Are low interest rates actually a good thing?

Jul 20, 2018

For the last few weeks we have been talking a lot about the economy; the Reserve Bank, printing money, and now we will be finishing off by talking about the final effect of this – Interest Rates.

Today, we ask the question; Are low interest rates actually a good thing?

Well, I guess it depends on who you’re asking…

1. The Economy as a whole
   • e.g. Business
2. The population – you and I
3. Retirees – Low rates don’t look so good – they’re trying to save money in cash to live their lives out. But they’re not really getting ahead when accounting for inflation – the real return on money is close to zero. They’re actually going backwards
4. Younger people – it’s great for borrowing because it’s cheap to do so.
   • But in the long run it’s not so good for affordability. As people borrow more money, they can artificially afford to buy more…affordability over all isn’t as good, so the real value of money decreases.

Interest rates

1. Nixon in 1971 – Ended the Bretton Woods system and the last days of currency being tied to gold. The Reserve/Central Banks can just go ahead and print more money and control interest rates that way.
2. Monetary system – Fiat currency – printing money and control of the supply (interest rates)
3. We have talked about the control of money supply by the reserve banks in this other episode
   • Our economy over all doesn’t operate as a purely free market as rates are very heavily controlled - the free market for interest rates is gone
4. Interest rates are no longer allowed to fluctuate naturally. The central banks, in their wisdom, have capped them!

 

What are interest rates currently?

1. 50% Interbank rate – set by the RBA
2. Then separately, there is the rate that banks lend out at: the commercial rate.
3. Low rates means we can borrow more – Simple!

 

In the Economy: What do low rates lead to?

1. Price rises
   • Inflation – More money, more being spent, increase in prices of goods
     • When money is printed at high rates, with no domestic and/or international demand for that currency to suck it up, the result is Hyperinflation (real devaluation)
   • Asset bubbles - Transfer of assets
     • Artificially higher overall asset values (e.g. property)
     • Low rates lead to an artificial share market rise

• Valuation of shares is based off the risk-free rate – Bonds and long term cash rates
  When rates go up, shares go down – Free cash flows

2. Currency
   • When domestic rates are high compared to those of other countries, it attracts foreign investment – Back in 2012 – High rates, high demand on the currency, high AUD
   • They don’t determine fully, but play a role

3. Savings:
   • Where is the incentive to save? If you can only earn 2% interest on your cash savings, and inflation is at 2%, then why bother saving?
   • Increase of money supply = Banks lend more = Increase money (our last episode).
   • Cheap money = Increase in credit = No savings
     • If you could earn 10% interest on your savings you’d likely save more because your money is working for you, as opposed to going backwards.
     • Savings (deposits) can then be loaned out rather than the Reserve Bank printing money to prop up lending (Deposits at banks being the cash reserves)
4. Savings are declining:
   • Back in the 1980’s savings were about 20% of disposable income
   • 0% in 2002
   • At the end of 2009, this increased to about 14-15%
   • However now we’re back down to close to 2%
   • There’s no savings and people are putting their lives on credit
   • Only way to increase the supply of savings is to increase rates
     • Need to increase supply through higher rates incentivising people to save

 

Let’s take a look at what happens in very low interest rate environments. A good example is Japan, and their current zombie economy;

• Late 1980s – Japan went through massive growth periods, but it was a bubble.
• There was a tripling of land prices and stock market prices during the prosperous 1980’s. Post-WW2 they were one of the most productive economies in the world.
• The Bubble burst around 1991

Liquidity Trap

• A situation in which monetary policy is unable to lower nominal interest rates because these are already close to zero, and there is no control in this way to stimulate the economy.
• Therefore, you can’t stimulate the economy and you can’t drop rates further
• Negative interest rates mean it actually costs money to keep your savings in the bank
• Interest rate has remained below 1% since 1994

The financial institutions:

1. They have been bailed out through capital infusions from the government, loans and cheap credit from the central bank (we have talked about this time and time again)
   • This postpones the recognition of losses, ultimately turning them into ‘Zombie’ Banks
   • Zombie Banks are essentially dead – no real asset value – very, very, low economic growth
2. When low growth occurs, there are lower tax revenues for the government, which is a problem because they have debts! For example, government bonds (which are just debt instruments).
   These are bought by the RBA, banks, other countries, or by individual people.
   • One solution is to raise taxes to try and pay back Gov Debt
   • Stimulus leads to Debt to GDP – 240%
   • Australia is at about 43% now

 

If low rates are good, then 0% would be better, right?

1. ZIRP – Zero interest-rate policy: associated with
   • Slow Economic growth – easy money leads to decrease in required productivity
   • Deflation – Decrease in the price of goods and services = Increase in real value of debt
   • Deleverage – Decrease in debt. When economy RUN on debt however, a severe recession is very, very, likely.
2. Exactly what has occurred in Japan for the past 20 years

 

Monetary and Fiscal Policy

1. Fiscal policy negates a lot of monetary policy
2. A truism of the political system is that to win an election there is no point giving the electorate the facts about how things work. You’re much more popular if you tell the population you’re going to give out free money!

Australia needs serious productivity and innovation reform …not cheap money.

1. To pay for things the government can either tax you, or borrow money (which they will need to tax you to repay anyway)
2. Increased welfare increases reliance on the fiscal policy side of things, whilst negating monetary policy.
3. There is a burden and over taxation on the productive side of the economy. This disincentivises production. Why be more productive if you’re only going to get taxed more?

So, if you don’t produce anything, you don’t get taxed. You produce too much, you lose half of it. This decreases incentives - Why borrow/save and start business if you will be taxed to death!?

• This is the same with home deposits – there’s no real incentive because it takes so long to save up the required amount with property prices so high. As well, there’s no real return on your money. If you’re keeping it in cash (the best way to save for a home deposit) you’re not getting a real interest return – property prices are going up at a greater rate than what cash rates currently are.

 The solution to this isn’t popular

• No government is suicidal in terms of their political careers. It’s all about being popular. They refuse to give up and accept defeat – instead they just keep plugging the dam.
• Without a free market for interest rates there’s no ability for the economy to respond – No feedback loop
• It’s pretty hard for a few people to use the crystal ball and tarot cards to set rates as there are millions of factors

Summary

Lower rates get, the further into the hole we go. Currently, at 1.50% we have a LITTLE wiggle room.

BUT, if a large economic downturn occurs though, the RBA won’t have the same ability to drop rates like they have before.

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