrely easy for an 18-year-old to go into massive debt – with no real career game plan. This has led to one of the most surreal malinvestment bubbles in human history with incomprehensible levels of squandered human resources. People are graduating colleges with horrible educations, massive debts, and no real understanding of how to build a career. This bubble is so entrenched in our society that the fallout – the “popping” of the bubble – might just be a permanent system of inefficiency rather than an abrupt drop in attendance or something. Frankly, a permanently malinvested educational system is even worse than the traditional bubble-popping we’ve seen in other areas like real estate or stocks.
- The Global Government Debt Bubble. Through the use of force, essentially all interest rates are used to benefit the entities that control them: namely, governments. This has led to a shocking bloating of governments around the world. And, drastically worse even than the likely permanent squandering of the student-loan bubble, the government bubble is essentially the widespread funding of bureaucracy, wars, regulations, and other resource-obliterating activities. A government controls people and blows things up. You don’t want that part of society artificially inflated.
Debt Bubbles and the Next Economic Disaster(s)
There are massive bubbles everywhere throughout the world economy. Emerging market bubbles, corporate debt bubbles, student loan bubbles, government debt bubbles – the list goes on and on.
We don’t know exactly when the bubbles will burst. We don’t even know, necessarily, what the bursting bubble will look like.
But we know it will happen. And that’s why it’s critical to learn the basics of financial strategy to prepare yourself and your loved ones.
During times of disruption, not everyone is wiped out. Some people will always benefit. Once you know what to look for, that can include you.