Trapped in a low interest environment

Dr Oliver Hartwich
25 November, 2019

No one has ever accused the Germans of boundless optimism. There is a reason the word Weltschmerz (world-weariness) was once coined in Germany.

For the Germans, the glass is never just half-empty. It is probably dirty, has a few cracks and it leaks.

The reason for the Germans’ current Weltuntergangsstimmung (apocalyptic mood) is economic. A new book promising “The biggest crash of all time” before 2023 tops’s bestseller list. And now the Bundesbank, the country’s central bank, has joined the choir of doomsday merchants with its annual Financial Stability Report.

As far as I can tell, no-one in the New Zealand media has covered this report. Frankly, that is understandable. Since we have so many unresolved challenges of our own, why should we care for other countries’ neuroses?

And yet, this Bundesbank report is worth a read. It shows the dangers of operating in a negative interest environment from which there is no clear escape path. For anyone in New Zealand considering unconventional monetary policy, the German example should ring the alarm bells.

Since the Global Financial Crisis and the coinciding European debt crisis, Europe has been living with extremely low interest rates. On top of nominally low rates, the European Central Bank also engaged in a variety of other stimulatory policies.

There was quantitative easing through its expanded asset purchase programme (EAPP) in all its many forms (e.g. SMP, ABSPP, CBPP, CBPP2, CBPP3). The ECB also conducted longer term refinancing operations (LTROs) and targeted longer-term refinancing operations (TLTROs) – all of this while letting balances under its Trans-European Automated Real-time Gross Settlement Express Transfer System (TARGET2) balloon.

While interest rates were kept at record lows, markets were flooded with cash – and a soup of acronyms.

After a decade of this unprecedented policy experiment, some unintended side effects and new stability risks are becoming apparent. That is what the Bundesbank’s report is all about.

Despite the extraordinary amounts of money created, there was no discernible upswing in inflation. The Harmonised Index of Consumer Prices recorded an annual change of just 0.7 percent in October across the Euro Area. It has been trending down since it peaked at 3.0 percent in October 2011.

While consumer prices thus show no signs of inflation, the Eurozone’s actual inflation is happening in asset markets. The Bundesbank’s report shows this clearly and highlights the performance of the German real estate market.

For decades, German property was among the most boring asset classes in the world. Nothing ever happened to Germany house prices. With the flood of money now washing over Germany, that changed during the financial crisis.

residental property prices Oliver Newsroom

Demand for German property surged for two reasons: First, as foreign capital especially from periphery Eurozone economies needed a safe haven. And second, because German saver-tenants realised that zero interest rates favoured becoming a homeowner with a mortgage.

What happened then was a real estate boom of the kind Germany had never seen. Banks lent more and more to German households to finance house purchases:

German banks lending to domestic households

But not just that: The mortgage rates given out were increasingly fixed for periods longer than 10 years. No wonder, really: When interest rates are that low, why would you not fix? Just as an example, Stadtsparkasse Essen, a regional savings bank offers 30-year fixed mortgages at 1.79 percent.

The increase in long-term lending shows how ingrained low-interest rate expectations have become. However, this comes with a built-in risk. If interest rates ever increase again, Germany’s banking system will have a problem. Their lending is financed through short-term deposits – a potentially dangerous maturity transformation. Should savers in 15 or 20 years’ time expect a 3 percent return on their savings, banks will realise massive losses on those mortgages they are issuing today.

Graph 4

Still, German banks are issuing them because what alternative do they have? As they need to make their money from the difference between credit and deposit rates, this business model has become a lot harder when interest rates are that low.

Banks are not the only institutions suffering in a low-interest rate environment. As the Bundesbank notes, “Persistently low interest rates can tempt investors to take on greater risk in their search for yield. This may be why more loans have been granted to relatively risky enterprises.” In other words, the Bundesbank sees the risk of a zombification of the German economy.  

It also says this: “Not least, in a prolonged environment of low interest rates, life insurers and pension funds, in particular, find it difficult to generate sufficient yields to honour the commitments from guaranteed returns, which are sometimes rather high”.

Reading the Bundesbank’s report, it leaves you puzzled if and how Germany (and the rest of the Eurozone) could ever escape the low-interest rate trap they have manoeuvred themselves into. There is no obvious escape path which would keep the financial system functional. Germany did not have a strong banking system to start with but after a decade of ultra-loose monetary policy, the system has become dependent on an indefinite continuation of the current conditions.

When even the venerable Bundesbank paints such a gloomy picture of financial stability risks, maybe those doomsters that promise a great crash before 2023 have a point?

Meanwhile, for gloomy Germans like me, New Zealand with its still more normal interest rate environment feels somewhat more reassuring. Long may it remain that way.

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