Archives for July 2012

Low Interest Rates Could be Hurting the Economy

A lot of people think this is a great time for real estate because of the historic low-interest rates.  While it might stimulate some people to buy houses earlier than expected, it is most likely coming at a cost to our economy.  Let me explain…

Low Interest Rates = Inflation

Interest is the price of borrowing money.  When savers want to lend money out, they charge the price of interest.  Therefore it would make sense that when interest rates are low, there are plenty of savers competing to offer borrowers better rates for their money.  But, that is not the case right now.  Savings amongst individuals is very low, and interest rates are low.  If the supply of money (savings) is low, then the demand should be high, thus causing higher interest rates, so how can interest rates be low if savings are low?

The reason is because the Federal Reserve has the ability to print money to create the illusion of savings in the market.  They do this for a number of reasons: to try and stimulate the economy, to keep their debt payments low, and to avoid cuts in spending.  All of this comes at a cost though: inflation.

When money is printed out of thin air, it dilutes the value of everyone’s dollars.  Prices rise as our cost of living increases, but our standard of living does not.  Inflation is a hidden tax that destroys savings.

The Fed is pumping more air into the bubble, and when the bubble bursts it will just burst that much bigger.

Artificially low-interest rates discourage savings

In the free market, unencumbered by the Fed, interest rates rise as people decide to save their money instead of spend it.  There is less supply of money in the marketplace, therefore the price of it (interest) goes up.  This is not a bad thing.  Savings are what allow people to come up with the capital to start their own businesses, manufacture goods, and take advantage of opportunities available to them.  Savings create a strong economy with stability.

However, when interest rates are artificially set too low, there is little advantage in saving.  First, the low-interest rates try to stimulate spending and borrowing, which is the opposite of saving.  Second, low-interest rates provide very little return on savings.  Lastly, the low rates are brought about through inflation, which makes savings worthless.  Most savers during the times of inflation are losing the value of their money instead of gaining value.

What will happen when interest rates rise after all the artificial lows?

There is no way that interest rates can stay low forever.  Each time the government intervenes to lower them, the pleasing effects only last for a short time.  But instead of rehab, they just keep giving the economy another boost of drugs in hopes that it will get better.  The problem is that the interest cannot get much lower.  Japan tried to keep interest rates low, all the way down to 0%.  They now refer to that time as the Lost Decade.

When interest rates do rise after such long artificial lows, we will feel the pain.  It will not be easy.  Our country has such a large debt that the government won’t be able to sustain its current spending with higher interest payments.  Therefore, when interest rates initially rise, there will be a lot of cuts in spending.  This is what we have needed for a while, only this time we won’t have the choice of whether to cut or not, it will be required.  And since the bubble has been inflated for so long, it will be that much harder on the economy before we see the light at the end of the tunnel.

Maybe on the backside of this recovery we will realize that distorting the interest rates have huge consequences.  If left alone, the rates will adjust by themselves, just like the prices of most items.  Nobel Prized economist F.A. Hayek made it quite clear that regulators and economists cannot control the economy, and to think they can is the “pretense of knowledge.”  Our economy is much too complex and diverse to leave it in the hands of the few regulators, only the free-market (which includes the knowledge of everyone) can decide the right interest rates.

This is just something to think about next time we are amazed at how low-interest rates are…. To me, they are a sign that our market may have some rough roads ahead.

Photo Credit: Living on Credit Cards” by  CC Licensed.