The Dark Side Of Artificially Low Interest Rates

Artificially Low Interest Rates

Update November 29, 2016:

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The Lowest Cost. Period.

Artificially low interest rates are bad for the economy.

Public opinion always wants easy money, that is, low interest rates” – Ludvig Von Mises, A Critique of Interventionism

Over the past decade or so the Federal Reserve (the Fed) has used monetary policy to drive down interest rates below market levels. They have done this through keeping the Fed funds rate low and through quantitative easing (QE) – the creation of dollars out of thin air in order to purchase U.S. Treasuries and mortgage backed securities.

Wall Street and Main Street cheer on lower rates because they make access to dollars cheaper. With cheaper access, people have more money to spend, their debts are easier to pay off and stocks and real estate prices rise.

It’s all good, right? Maybe not. Here is the dark side of artificially low interest rates.

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How Artificially Low Rates Harm the Economy

Artificially low rates:

Discourage savings and investment by individuals and companies

Savings and investment provide the capital needed to create productive capacity that is self-sustaining. Low rates discourage savings as the return on savings is de minimis. Therefore, when rates are artificially low, some capital gets diverted from productive investments where there might be a long term return on investment, and flows instead towards either speculative ventures or assets (like real estate) with the potential of large returns, or towards the purchase of consumer goods.

Things may go well for a while as the artificially low rates spur rising stock and real estate prices. As rates rise, however, gains on unprofitable speculative ventures often evaporate and the bills must be paid on the consumer goods. Share prices of speculative companies with no earnings crash, companies go out of business and workers are laid off. On the consumer side, spending slows, the consumer goods have been used up and there are little or no savings to repay consumer debt.

Without the lower rates the economy has a weak foundation upon which to support itself as insufficient productive capacity has been built or capital saved during the period of artificially low rates.

Encourage Excessive Consumption

People who can borrow to take advantage of low interest rates will often increase their spending on consumption. They will buy cars, boats, automobiles, homes and high priced speculative stocks.

When money is on sale, we spend more. So when rates are artificially low, people and countries spend instead of saving or paying down debt.

A good portion of the consumer goods purchased in the United States are produced overseas. In the U.S. this is especially troubling as the consumption of foreign goods doesn’t create high paying jobs in the U.S. and increases the trade deficit.

Low rates cause people to spend in excess of their incomes as they believe the economy is improving and good times are ahead. When rates rise the debts need to be paid but there is no corresponding increase in wages to pay for them.

Because the Federal Reserve has engineered artificially low interest rates for more than a decade, a culture of spending has become engrained in the country’s culture. What we spend is more important than what we produce. Indeed, spending money is now considered to be a patriotic duty.

George Bush – State of the Union- “Go Shopping”

Encourage Malinvestment by Sending False Signals

When investments are made during a period of artificially low interest rates they are often malinvestments as the low rates may send false signals to entrepreneurs and home buyers that the economy is good and investments/purchases should be made. The Fed has driven interest rates down precisely because the economy is not doing well and to encourage, rather, trick entrepreneurs and consumers to employ capital in places they otherwise might not spend or invest.

Austrian economists argue that artificially low interest rates fool entrepreneurs into making investments they otherwise would not make. We think, rather, many entrepreneurs understand the artificial nature of the low interest rates but nonetheless take advantage of them, hoping interest rates stay low long enough for their projects and profits to be realized. Consumers and home buyers,on the other hand we believe are fooled by artificially low interest rates as to the underlying health of the economy.

Over the past year home builders have been building more spec houses based on the demand they see from the artificially low rates and a temporary inventory shortage. Should this dynamic turn out to be ephemeral they will have miscalculated demand and many of their homes will remain vacant and they will incur losses.

Lord Maynard Keynes was a proponent of stimulating the economy to bring forward demand when the economy was in recession. In reaction to criticism that stimulus spending would in the end create problems further down the road, Keynes remarked “in the end we are all dead”. The problem with this type of thinking is tomorrow often comes and the bills for yesterdays’ excesses must be paid for.

Aesop’s The Grasshopper and the Ant fable comes to mind.

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Hurt Job Growth

An unintended consequence of artificially low interest rates is muted job growth. Low rates encourage savers to abandon fixed income investments like Certificates of Deposits (CD’s) because the yields on these instruments are low and the stock market offers higher potential returns. Corporations also seek higher returns and react to artificially low rates by buying back their own shares (either with existing cash or with dollars borrowed at the artificially low rates) to reduce the inventory of shares available on the market and thereby increase their earnings per share. As earnings per share increase a company’s stock price often rises.

Thus, the artificially low rates encourage companies to use their cash to buy back their own shares to drive up their share prices, rather than to invest in their businesses. This explains partially why the economy is showing limited growth but the stock market is hitting record highs.

Perhaps with higher market interest rates, companies would invest in capital equipment and labor to gain a competitive advantage over their competitors. If companies, however, make the determination that they get a better and more immediate return on investment in the form of higher share prices from buying back their own shares than hiring new employees or making investments in their business, workers are not hired and additional productive capacity is not built.

To further reduce expenses and increase profits and their share prices, companies often also lay off workers.

Create Asset Bubbles

Because returns on fixed income instruments are low, larger amounts of existing and borrowed capital flow into the stock and real estate markets chasing assets that are rising in price, not necessarily based on fundamentals but on the notion that they are rising and the potential returns are greater than CD’s paying .75% annual interest.

In a stock market bubble companies with little or no profits often see the prices of their shares rise dramatically. In a real estate bubble homes that have not changed in any way other than the lower cost of borrowing march higher.

Without high yielding alternative places to put their money and armed with the false understanding that rising stock and real estate prices mean the economy is doing well, people will pour money into the real estate and stock markets chasing them higher until the bubbles burst.

Make Homes Unaffordable

One of the Fed’s stated purposes of low interest rates is to drive up the prices of homes so that those suffering from negative equity will be relieved and those showing gains in their home values will perhaps take out low interest home equity loans and spend money, or perhaps they will just feel richer and save less and spend more.

That scenario may benefit the homeowner. But what about those that don’t own homes? They don’t participate in the price appreciation. Artificially low rates favor home owners over non home owners.

Ask a first time home buyer, a part time worker or anyone looking for a home if higher home prices are a good thing. Higher home prices shut would be home buyers out of the market, lower the home ownership rate and raise the cost of shelter.

Create Wealth Inequality

Low interest rates are only a benefit if you can take advantage of them. The main beneficiaries of low interest rates are those who have access to credit, own stocks and real estate (i.e. those in the wealthier income brackets). Those not owing stocks or real estate miss out on the appreciation of stocks and lacking good credit can not participate in the housing market.

As home prices rise, wealth disparity is created between home owners and non homeowners. Homeowners get richer merely by occupying homes while renters don’t obtain the same passive benefits.

Homeowners also gain access to cheap credit not available to renters in the form of low interest home equity loans and benefit from the mortgage interest deduction.

Punish Savers

Many retired people relied on fixed income to fund their expenses. They saved for years to build their nest eggs for their retirement but are seeing their savings run out because of dramatically reduced fixed income interest payments.

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Are Inflationary

Inflation is defined as the increase in the supply of unbacked money and credit. Inflation in the price of finished goods comes soon thereafter. The Fed has created inflation through QE. The reason the consumer price index is not registering double digit increases (putting aside the methodology of its calculation) is because the Fed is battling deflation that naturally occurs after a bubble bursts. QE has caused price inflation in stocks and real estate and in the automotive market. Because credit is cheap and readily available the prices of cars have risen to an all time high.

Cost a Lot to Engineer and to Maintain

The Fed’s QE program to date has pumped more than $3 trillion of money printed out of thin air into the economy, or rather the banks and the U.S. Treasury. The beneficial results are only evident in higher stock and real estate prices. Job and wage growth is almost non existent with the labor participation rate at a thirty-two year low. The gains in the stock market can be wiped out in a matter of minutes and home prices can also drop quickly. The labor market certainly won’t improve after a stock market crash.

Earlier this year when Chairman of the Federal Reserve Ben Bernanke first started talking about tapering the $85 billion a month QE program he was thinking that the Fed could keep the Fed funds rate low while tapering the size of the QE purchases and still achieve low interest rates. Mr. Bernanke found out soon that even talking taper would cause rates to rise irrespective of where the Fed funds rate is. Since the Fed knows the economy is weak and can’t withstand higher interest rates it knows that rates must be kept low. Rates won’t stay low just because the Fed keeps the Fed funds rate low – it will require more QE.*

Will Move Higher

All manipulation schemes eventually become overwhelmed by natural market forces. The Fed’s QE program is entering its sixth year. Eventually the market will demand higher rates for the risk of extending credit to a sovereign that meets its obligations by printing the difference. When that happens the party that was enjoyed be a small segment of the population is over.

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* at some point no amount of QE will keep rates low if confidence is lost in the Fed and the dollar due to excessive dollar creation.

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Further Reading:

From the Smaulgld Dark Side Series

The Dark Side of Minimum Wage Laws

The Dark Side of Negative Interest Rates

The Dark Side of Rising Home Prices

The Dark Side of a Cashless Society

Why are interest rates being kept at a low level? (linked to a federal explanation, since removed BUT you can see it here)

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