Low interest rates – a toxic medicine

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Economics / Politics / Quantitive Easing

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Low interest rates are the solution to the problem of deficient demand in the same way that taking heroin is the solution to the problem of heroin addiction – quick acting, superficially compelling and yet totally wrong.

If there is one belief that unites the UK mainstream it is a belief in the benefits of low interest rates. The chief desire of successive UK governments has been to finagle lower interest rates by any means. Investors have traditionally demanded a premium from the UK, worried that it would inflate away its debt. This has driven up the costs paid by British businesses, leaving them less competitive against hard currency countries.

For this reason the condition of low interest rates has taken on a utopian character. Lower interest rates would make lower yielding projects viable for UK companies. This would drive down unemployment and bring the country closer to its true potential. The land of milk and honey was imagined to have perpetually low interest rates.

But we should be careful what we wish for. For we have entered the promised land and it is anything but a utopia. Interest rates have tanked across the developed world. The highest interest rate implemented by the four most important central banks of the high-income countries is just half a per cent – an extraordinarily low rate. The European Central Bank is at 0.05%. Rates almost as low as this have been in place in Japan for two decades. Sweden, Denmark and Switzerland are now experimenting with negative rates. And yet none of these countries are enjoying an economic boom.

The economist Larry Summers calls these conditions ‘Secular Stagnation’. But giving them a name has done nothing to fix the problem. If low interest rates have turned out to be a symptom of weakness not a herald of strength, why haven’t things turned out as planned? Why hasn’t our policy response to the downturn been more successful?

We have become so fixated on the consensus approach to economic management that its shortcomings have become invisible to us. Extreme and persistent changes in the level of interest rates boost the economy by stealing consumption from the future. They cause a one off, unfair redistribution of wealth between the generations and inevitably lead to permanent and lasting inequality. Adjustments to interest rates have become the prime method of wealth redistribution. Government usually acts to reduce inequality. But in this case huge amounts of money are being transferred from the poor to the rich, from the young to the old and from those who consume to those who save.

And rather than being redistributed by fiscal measures under democratic control the money is being allocated by central banks: supposedly apolitical actors, who have set out on this disastrous course at their own discretion.

We are slowly discovering that low interest rates are the solution to the problem of deficient demand in the same way that taking heroin is the solution to the problems of a heroin addict. First there is a buzz. Our symptoms recede temporarily. But its not long before we need another dose, and the long term effects are disastrous.

Its often claimed that changes in the level of interest rates and asset prices don’t really matter as long as inflation remains under control. This reflects a fundamental misunderstanding. To see why let us imagine a real estate asset that yields a constant financial return of £10k a year when interest rates are 5%. As an investor, how much would I be willing to pay for the asset? The answer will be around £200k, the price at which the asset produces a 5% return. If the central bank reduces the interest rate to 2.5%, the investor would pay £400k for the asset. At that price it would also return 2.5%.

If we were to buy this asset with a loan it seems nothing much would change on our income statement whether we took it out before or after the change in rates. The price of the asset might have doubled but the interest rate on the loan also halved. The interest payments are left the same.

Does this then mean that a change in interest rates is a neutral one that impacts no one? Not at all. The value of the property has doubled. The owner of the asset has profited enormously. Perhaps you imagine this a ‘paper profit’. The owner of the house has to live somewhere. The prices of every house will also have doubled. But economic statistics show that this paper profit has been spent by many. David Willetts explains the process this way:

swings in house prices can have a big impact on the distribution of wealth between generations – but the effect depends on what we do. Let us start with the case in which we respond to higher house prices with true wisdom and do absolutely nothing. We realise that we have not created any more wealth and have nothing extra to spend or to save. We just leave our house unencumbered for our children to inherit … as a generation we have not imposed any further burden on our children.

[But in the real world] we have not behaved with such wise self-control. Instead we have borrowed against the house or not saved as much as would otherwise have done [The statistics show that the savings rate has fallen heavily as house prices have risen.] We have either borrowed against the house already or we expect to finance our retirement by borrowing against it in future. And where does this money that we thought we had come from? From our children. If we increase our spending because our houses have gone up in value then we were taking from the younger generation. They have to spend more for their house and there is less of an inheritance to pay for it. So they have to pay more for their house out of their lifetime earnings. The flow of resource is from children to parents, not the other way round.

Imagine a country where every couple has two children, and where every house was previously un-mortgaged and worth £150,000 and houses were passed on, debt-free, from generation to generation. But each now increases in value to £250,000. We do not see that extra £100,000 as just an increase in the price of land but instead we see it more as a performance bonus, a testament to the extraordinary skills and virtues of our generation. We spend it now or intend to spend it during our retirement. Somehow or other we intend to release that wealth for our use. That means that when we die our children will find that instead of an inheritance of £250,000 to get a house like ours they find there is a mortgage on it and between them they get only £150,000.

That means that they either have to lower their living standards so they can service a mortgage to enable them to borrow the money to buy a house like their parents, or accept lower living standards in the form of smaller and cheaper accommodation than we leave them.

It is as if your parents die leaving a treasure chest and when you open it you discover a pile of IOUs which you are obliged to pay. A single generation has had a one-off wealth gain as the price of land shoots up relative to everything else. That one generation is converting this one-off wealth effect into higher consumption. If we thought house prices were going to stay high, our children would need the money to pay for their houses. If we thought they would fall, then it was never there to spend.

Martin Weale has calculated the scale of what we are talking about here. House prices rose between 1987 and 2006 at 1.9 per cent per annum faster than real earnings. That adds up to an extra £1,300bn of housing wealth on top of what would have matched the growth in our incomes. It is approximately 100 per cent of GDP transferred to current houseowners from future houseowners. This is a heavy burden for the next generation – in fact it is as if the government had increased the national debt by that amount and left the younger generation to pay it off with higher taxes.

Changes in interest rates and asset prices have deep and very significant effects. It impacts wealth inequality, and it impacts the relative wellbeing of generations.

When one generation spends a housing windfall it causes a short term boost to consumption. Unfortunately there is an equally large drain on the consumption of the next generation. What would an economy look like once these ill effects began to kick in? Young people faced with far higher house prices would be forced to save heavily, first for their deposit, and then for repayments of the principle of their mortgage. A higher rate of savings would mean less cash available to spend on consumer goods. The broader economy would stagnate.

Young people who are yet to establish themselves in their career would feel the greatest impact. Many of them would take longer to buy their first house. The barriers to the formation of new households would be higher. We would see changes in behaviour. Couples prefer to delay having children until their financial lives are stable. We would expect both the age at which couples marry and at which their first child is born to rise substantially.

As household formation is a major driver of demand for many consumer goods and services, from pillows and carpets to builders and event planners, we would also expect to see a drop in demand across the board. In fact, we would expect to see something like the ‘Secular Stagnation’ now observed. In principle, one unit of consumption would be lost to the young for every current additional one spent by the old. But this understates the effect. The higher barriers to life progression would change their destinies in ways that harm the economy over the long term.

Fewer households would be formed. There would be higher unemployment and less skilled workforce. Some economic activity would be lost forever. The negative effects would then outweigh the positive. Consumption and activity would drop over the long term. Willetts’ estimates of the scale of the effect are conservative. This effect is not limited to house prices. The values of all financial assets have been boosted by falling interest rates. His model can be extended to cover them all.

Imagine that every couple saved a pension pot worth £150k over their lifetime. Interest rates are flat at 10%. Once each couple retired they received £15k a year in dividends from the assorted financial assets that made up their pension pot. If interest rates fell from 10% to 6%, while the stream of income from the retirees’ pension assets remained the same, the value of the pension pot would also increase to £250k.

Just as before, the old receive a one off boost to their net worth. Some of these lucky people decide to use this windfall to increase consumption. Once again this bonanza is paid for by the young. They now find themselves required to accumulate £250k over their lifetime in order to receive £15k a year in retirement income. Again consumption has been transferred from the young to the old, and from the future to the present. We see the same picture whether we look at the rising prices of homes as any financial asset.

Every family’s income has remained the same. Yet after the drop in the interest rates each has to save £500k over their lifetime to secure a house and pension- £200k more than before. How will younger people respond to this? They have a range of options. At the one extreme they can reduce their consumption to save an extra £5k each year over their 40 year working life. At the other extreme they can maintain their lifestyle and ignore the problem. This means renting for their whole lives and failing to put away money for a pension.

If they choose the first option the economy will tend towards stagnation immediately. Money is immediately diverted away from consumption. If they choose the second option society stores the problem for later. The family will have no income at retirement and still be obliged to pay rent. The fall in interest rates effectively deducts £200k from the family’s net worth. It can choose to make it up now or later, but the deficit must be made up.

As Willetts’ notes, his fairytale has some rather unrealistic characteristics. In real life all houses are not the same and they are not spread uniformly across the population. Some people inherit a house in Belgravia others a cottage in Bangor. Many people inherit nothing at all. Every house purchaser has to fill the gap between the housing wealth they inherit and the value of any housing they purchase themselves.

It is getting ever harder for those dependent on earned income to save enough to raise a deposit. They simply can not match the purchasing power of those already holding housing wealth, whether older people or those who hold it because of an inheritance. The interest rate helps determine the relative power of workers and capital. The lower the interest rate the harder it is for workers to use income generated from labour to gain control of capital assets.

Imagine as an extreme case that interest rates were 100%. The sale value of a house would then approximate to its yearly rental value. In this scenario it would be an arbitrary decision whether to rent or buy a property. Imagine instead interest rates at 25%. Now the sale value of a house would approximate to four times its rental value. A 25 year repayment mortgage on the property would require a premium of only (4/25) or 16% a year over rent. It’s quite easy to adjust your consumption level by 16% to fund a mortgage. But now imagine interest rates at 2%, the sale value now approximates to 50 times its rental value. The premium of a repayment mortgage over rent rises to 200%. It is quite a different prospect for a renter to find 200% extra over their rent.

Falling interest rates undermine the position of those who use income to buy assets and empowers those who already have capital. Rather than being bought and sold by workers, assets begin to circulate amongst those who already control wealth. A rising percentage of the population is condemned to rent throughout their lives and pass their retirement in poverty, dependent upon the state.

The worst effect of the low interest rate policy is its legacy. The intergenerational effects will pass with those generations. The effect on inequality will be permanent. A gaping divide will open between those lucky enough to inherit wealth and the rest of us. In the words of Paul Johnson of the Institute for Fiscal Studies

“In the short run we are putting the jobs and earnings of the younger generations at risk and keeping them off the housing ladder. But in the long run this is about what will happen to inequality within the younger generation. We are in danger of entrenching economic advantage and disadvantage in a way we haven’t seen for a hundred years or more. For young people the wealth of their parents and grandparents is rapidly coming to matter more for their long term welfare than anything they can ever do for themselves through their own earnings. Which young people can expect a comfortable retirement in their own homes? Not those with the greatest talent, not those who have worked the hardest, just as in Victorian times it will be those who are wise enough to be born to rich parents”.


Following Willetts’ analysis we’ve seen that falling interest rates cause future stagnation by shifting the pattern of consumption. We’ve found that those who benefit from falling interest rates and choose to spend the windfall borrow demand from the future. But this is exactly the pattern of behaviour that the Bank of England has been attempting to promote since the GFC. The BoE has been doing its best to provide windfall gains to asset holders in the hope they will spend the money on consumption.

The UK interest rate is now so low it has now at what the BoE regard as its lowest practical value. The BoE has been forced to look out another technique simulate negative interest rates. They have alighted on buying up financial assets using printed money in order to push up the value of financial assets (Quantitive Easing). The intention is to boost spending via the ‘Wealth Effect’. It is hoped that people with assets that grow in value will feel richer and spend more.

Attentive readers will note that this reaction is exactly the one that Willetts counselled against – the reaction that will inevitably heap debt on following generations. If Willetts is right the ‘Wealth Effect’ might be better the called the ‘Debt Effect’.

Homer Simpson described alcohol as the cause and solution to all life’s problems. He would surely have approved of the BoE’s use of QE to address the problem of secular stagnation. The deficit in current demand results from past attempts to shift consumption from the future of old that is now our present. The cure proposed is the shifting of even more consumption from the future to cover over today’s demand deficit.

Low interest rates are the solution to the problem of deficient demand in the same way that taking heroin is the solution to the problem of heroin addiction – quick acting, superficially compelling and yet totally wrong.

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