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The High, High Cost of Low, Low Rates

Saturday, August 4, 2012

Monetary easing combined with a promise to increase both nominal GDP growth and interest rates would jump-start this stagnant economy.

In a recent Wells Fargo/Gallup survey, one in three investors report that low interest rates have forced them to delay retirement. Forty-two percent of people now investing say that low rates have made them doubt that their retirement savings will last as long as they will, and nearly 40 percent of retirees report reduced consumption because of low interest rates.

Most of us assume that low interest rates are good for the economy. The Fed surely must agree, as it has pushed interest rates about as low as they can go. Then why isn’t the economy growing? Could it be that low interest rates are causing our economic difficulties?

Annual interest income for savers has dropped $450 billion in the past four years. That’s income which flows to individual savers, often retirees, and can no longer be spent.

That’s a pretty big number, when you think about it. It’s a number big enough to equal Obama’s stimulus program in less than two years. It’s not in this administration’s nature to worry about those who have succeeded in life and have savings to invest, but perhaps officials should mention that lost demand the next time they talk with Federal Reserve Chairman Ben Bernanke. Just because “somebody else did that,” doesn’t mean the economy wouldn’t benefit from increased spending by retirees.

Not only that, but the extended period of low interest rates will sound the death knell for the defined-benefit pension. Pension plans are funded by contributions from employers and from the returns those contributions earn. Low interest rates translate rather quickly and brutally into underfunded pensions. Most public pensions assume an investment return of around 7.5 to 8 percent. Moody’s has estimated that public pensions are underfunded by $2.2 trillion if that assumption is lowered to a 5.5 percent return. This estimated rate is still over the return from the S&P 500 in the last decade and almost double the return available from long-term bonds.

Annual interest income for savers has dropped $450 billion in the past four years.

It was little noticed, but the recently passed highway bill included provisions that will allow corporations to defer the increased pension contributions that had become necessary because of low interest rates. This is a perfect example of crony capitalism—run a monetary policy that makes it impossible to fund pensions, then reward large corporations with the ability to use accounting gimmicks (all in a bill that’s supposed to be about fixing bridges).

There is a real problem here. Many public pension plans have overpromised, even if interest rates had remained at the levels of the past. At present rates, even pension plans in municipalities and states that were conservative in their funding and financial projections are facing bleak futures.

Consumers are seeing steady increases in the premiums for property and casualty insurance. That increase in rates is a result of bad loss experience in the past few years, as the United States has seen a series of devastating storms. But rates are also rising because investment income is declining. Insurance companies depend on investment income from present premiums and retained earnings. When that income disappears, the only way to replace the lost revenue is to increase rates. The same holds true for life insurance. The interest rate used in life insurance pricing assumptions was recently lowered from 4 percent to 3.5 percent. This will lead to increases in both term and whole life insurance prices. Any financial product that depends on long-term assumptions about interest rates is under-reserved or underpriced at the present time. Any company that depends on profits from these products faces a very bleak future.

The Federal Reserve manages monetary policy in large part by targeting short-term interest rates. But there are other ways to govern monetary policy, and at least some observers are urging the Fed to target nominal GDP growth. Such a policy would imply an increase in monetary supply, as we attempt to return to more normal rates of GDP growth. An increase in the money supply would normally lead to lower interest rates, if that were possible. But if the increase in the money supply were seen as leading to higher GDP growth, then interest rates would rise to account for that fact. Long-term interest rates as low as they are now mean that investors expect no inflation in the future. But low interest rates mean that investors also expect little economic growth, and, consequently, low returns to investment. A money supply managed with the goal of increasing nominal GDP growth in our present situation would likely have the counterintuitive effect of raising interest rates. That would be a very good thing for savers, investors, financial firms, and the economy as a whole.

Our present fiscal policy risks managing interest rates to protect the government’s ability to borrow, rather than managing monetary policy for the benefit of the private economy.

There is one large beneficiary of low interest rates. The U.S. Treasury is the world’s largest borrower, and the costs of deficit financing are much lower than they would be in a more rational interest rate environment. We should take the Fed at its word. It’s undoubtedly managing interest rates with the goal of increasing economic growth. But the temptation is surely there to help finance our out-of-control spending. A tighter fiscal policy would increase investor confidence and lower the financial pain for the federal government as interest rates increase. Our present fiscal policy risks managing interest rates to protect the government’s ability to borrow, rather than managing monetary policy for the benefit of the private economy.

The presidential campaign seems to be settling into a battle of competing visions. In one vision, the federal government is seen as the source of all that is good and true, and in the other vision, private endeavors are seen as the solution to our problems. President Obama trumpets all that his administration has done to improve the lot of the downtrodden, while Mitt Romney warns of the dangers of increasing taxes and increasing dependency on the federal government. It is passing strange that the greatest harm to the economy coming from our economic leaders—the biggest income transfer in memory from the private to the public sector—isn’t mentioned at all. I suppose that favoring higher interest rates is hardly a winning campaign theme, but talking about a monetary policy that would increase growth and restore a rational environment for investors, savers, and businesspeople would surely be worth mentioning.

The Federal Open Market Committee is meeting in the next few weeks, and there is talk of another round of quantitative easing. The last two rounds have met with limited success, but monetary easing combined with a promise to increase both nominal GDP growth and interest rates would jump-start this stagnant economy.

Blake Hurst is a Missouri farmer and a frequent contributor to THE AMERICAN.

FURTHER READING: Hurst also writes “And the Regulatory State Drones On,” “The Forgotten Man of the Tax Debate,” and “An Imaginary Dustup? The Incalculable Harm of Regulation.” John H. Makin discusses “Why Are Interest Rates Presently So Low?” Alex J. Pollock contributes “The Federal Reserve: The Biggest Systemic Risk of All” and “Fearful Symmetry: Six Decades of Treasury Yields.

Image by Dianna Ingram / Bergman Group

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