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Why Low Interest Rates Do Not Translate Into Economic Growth

Do low interest rates stimulate economic growth? A subject that has been much debated through the recent recession/slowdown. Historic experience in Japan says no. Increasingly, the experience in the US and Europe seems to suggest the same.

One reason for this is that interest rates only impact the cost of one of the two components of capital - debt. The impact on the overall cost of capital (when you include equity in the mix) may however be different.

The general premise would be that central banks reduce interest rates in a recessionary environment to make it cheaper for individuals and businesses to borrow, using the money to spend and/or invest. However, it is also an environment, when lenders have a reduced risk appetite, and the overall economy is de-leveraging. This translates into an increased level of equity in transactions. For example, home buyers who could buy houses and apartments with down payments of 10% may be required to put in down payments of 20% or even 25%. Corporates who were able to borrow with equity as low as 25% or 30% in the capital structure, were required to put in equity closer to 40% or in some cases even 45%.

As we all know, equity is the more expensive source of capital. Therefore, if an asset is now required to be funded with greater equity, even though the cost of debt has come down, the overall cost of capital may not be lower. It may in some cases be higher - e.g.: one could argue that a home owner's cost of equity is higher as a result of the uncertainty associated with their income (risk of lay-offs etc.).

This is primarily the reason why low interest rates do not necessarily induce growth. At the end of the day, it goes back to basic economics and human behavior. For businesses to spend there have to be real opportunities for investing which generate a return on investment that exceeds the cost of capital. For consumers to spend, they have to feel confident and secure about their economic situation - be it the stability of their jobs and earning, the value of their savings, and how good they feel about their future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.