The markets are currently expecting higher interest rates for a longer period of time, but that can change. The shrinking money supply and the resulting downward pressure on goods prices are still underestimated by investors.
With their policy of uninhibited increase in money supply, the central banks from the beginning of 2020 sowed the seeds for the high inflation that followed. Belatedly, but nevertheless, many monetary authorities raised interest rates relatively sharply in a short period of time at the beginning of 2022. With visible success: fortunately, inflation in consumer goods prices has already declined, even if it remains unbearably high in many places. This result is due not least to the monetary braking effect that has caused the increase in credit costs.
The sharp increase in the cost of consumer, business and mortgage loans has sharply reduced demand for new loans. At the same time, banks have become cautious and reticent when it comes to offering new loans – because rising interest rates lead to an increase in loan defaults and bank equity losses. Such a scenario is particularly likely because interest rates have been extremely low for many years and private and state debt has been built up and refinanced as a result of exceptionally low borrowing costs.
The International Institute of Finance (IIF) estimates that global debt will reach $307 trillion in the second quarter of 2023. $ reached. That was 336% of global economic output. In the first half of 2023 alone, debt rose by 10 trillion. $, measured over the last decade by 100 trillion. $. It is foreseeable that the increased credit costs – if they remain at the increased levels – will significantly increase the interest burden on debtors. However, this does not happen overnight, but gradually, over time. Because each year only a portion of the outstanding debts usually falls due.
If the debtors do not want to or cannot repay their liabilities, due debts are replaced with new loans, which now carry a noticeably higher interest rate. So if interest rates remain high, the interest bills of consumers, companies and states will inevitably rise from year to year. This will likely put some borrowers under pressure. At the same time, the rise in interest rates has another effect: investments and jobs that were created in an environment of extremely low interest rates lose their profitability. Companies suddenly notice that their hoped-for sales and profits are not materializing.
“The political pressure and the economic temptation to reduce interest costs again will be irresistible.”
The economy is weakening or even falling into recession, jobs are being lost, and the national economy’s debt sustainability is deteriorating. This is generally associated with payment difficulties and loan defaults on the part of the borrower. Conditions on the credit market are deteriorating. Credit is becoming more expensive and its availability is decreasing. As a result, interest rate increases by central banks affect the real economy with a time lag, and the economy, which was still booming when interest rates were low (“boom”), inevitably turns into a downturn (“bust”) when interest rates are tightened.
Given the current situation, such an economic slowdown can all too easily turn into a really big problem. The central banks’ interest rate hikes are now causing an extraordinary shortage of money supplies. In the USA, for example, the M2 money supply has been shrinking since the end of 2022; in July 2023 it fell by 3.7% compared to the previous year, and the Euro money supply M3 fell by 0.4% in the same month.
Fiat money relies on goods price inflation
Not least because of this, there is now a decline in the money supply throughout the OECD. A serious development, but one that is overlooked by many market commentators. After all, it is one of the most proven insights in economics that the money supply determines the price level and that an increasing (decreasing) money supply raises (lowers) the prices of goods.
The shrinking of the money supply suggests two things. On the one hand, the economic downturn is intensified because the “real cash” that consumers and producers have at their disposal is decreasing: real purchasing power is dwindling and weakening the demand for goods. On the other hand, a shrinking money supply puts downward pressure on goods price inflation. The loss of money supply – to the extent that it proves to be permanent – even causes a downward pull on goods prices, resulting in goods price deflation. It is not difficult to see that such a combination of economic downturn (or even a “bust”), coupled with falling goods prices across the board, would be a truly explosive cocktail.
It would put the global fiat monetary system in difficult waters. The fiat monetary system is ultimately built on credit and continued inflation of goods prices, and a loss of confidence in the credit market and a fall in goods prices across the board are thwarting the calculations of those in debt. Although credit default rates in the US and the Eurozone remain fairly low, they have already begun to rise. So the “dark side of the interest rate cycle” is beginning to emerge. Seen from this point of view, it would not be all that surprising if interest rate policy on both sides of the Atlantic soon turns out to be too restrictive and central banks find themselves forced to lower borrowing costs again.
Debt load too big for high interest rates
It’s an uncomfortable truth, but the fiat money system needs low or falling interest rates over time to stay going. This is exactly what has been the case in major economies since the early 1980s. However, this trend decline in interest rates has now been broken at the beginning of 2022. If the rise in interest rates proves to be permanent, then – as has been made clear above – very significant economic adjustment costs can be expected in the form of losses in growth and employment. A return to low interest rates, a return to the path of falling interest rates, would probably be the only way to escape the dark side of the interest rate cycle, a truly “big crisis”.
Even if the interest markets are currently expecting higher interest rates for a little longer, the mood could change quite soon. In particular, the shrinking money supply and the associated downward pressure on goods prices are probably still being underestimated by financial market investors. It would be anything but surprising if annual inflation in consumer goods prices even fell below zero over the next year. Then at the latest, and probably sooner, the political pressure and the economic temptation to reduce interest costs again will be irresistible.
The outstanding debt burden has simply become too great for national economies to be able or willing to afford increased interest rates. The current phase of increased interest rates could prove to be short-term – and it would sow the seeds for the next boom-bust cycle and very likely also ensure a subsequent resurgence of the wave of high inflation.
Thorsten Polleit is honorary professor of economics at the University of Bayreuth and president of the Ludwig von Mises Institute Germany.