Subscriber OnlyOpinion

David McWilliams: The rules of economics have changed. Could someone tell central bankers?

Disruptive technology has rewritten the economic rulebook, but the old manual is still in use

This week, the column will focus on global economic policy and why central banks – still the most powerful economic institutions in the world – don’t understand how disruptive technology is changing the way our world works.

What if they are stuck in a late 20th-century mindset not sufficiently clued in to the impact of new technology and therefore, as the world worries about an impending recession, they are like old generals, fighting the last war not the new one?

This week saw a flurry of activity from the world’s central bankers. From the US to New Zealand, Thailand and India, interest rates were slashed to all-time lows. Why the hyperactivity now? What they are up to?

Traditionally, interest rates are cut to stimulate inflation. When an economy is slowing down, central banks drop interest rates to encourage demand, push down unemployment and push up prices. The central banks make credit cheaper, coaxing people to borrow and spend, driving the economy upwards.


There are many countries where investors now have to pay the government for the pleasure of lending to them, not the other way around

For central bankers, deflation is the big fear and when deflation is the problem, inflation is the answer. Falling prices can become ingrained, and such deflation makes existing debts much harder to pay because companies and countries have to sell more products to pay back the same amount of debt.

Since the 2009 financial crisis, global debts have risen substantially. According to the Institute of International Finance, global debt levels currently stand at a near-record high of $244 trillion.

The data from Q3 2018 reveals that this debt pile is over three times the size of the global economy, with the global debt-to-gross domestic product ratio rising to 318 per cent. Global debt has ballooned over the past decade or two. Global debt doubled from $84 trillion at the turn of the century to $173 trillion in 2008 at the height of the financial crisis.

Over the decade since, global debt levels have risen a further 40 per cent or so. This debt has found its way into every nook and cranny of the world economy; only some of it has been invested productively.

Plunging prices

With these levels of debt, any threat of deflation must be taken very seriously. The best indicator of coming deflation is the long-term interest rate. All around the world, these rates are signalling that falling prices are coming. Long-term interest rates – the rates governments borrow at – have fallen to historic lows in recent days.

There are many countries where investors now have to pay the government for the pleasure of lending to them, not the other way around. In Germany, Japan, Switzerland and Sweden, long-term interest rates are negative.

Traditionally, such drastically low long-term interest rates are a sure signal that financial markets expect a recession in the years ahead. This is why central banks are cutting interest rates, to avoid recession, drive demand and push up prices.

But what if that way of looking at the economy – linking interest rates cuts to higher inflation – is outdated? Let’s consider that there is a new economy emerging, driven by disruptive technology.

When it comes to financing disruptive technology, lower interest rates are deflationary rather than inflationary

In the 20th century, the key rule of monetary economics was that easier monetary conditions, lower interest rates and more availability of credit drove prices up. Traditionally, full employment was associated with wages going up. Therefore, when interest rates were pushed down, demand would rise, employment would take off and eventually so would wages.

But these days, we see unemployment at very low levels in the US for example, and yet wages are not rising. Interest rates are at an all-time low, yet inflation is not going up. What if, rather than causing inflation and higher prices, lower interest rates actually cause deflation and lower prices?

If this were to be true, it would have revolutionary consequences for our understanding of the global economy.

Cost of capital

Here’s my new line of thinking. Today, when interest rates are very low and credit is abundant, investors are prepared to invest in speculative new technology where the pay-off might be years and years away. Because low interest rates drive down the cost of capital, the cost of waiting for a return also falls.

Therefore, investors are prepared to wait for possible riches tomorrow rather than real income today. Investing becomes more akin to winning the lotto than accumulating steady profit.

Many of these new tech companies might not survive but some will. Technology is often about trying to cut out the middle man, making the final product cheaper for the consumer. Essentially, new technology disrupts old business models, pushing down prices. So, if there is an infinite investor appetite for new technology as Silicon Valley is awash with capital because the central banks are cutting interest rates, lower rates might cause prices to fall rather than rise.

Let's take Uber as an example of this disruptive-technology process. Uber makes transport much cheaper. But right now, the investors of Uber are subsidising the consumer. Last year, Uber lost $3.04 billion on an operating basis on revenue of $11.3 billion, bringing total operating losses over the past three years to more than $10 billion. This $10 billion is money that investors have put into the company and it enables Uber to keep its prices low, keeping transport costs down.

Like Amazon, Uber intends to continue driving prices down until it destroys the competition. To do this, it needs investors to tolerate losses for a long time because this is the only way it will emerge as the winner. It aims to be the last one standing.

However, to do this, interest rates must be low because it is only via the mechanism of very low costs of capital that investors are prepared to wait indefinitely.

When it comes to financing disruptive technology, lower interest rates are deflationary rather than inflationary. In short, technology changes the game. This process is further aided by the emergence of huge new sources of cheap workers in places like India, Vietnam, Laos and Myanmar.

Long periods of deflation driven by technology are not unusual in economic history. For example, innovations like refrigeration and electricity drove down the cost of food and production for almost half a century from 1860 to 1910. This was a 50-year period when prices fell and remained low. We could be in a similar period now.

And if we are, central banks panicking into cutting rates as they did this week will just make prices fall further rather than rise any time soon.