Opinion

David Cay Johnston

The hidden dangers of low interest rates

By David Cay Johnston
January 10, 2012

The Fed’s campaign to hold short-term interest rates near zero is a loser for taxpayers. A rise in rates would also burden taxpayers, but it would come with a benefit for those who save.

Low rates keep alive the banks that the government considers too big to fail and reduce the cost of servicing the burgeoning federal debt. Low rates also come at a cost, cutting income to older Americans and to pension funds. This forces retirees to eat into principal, may put more pressure on welfare programs for the elderly, and will probably require the government to spend money to fulfill pension guarantees.

Raising interest rates shifts the costs and benefits, increasing the risks that mismanaged banks will collapse and diverting more taxpayers’ money to service federal debt. On the other hand, higher interest rates mean that savers, both individual and in pension funds, enjoy the fruits of their prudence.

No matter which way interest rates go, taxpayers face dangers. The question is where we want to take our losses. For my money, saving the mismanaged mega-banks should be the last priority and savers the first. Of course breaking up the big banks or letting them fail also imposes costs and low interest rates benefit many Americans, though mostly those with top credit scores, but policy involves choices and rescuing banks from their own mistakes and subtly siphoning wealth from the prudent is corrosive to the ethical and social fabric.

ON THE RISE?

The federal government paid $454 billion in interest on its debt in 2011. That is the equivalent of all the individual income taxes paid last year through the first three weeks of June

If rates return to, say, 6.64 percent, the level they were in 2000, one year’s interest costs would equal the individual income taxes for all of 2011 plus the first few weeks of 2012.

Last week , rates took a step in that direction. The yield on the 10-year bond, a benchmark for other interest rates, jumped to 3.3 percent, from 2.57 percent in early November, raising the government’s cost of borrowing in that sale by one fourth.

The average maturity of federal bills, notes and bonds is just five years, with just 7 percent of debt financed for more than 10 years, the equivalent of an adjustable rate mortgage with no upside limit.

PRUDENT PEOPLE

The low interest rates since the financial crisis already have imposed a cost on the prudent people who saved for the future, both those who saved as individuals and those who put their money in pension funds.

Banks are paying less than one percent interest on savings, which means rates are negative in real terms, forcing retirees to dig into their nest eggs or cut spending.

Across the country, some fundraisers have told me of benefactors who called to say that expected bequests would not be forthcoming because they had been forced to dig into their savings.

Tax returns, too, show a disturbing, if logical, trend toward less saving. The share of income from taxable interest fell from 3 percent in 1999 to 2.2 percent in 2009, the latest year for which tax return data are available.

More troubling is that the number of taxpayers grew by more than 13 million over those years, while those reporting any taxable interest fell from 67.2 million to 57.8 million. The share of taxpayers earning interest plummeted from 52.9 percent to 44.1 percent.

RAVAGED PENSION FUNDS

At the same time, low interest rates, on top of weak stock prices, have ravaged pension funds.

Overall, state and local public employee plans lost 22.7 percent of their value in 2009, the Census Bureau reported in October. Their assets fell to $2.5 trillion from more than $3.2 trillion, while annual payments to retirees and survivors rose 6.7 percent to $187 billion.

In 2007 California’s three main funds had from 96.6 percent to 102 percent of the funds needed to pay benefits. As of last June 30, however, two of the funds held less than two-thirds of the assets needed to pay benefits, while the teachers’ fund had just 69.5 percent.

Eventually, inadequate endowments will require taxpayers to pay more so state and local governments can keep their pension promises.

The Pension Benefit Guaranty Corporation, which insures corporate plans, owed $106.7 billion to retirees as of Sept. 30, but had only $80.7 billion of assets, a $26 billion shortfall. Just four years earlier it reported a surplus of nearly $10 billion, or 87 percent.

The guaranty corporation also reported that its “reasonably possible exposure” to plans that may fail increased by a third last year to $227.2 billion. Low interest rates are a key part of that risk.

Low interest rates are good for mismanaged banks and for obscuring the cost of servicing the federal debt. But why do we elevate those issues above the interests of society’s prudent people whose personal and pension fund endowments are being consumed prematurely due to government policy?

Comments
21 comments so far | RSS Comments RSS

Other major beneficiaries of Professor Bernanke’s zero interest rate regime include the hedge funds and leveraged-buy-out funds which now go by the euphemism of “private equity”. These entities employ huge leverage to magnify their returns (and losses). Hence we see much increased volatility in the prices of securities, commodities and currencies. The result is a loss of investor confidence, which in turn hampers real economic growth as our capital markets have become little more than a casino.
Sadly, the institutional investors who used to be among the most conservative investors, such as pension and endowment funds, have embraced hedge and LBO funds in a big way. Recently, for example, the Yale endowment fund was 2/3rds invested in a category they call “absolute return” which is a euphemism for hedge and LBO funds. The zero interest rate environment reduces the returns available in traditional investments to practically nothing, giving the big institutions little choice but to employ the huge leverage favored by the hedge and LBO funds.
It appears that Prof. Bernanke’s zero interest rate policy, designed to support the zombie banks, has not only destroyed the savings of an entire generation but has also skewed the capital markets by making the use of high leverage the only viable option to obtain the needed rate of return. The unwinding of these huge misallocations of capital and resources will not be a pleasant experience.

Posted by unclepie | Report as abusive
 

David: You say that “Last week , rates took a step in that direction. The yield on the 10-year bond, a benchmark for other interest rates, jumped to 3.3 percent, from 2.57 percent in early November, raising the government’s cost of borrowing in that sale by one fourth.” That’s not correct.

I have posted a chart showing the interest rates on the 10 year for the last twelve months here: http://bit.ly/y45tmN You can see that the rate is now a shade under 2.0% and was only about 2.4% in November.

Posted by StuartLevine | Report as abusive
 

You state, “For my money, saving the mismanaged mega-banks should be the last priority and savers the first. Of course breaking up the big banks or letting them fail also imposes costs and low interest rates benefit many Americans, though mostly those with top credit scores, but policy involves choices and rescuing banks from their own mistakes and subtly siphoning wealth from the prudent is corrosive to the ethical and social fabric.”

While this may sound like good advice, this course of action would undoubtedly cause the US economy to crash into another recession, or worse.

And you are confusing “moral hazard” with economic policy.

This is why, after bailing out the “too big to fail banks” in 2008, Bernanke locked himself — and the US economy — into a straightjacket in terms interest rates, and of forcing the US to continue to bail out the wealthy.

Hence, the reason for the QE2 program and probably a QE3 shortly, since the wealthy are clamoring for it, and if the eurozone fails, it is a near certainty. (Regardless of the prevailing market opinion, the collapse of the eurozone WILL cause the US to collapse as well.)

The real problem with low interest rates is that it provides cheap money for investment in jobs in 3rd world countries, but not in the US, and simply exacerbates the wealthy/poor divide in the US due to excess profits from their investments.

Bernanke’s incredibly bad choice (plus the Bush tax cuts) are the main reasons why the US is in $15 trillion of debt today. (In fact, the US ran a slight surplus just prior to Bush taking office, so our massive debt IS attributable to him and the bailouts.)

This is the main reason why we must insist the wealthy begin paying their income taxes once again, because we CANNOT compensate for the loss of that revenue in any other way — certainly, not by cutting back on spending (except, of course, in military spending, which will never happen).

Leaving the income tax rates where they are now, and attempting to cut back on social spending as the Republicans want, will create 3rd world conditions in the US overnight.

If you doubt that, take a close look at Romney’s so-called tax plan.

Unfortunately, at this point, for better or worse, we are “wed” to Bernanke’s policies.

Unless and until the US Congress begins to do their job and pass legislation to bring “our” outsourced jobs home, we will be stuck in this “liquidity trap” until the US economy collapses.

PseudoTurtle

Posted by Gordon2352 | Report as abusive
 

Excellent evenhanded explanation of current policy pros and cons.

There has been the public perception of a generational “transfer” of wealth from the young to older Americans as “our” government looks at every possible way to renege on delivering on promises “made and paid”.

You correctly point out how “our” government concurrently benefits by allowing inflation and low rates of interest to steal the historic rewards of prudence and saving from older citizens. It would seem Americans live ever more with “public policy” that careens back and forth between bad faith and incompetency.

Posted by OneOfTheSheep | Report as abusive
 

Low rates also help keep the retirees and a lot of other people in their homes. I am a retiree and welcome the low rates.

Posted by David123456789 | Report as abusive
 

Reducing interest payments on the debt is certainly one reason the government (and quasi-governmental Federal Reserve) has kept interest rates near zero, but another reason not mentioned in the article is that the government wants to discourage savings and encourage spending. It’s logical for individuals to reduce spending in difficult times, but we’ve built our economy on consumer spending and a significant increase in saving will reduce growth. Personally, I’d prefer we save more and build a stronger foundation for the future and take the hit now, but in our political environment there is no such thing as ‘long-term’. So, spend away, we can always borrow from our overseas ‘friends’.

Posted by hoosier_gdi | Report as abusive
 

All of this is the natural corollary of the increasing gap between rich and poor. The economy is becoming imbalanced. Without a serious effort at balancing budgets and implementing redistributive policy to compensate for the inherent unfairness of capitalism in the modern age (with increasing use of technology continually increasing economies of scale); growth naturally falters due to constrained demand, and the system will naturally force us to redistribute wealth by some other mechanism instead, via low/zero interest-rates. We’re essentially swimming in the urine peed out by the faulty tax system, over the last three decades.

The only way to get ourselves out of this corner we’ve painted ourselves into, is to start raising taxes on the wealthy, or, have a general spring-clean of unjustifiable tax breaks.

Posted by matthewslyman | Report as abusive
 

Alternatively, if you prefer a different analogy, I feel like we’re all in a big room with gas slowly leaking into it, increasing gradually in concentration… With Republican politicians excepting Jon Huntsman all furthest from the source, saying:
“What’s the problem? This is the smell of FREEDOM! Turn up that gas…”

Posted by matthewslyman | Report as abusive
 

I hope I’m wrong…

Posted by matthewslyman | Report as abusive
 

Gordon2352: You wrote: “While this may sound like good advice, this course of action would undoubtedly cause the US economy to crash into another recession, or worse.

And you are confusing “moral hazard” with economic policy.

This is why, after bailing out the “too big to fail banks” in 2008, Bernanke locked himself — and the US economy — into a straightjacket in terms interest rates, and of forcing the US to continue to bail out the wealthy.”

Do you think the outcome would be a severe economic downturn if bank creditors were forced to take some level of write down on the debt they are owed as part of a deal in which interest rates were kept low to allow the banks to get additional profit? I cannot understand how a long term economically healthy system can be enforced if there is no loss that the risk taking investors are forced to carry. Rather, the loss gets socialized by continuing ZIRP.

Posted by gvanc | Report as abusive
 

…My thinking in relation to economic equilibria is based loosely on Le Chatelier’s Principle…

Posted by matthewslyman | Report as abusive
 

Interesting. Mr. Johnston is proposing that in risky times that interest rates rise to reflect that risk. Radical. But wait. Wasn’t that what we were taught in high-school?

The point of interest was to reflect the risk profile. Are these stable, or risky times.
The system seems rigged by the big five players that compose the Fed, and control the Open Market Committee that sets the rates.

King Knut was making a point when he walked to the beach and ordered the tide to go out. Dang, the tide did not obey. The point was that there are limits to power. Apparently, some in the banking world do not see this point. Just like the bankers in Hong Kong would not write down their losses and created the opium wars.

Posted by TheOldSodbuster | Report as abusive
 

This article (and most of the comments) show a basic misunderstanding of macroeconomics. It is the REAL economy that matters — how much is being produced and how many people are employed. All the rest are distributional issues. It is the size of the pie that matters, not how it is cut up.

Higher interest rates — which the article seems to be advocating — would depress the economy even more than it already is. Bernanke knows this, he is doing an excellent job considering the limitations of monetary policy.

Posted by Ed62 | Report as abusive
 

If I were a free market purist, which I’m not, I’d say that low interest rates reflect low demand. Low demand generated by low wages and a loss of equity. Once prices spiral down, the market will find equilibrium where the free market thrives.

But getting there is another story. The pain of further drops in prices, especially home values will lead to more defaults, which accelerates the race down to equilibrium. Once prices are rock bottom, those who saved and had income will buy up everything and the concentration of wealth will be even greater.

Seems clear to me that we need to print some cash to push a healthy 3% inflation rate so people can pay back their loans and stem the flight from saving. We could also do some more Government spending without going into debt by taking the capital the rich are sitting on and do some good with it. Some rich folks like Warren Buffet even think this is a good idea. I guess they understand that you can’t decimate your middle class if you want a thriving economy.

Posted by LEEDAP | Report as abusive
 

The interest rates on savings accounts has been plummeting for so many years (decades) that one can hardly wonder why people have lost faith in having them.
Credit cards are the new cash and everyday people push them to their limits, substituting the mirage of increased spending power for a more solid financial profile. And now the housing market has been wrecked. Right now, I rent (no interest deductions) because of the failure in fair and stable housing costs.
I wonder if banks could come up with a shared ownership property offering no damage to either them or us?
That would stimulate some business again.

Posted by pdowney | Report as abusive
 

Just end the fed, break up the banks, and replace congress with actual policymakers that will do the right thing for the American people (not corporations), and create (tax) incentives for investment in local areas of the economy.

Posted by AldoHux_iv | Report as abusive
 

“This is the main reason why we must insist the wealthy begin paying their income taxes once again, because we CANNOT compensate for the loss of that revenue in any other way — certainly, not by cutting back on spending (except, of course, in military spending, which will never happen).”

One little problem. If we tax the wealthy to the point that there is no incentive to invest in the US, then they logically will stop investing here and we will exacerbate our unemployment problem.

Would YOU stay here to see your taxes dramatically increase when simply moving would solve the problem?

We could, of course, ask all of the wealthy to move their official residences to the Bahamas. Then the power brokers of the world that, for the most part, now reside in the US, would not skew the wealth numbers as sharply as they do. Then the Left would be happy – though our country would be much weaker and poorer.

Oh, details, details…

Posted by charliethompto | Report as abusive
 

@charliethompto: personal income tax rates are not what is causing the rich to avoid investment. Such rates are at historically very low levels for the ultra-wealthy. Yet they are not investing. Instead, they are converting all their money into gold, to ride out the storm, because they have no confidence in the economic management of the major industrialised nations. Why not? Because they know that as long as governments pander to the populist demand for “lower taxation”, they will either run a huge deficit or risk a major working-class revolt. They know that paying Paul with money that doesn’t exist must surely be followed by borrowing from Peter… That currencies must inevitably be devalued so rapidly that it’s difficult to make money on bricks-and-mortar, cash-based business. They know that even the bricks-and-mortar are economically depressed at the moment, due to dishonesty and corruption on a grand scale. They know that these problems fundamentally haven’t been fixed yet. So why invest?

Posted by matthewslyman | Report as abusive
 

A good article but with some serious errors. The 10 year US Treasury bond yield has been stuck around 2% for months now. Where did Mr. Johnston see they were trading at 3.33% last week??? If the author can’t get a correct quote on the most liquid bond market in the world my propensity to pay serious attention to him wanes considerably.

Posted by Bond_Canuk | Report as abusive
 

The first comment here by “Unclepie” pretty much nails it.
Historically, interest rates tend to swing in a broad arc,such as a pendulum. When the pendulum changes direction, historians will only remember Ben Bernanke with amusement. When the pendulum changes direction, there will be a bloodbath in the long end of the bond market.

Posted by Amelia196 | Report as abusive
 

Higher interest rate can be achieved with economic growth and subsequent inflation.

At present there is scarcity of both.

As far as pension funds going dry, perhaps those “promises” where too fat to begin with.

Most of us have only SSA benefit to live with.

Posted by robb1 | Report as abusive
 

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