Stop Worrying and Learn to Love Rising Interest Rates

 | Feb 17, 2017 | 8:00 AM EST
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For years, the markets have recoiled at the prospect of higher interest rates. This time, though, it seems to be different. Investors seem unperturbed by Fed Chairwoman Janet Yellen's hawkish disposition.

Are they right? Paradoxically, they might be. Boosting interest rates finally may bring about a much-needed economic shake-out, the absence of which has hindered, not helped, growth.

Immediately after the financial crisis, the interest rate cuts and money-printing actions by various central banks lifted all boats; productive companies as well as unproductive ones were helped to survive. Lifelines in the form of debt forgiveness, forbearance, bailouts or subsidies were thrown to companies in the banking, auto and housing sectors.

These lifelines prevented bankruptcies and severe job losses and -- quite possibly -- a global depression that could have followed. But they also prevented the creative destruction that is needed for a true economic recovery.

Together with an aging population that threatens to turn into a full-blown demographic crisis, excess capacity and low productivity could be the reasons why the post-crisis recovery has been so anemic.

Viewed in that light, raising interest rates could bring a welcome change. They can help eliminate weaker companies and help stronger companies improve their productivity, which is crucial if economic growth is to accelerate.

The 2007-2009 financial crisis depressed investment in research and development, because companies did not trust future growth and returns enough to commit fresh funds. Financial repression -- negative real interest rates on "safe" investments -- sought to entice them into doing just that.

For many businesses, it didn't work out that way. Instead, a lot of firms took advantage of the record-low interest rates by borrowing cheaply and rewarding shareholders with higher dividends and stock buybacks, which flattered their earnings per share.

But if higher interest rates make that kind of financial engineering unprofitable, perhaps investment in research and development, and in expansion, would pick up as funds no longer would be diverted toward rewarding shareholders. Investment in new technology and new ways of working would improve productivity down the line.

Labor productivity growth slowed by one percentage point since the 2007 financial crisis in the G-7 countries, according to Adam Slater, lead economist at the Oxford Economics think tank.

Slater said the disappearance of weak, "zombie" companies that have been kept afloat by low interest rates or forbearance on loans will improve overall productivity and make life easier for the businesses where productivity is growing.

"These weak firms not only drag down aggregate productivity but compete for resources (credit, workers) with better or new firms, hampering the growth of the more efficient companies as well as potential market entrants. The end result of these mechanisms is that the pace at which innovation and 'best practice' spreads throughout the economy may have slowed," he wrote in a recent research note on the issue.

This scenario doesn't mean the markets will be happy that interest rates are rising, ignoring other news. Already, the VIX volatility index is going up -- albeit it is still closer to its 52-week low than to its high -- indicating fresh worries among investors.

These fears are varied, from U.S. uncertainty over policy to geopolitical tension in Asia to a hot election year in Europe. One thing is clear: Politics is replacing central banks as the main reason for investors to worry. Rising interest rates may turn out to be just a sideshow this year.

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