How 0% interest rates have mutated our economy

This week I want to take a look at just how much damage keeping interest rates at 0% may have done to our economy.

Later in the week, I’ll look at everyone’s favourite topic – the housing market.

But today, let’s have a look at how 0% rates could have distorted the investment behaviour of companies and individuals – and how the longer we stay at zero, the worse it gets…

Zombie companies and Russian-roulette playing investors

As Kristin Forbes pointed out in her recent speech marking her departure from the Bank of England, one worry about low interest rates is that they may create behavioural distortions that in turn damage the economy.

Firstly, low rates may force worried individuals to save harder for retirement. Did you know that in 2009, a mere seven years ago, a pension pot of £500,000 would have bought a 65-year old man an annuity income of roughly £35,000 a year (though with no inflation protection)? Today, it would buy him about £25,000 a year.

As a saver, that’s terrifying. If you want to get the same income that you could have bought in 2009, you’re going to need a much, much bigger pension pot on retirement. (And yes, while we’re all very happy about the new pension freedom rules that mean you don’t have to buy an annuity, the same basic problem still exists.)

So what can you do about it? Potential future returns today look a lot lower than they did in 2009, because markets are a lot more overvalued than they were back then. So there’s no reason to expect your pension pot to grow faster today than it would have back then.

That leaves only three options. The first is to save harder. As Forbes notes, when faced with this sort of hostile savings environment and the desire to “ensure a certain income stream”, a worried saver might “increase savings and reduce spending – thereby slowing overall GDP growth”.

The second option – for those who can’t increase their savings – is to take careless risks in the hope of growing your pot faster. Let’s say you cannot see a scenario in which you will be able to save enough for a comfortable retirement, regardless of how hard you save. What do you do?

The famous Daniel Kahneman and Amos Tversky “loss aversion” experiment presents investors with two choices. Choice A is a certain loss of $7,500. Choice B is a 75% chance of losing $10,000 and a 25% chance of losing nothing. Statistically speaking, neither option is better. But most people prefer option B – they’d rather risk losing a bit more money in return for a shot at losing nothing.

Say we swap Choice A for a 100% chance of “an uncomfortable retirement” and Choice B for a 75% chance of “a slightly more uncomfortable retirement” and a 25% chance of “enjoying a bitcoin-and-FX-speculation-fuelled windfall that delivers an acceptable retirement” (25%). Put it that way, and you can see why zero rates might inspire more speculative behaviour among ordinary investors.

It’s no coincidence that the rise of Mrs Watanabe – the name given to the phenomenon of Japanese housewives turning to currency speculation to supplement (or devastate) the household’s savings – began during the 1990s, when Japanese interest rates collapsed.

And you do have to wonder if something like bitcoin could ever have achieved its current success in a higher interest-rate environment.

Finally, you could just abandon the idea of ever having enough saved up for tomorrow, and blow the lot today, in the hope of throwing yourself on the mercy of the state in your old age. As implied by the current record-low savings ratio, a sizeable portion of the population might just have gone for this option.

The point is, none of this – desperate saving, unhinged risk-taking, or hysterical consumption – represents a healthy approach to investment.

And unfortunately, these arguments apply to companies too. As Forbes notes, firms with exploding pension deficits “could cut back investment… in order to replenish pensions – further slowing overall GDP growth”. In other words, everyone’s productive resources get diverted to fruitless efforts at running to stand still.

Meanwhile, low rates “can reduce the ‘churn’ in an economy” – the pace at which new, more efficient companies replace older, indebted, less efficient ones.

In other words, low rates short-circuit the process of creative destruction, by allowing “zombie” companies to trudge on and crowd out youthful challengers. In turn, that holds back productivity growth.

That’s certainly something we’ve seen – productivity in the UK has been particularly bad since the financial crisis. It’s only just recovered to the levels seen before the crisis, and it’s probably the biggest economic concern we have right now.

This looks just like an economy in secular stagnation

All of this might not matter in the early stages. When rates first fall, the boost to activity outweighs the drag from these side-effects.

But leave rates at zero for a long time, and this behaviour starts to get ingrained. Eventually, you’re doing more harm than good.

If you leave your population in a demoralised state of financial “learned helplessness” – too mentally paralysed to invest and save sensibly – then it’s no wonder that productivity suffers.

Similarly, creative destruction between companies might not be much fun for those who are creatively destroyed. But it means more competition in the economy, and in turn that means more efficiency, and in turn that means higher wages and a better standard of living for everyone as a whole.

An economy without creative destruction is an economy in limbo. In fact, an economy without creative destruction looks an awful lot like an economy in “secular stagnation”.

This is the buzz phrase used by economists (most prominently, ex-US Treasury Secretary Larry Summers) who think that we’re now in a state of semi-permanent depression, which should be combated by permanently low interest rates and a massive fiscal stimulus.

They’d argue that interest rates are low because the economy is weak. And that might have been true in the early days of the crisis. However, I’m starting to think that the causality increasingly runs the other way.

Raising rates from here would be painful. But keeping them at zero only builds up the distortions. Unfortunately, as we noted in yesterday’s Money Morning, it’s only when the distortions get too big and damaging to ignore that central banks will feel forced to act. And by then, there will be no good choices left.

  • At what point in history did interest rate policy become one of social engineering? Surely low interest rates are good because government borrowing becomes cheap, which benefits all of us.

    Wouldn’t the treasury only raise interest rates if it needed to pay more for its borrowing?

    I know annuities suffer collateral damage here. But they were never supposed to be drivers of interest rates. Were they? Ditto pension fund asset/liability ratios. Perhaps we need to get used to a non-annuity paradigm, where our retirement savings are held as hard assets like property, shares and gold instead.

    • FriarStuck

      Wrong, wrong, and correct (but not for the reasons you think).

      – Price fixing against the sum of all transactions in a market is social engineering.

      – Government borrowing is almost pure consumption, as evidenced by the ever growing debt, at some point we will run out of resources and savings to service this debt if it is allowed to continue accruing at the current rate.

      – The market should set the interest rate or price of money. The price would be related to the amount of savings available for lending.

      Given that the savings ratio is at a record low, we know intuitively that interest rates are out of kilter with what they would otherwise be if the market were to decide.

      • My first point was rhetorical. People who advocate setting interest rates to suit a particular segment (e.g. those buying annuities) miss the point for the reasons you mention.

        And yes, the market should set the interest rate. But with the government such a big player, it will always effectively be the market. And yes, debt will increase until the currency bursts. I’d be amazed to see a government able to reverse that trend.

        Not sure I’m with you on the last point. You seem to be saying that because savings are at record lows, we should increase the base rate to restore savings to something like a historical average. Doesn’t that ignore any paradigm shift that might be going on? Interest rates are at record lows (and even negative in some countries) but asset prices just keep on rising. Which is what we expect with low rates causing more borrowing. But wasn’t that against a backdrop of deflation fears?

        I really believe we need to get away from our fixed idea that financing must be through debt markets and start thinking of equity financing.

        • FriarStuck

          Let me put it another way.

          In terms of the interest rate, the interest rate is the price of money.

          In a market if there is large demand for a product, but a scarcity of supply, the price is very likely to increase.

          In terms of interest rates, there is lots of demand for borrowing, but not an awful lot savings to do this with, which suggests to me, even though I cannot predict what the eventual price would be (neither can the Monetary Policy Committee), that interests rates, if set by the market would increase markedly from where they are.

          The so called paradigm shift, is the backward rationalisation of the price fixers and meddlers to explain away the negative consequences of their interference, and to pave the way for yet more of the same.

          • Horiboyable .

            In terms of the interest rate, the interest rate is the price of money.
            Price of risk & Inflation

          • I understand what you’re getting at, although as you say we can only postulate how supply and demand alone would point to any particular interest rate in a free market.

            I presume you are critical of the MPC’s role for using interest rates to control inflation etc.

        • FriarStuck

          N.B. the government in terms of borrowing are overwhelming on the demand side of the equation, not the supply side, which in an environment of scarce savings equates to higher interest rates.

          The government could join the supply side by running a surplus, but I don’t see that happening…

          • By 2022 apparently.
            No, me neither.

      • FriarStuck


  • Horiboyable .

    Years ago when pension plans were first being sold they used a model using a 6 to 8% interest rate which they have not been able to get now for over a decade. By law pension plans must hold a certain % of government debt. Also these pension funds have been chasing yield now for years and I bet some of them have been forced to take on riskier positions. It estimated that UK pensions are short at the moment by about 600 to 800 billion pounds.
    The UK government has fooled the public with their, “I’m in campaign”. Getting folks to pay into a pension plan for a second time. Hell how dumb do you have to be, they stole your first contribution, so you are going to give them a second bite at the apple. They will do what they did in Hungary and confiscate all private pensions.
    Folks you need to wake up and quick, all western governments are BROKE and if you look at history when governments get themselves in this situation they will start to steal off their own citizens. The process is already started in the USA with some states there will definitely go bankrupt, Porto Rico is gone, Venezuela, Turkey and then the dominos will begin to fall. We are entering a period of hell.

  • brianm101

    Not sure how much of the low interest rate argument is really true at least at the consumer and small business level. Interest rate are still vey high if you want a mortgage, business loan or just a personal loan. Looking at between 4 and 10% and even more(ingoing initial rates)! Yet interest rates made to savers hover close to zero.

    Might be great for government borrowing and possibly large corporations but for the average borrower lower interest rates are an illusion. Lenders are simply charging what they can get away with and giving the minimum, if any interest to their savers.

    Once again banks doing the proverbial!

    So although I disagree with your reasoning, agree with your solution interest rates need to rise, but maybe we are so far in the bad part of the drag curve that government daren’t raise rates!

  • FriarStuck

    Prices guide economic activity, politicians fixing prices distorts our economic efforts.

    History is absolutely littered with the accounts of the futile attempts and ensuing chaos created when politicians artificially fix prices.

    Yet we still persist with this bizarre and destructive way of organising our economic affairs, by allowing probably the most important price, the price of money (i.e. interest rate) to be set by committee.

    • Horiboyable .

      The west is about to find out the true cost of cheap money.
      It should end socialism in Europe. All those folks that thought it was a good idea to have babies on the state will be crowding the adoption centres. Old folks will not get their pensions and the NHS will be gone.
      Socialism never lasts long as the folks in Venezuela and Greece are finding out now. Empires ALWAYS collapse from outer edges to the centre.

  • murrayzz1

    Littered with typical neoclassical non-sequiturs.