How Low Interest Rates Sap Economic Growth

Conventional wisdom tells us we need record-low interest rates to help the global economy recover from the Great Recession and bring about a more prosperous future.

Let me respectfully point out that, in this country, we have had low interest rates – ranging from pretty low to astonishingly, jaw-droppingly low – for the past 15 years, and we have arrived at a future that is not what we were aiming for. The federal government and many states are wallowing in red ink. Retirees and other savers get almost nothing for the money they put in the bank, while healthy businesses and prudent individuals cannot get loans. Why should banks pay interest to take your money and lend it to me, a mere mortal, when they can get all the money they want from the government at virtually no cost, and use it to make a fortune in proprietary trading and the corporate money markets? They shouldn’t, and they don’t.

So we have near-zero interest rates that do little to promote long-term economic growth. In fact, prolonged low rates are getting in the way of growth by discouraging saving, lending and investment.

Brazil, on the other hand, has had high interest rates since the 1990s. Its economy is booming, and its federal budget forecasts a surplus (I repeat, a surplus, not a deficit) this year of more than 3 percent of gross domestic product.

High interest rates encourage efficiency and innovation. Families, companies and governments that pay a lot for the privilege of using someone else’s money are naturally going to borrow less, and they are going to use the money for endeavors that have a high expected rate of return. The hurdle rate for investments is higher when money is priced as though it is actually worth something.

Low interest rates, especially when maintained for many years, promote wasteful and inefficient use of resources. Governments pile layer upon layer of debt because, with ultra-low rates, the annual interest expense is manageable – until rates go up or until the debt mountain is so large that, as in the case of Greece, lenders abruptly stop refinancing it.

Businesses that can borrow money at low rates often make ill-considered acquisitions and other bad investments, or pay exorbitant salaries, dividends and other outlays that the enterprise cannot sustain through its own earnings.

Individuals tie up cheap credit in oversized houses that they don’t need. Once the jumbo mortgage is paid off, the individual has a very large residence that costs a lot to maintain and does not generate any income, but the opportunity cost is low, because money in the bank would not be generating any income, either. You might as well put your money into something tangible, like a house, and hope for the best.

Of course, if the individual pays too much for that house, gets caught with an adjustable-rate mortgage that he or she cannot carry, or suffers a financial reversal, that cheap mortgage might still go bad. We have recently seen this happen on an unprecedented scale, made possible by year after year of cheap credit.

The conventional wisdom about low interest rates is wrong. Or, more precisely, it would be right once in a while, when low rates are merely a temporary stimulus in an era in which capital generally is priced fairly. That is a very different world from the one we inhabit, in which interest rates are artificially restrained most of the time.

The wisdom I like comes from a more timeless source: the Aesop’s fables that I read when I was a boy. One that comes to mind is the story of the ant and the grasshopper.

The industrious ant toils all summer, storing grain in the insect equivalent of a money market fund, while the hedonistic grasshopper spends the comfortable days singing, carousing and making fun of the ant.

When winter arrives, the grasshopper is hungry and homeless, while the ant is snug and secure. The grasshopper arrives at the ant’s door seeking a handout but is quickly turned away. Harsh, yes, but fair. Even a youngster could recognize that all the incentives were in the right place.

The ant might at least have lent the grasshopper some grain, but it was obvious that the grasshopper was not a creditworthy applicant. So the ant chose to enjoy the fruits of her labor, by consuming what she needed and saving the rest.

If this were happening today, the grasshopper would seek extended unemployment benefits and a cramdown of his mortgage principal. The enterprising ant might use her savings as collateral for massive cheap borrowing, with which she could get into the business of making and securitizing subprime loans to grasshoppers. Why not swing for the financial fences? Her money market fund would pay her practically nothing for her savings, and Congress would be hell-bent on restoring an estate tax to siphon much of her accumulated wealth (for the benefit of every grasshopper earning less than $200,000 a year) before she could pass it on as seed capital to the next generation of ants.

Or the ant might just give up and gorge herself on her stored grain all winter before spending the next summer singing with the grasshoppers. Either way, the insect economy would stagnate.

The moral of this fable is to be careful what you wish for.

About Larry M. Elkin 525 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

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