This is part 3, with other parts to follow in future diaries (hopefully). If you missed the first couple of installments click on the links below to read them. I have also added an intended fifth segment talking about energy.
Part 1. The Bushies have dug a big, big hole.
Part 2. Consumers are up to their eyeballs
Part 3. How low interest rates have destroyed America
Part 4. Our foreign friends (?)
Part 5. An oily mess ( a look at energy)
If you go to an old time farmer's market you can see how prices can adjust based on the weather, what the stall across is selling its products for, and how much stock the farmer has as the market is about to finish. The sellers adjust their prices to try to make the most money, and hopefully sell all their produce too. This is how markets have worked for thousands of years.
Now think of money itself. What is the "price" of money? The answer is the interest rate. If you want to borrow money you need to pay someone to use their money. If you save, you want someone to pay you. Now how much you save or how much you borrow is tied to the price of money, the interest rate. If interest rates are low, you can borrow a lot more for the same "price". At the same time, low rates make it seem like it is not worth saving as you get so little interest in return.
Now if you have read the previous two diaries you may see where I am going with this. As I have mentioned, following the bursting of the tech bubble and the aftermath to 9/11, Greenspan and Bush have been trying like mad to keep the economy growing. (Bush wanted to get re-elected and Greenspan wanted to avoid what happened to Japan after their bubble burst in the 1980's). To do this they have flooded the market with money thereby keeping the price of it down (interest rates). We have had interest rates at record low levels the past couple of years, so low in fact that they were even below the rate of inflation. If you kept money in the bank you lost money. No wonder savings rates are at record lows.
What is so bad about low interest rates?
There is nothing bad about low interest rates as such. Low rates usually go hand in hand with low inflation. What is bad is if the rates are "artificially" low, as they have been the last couple of years. Why? Because they lead people to make bad economic decisions and that eventually is bad for the economy.
Let's look at an example. Let's say that after all your expenses you find you have another $100/month available. You have several choices:
a) you could save it and get interest from the bank (at maybe 1%),
b) you could spend it on going out or on taking a night class at school,
c) you could make extra monthly payments on your mortgage, or
d) you could borrow some money on your secured line of credit (at say 6%) and buy a big screen TV, a new sofa set and some new deck furniture. In fact, you could spend up to $20,000 before you would use up the $100 a month in interest payments. (If you wanted to spend half the money on interest and half on repayments, you could still spend $10,000)
So which option would you choose? Pretty hard not to choose d) isn't it? Now imagine that this kind of calculation is going on in homes all across America and what the cumulative effect could be. Also think how the decision would be different if you could get 5% interest on your savings at the bank, but had to pay 12% on your line of credit. Lower rates make borrowing easier and saving harder.
Let's look at a similar example from another perspective. This time you again have $100 to cover monthly interest payments. This means that if rates are 4%, you can borrow $30,000. If they are 6%, you can borrow $20,000. If they are 10%, you can borrow only $12,000. So if redoing the basement costs $12,000, the new home theatre system costs $8,000, and an extra second hand car for the kids costs $10,000, you can see that what you can afford depends upon what the interest rates are. You can also imagine that with low rates you can easily buy things that you would never even consider if rates were higher.
The other problem is that people seem to have a blind spot when it comes to borrowing money. They see the interest rate but miss the fact that they have to pay back the money too. So in our example above, if rates are 4% you can fix the basement, buy the home theatre, and the car, BUT you are also stuck with having to eventually pay back $30,000! If rates were 10%, you would probably only have fixed the basement and only owed $12,000.
Again all this is understandable, but remember I said interest rates were artificially low. So what happens when rates go to where they should be (or even higher)? We still have the $30,000 debt, but now that rates have risen to 8% we have to pay $200/month in interest instead of $100. Ooops! So much for any extra spending over the next little while. Essentially the artificially low rates have sucked people into taking on a lot more debt than they normally would have. When interest rates return to normal, there will be a big, big hit.
The US government is making the same mistake.
It is not just consumers that get sucked in by low rates. The government has also fallen victim. Some time ago the government got rid of the 30 year bonds that had a fixed interest rate (usually higher) and started borrowing more money short term, at the lower short term rates. Well surprise, surprise they too found they could borrow more money for less interest. As I showed in Part 2, despite debt going up by 30% since Bush got in, interest costs actually came down.
It's a nice trick, but it leaves the US very exposed to any move higher in rates and even more exposed should the world decide to stop lending the US the money it needs. As it stands now the average term of the US debt is only 4 years (think of a 4 year mortgage). So the US has to refinance its entire debt every four years on average (almost $8 trillion!). If the foreigners that hold about 25% of the debt decide that they want a higher interest payment next time around, look out below.
Inflation, Interest Rates and Debt:
Back when inflation and interest rates were higher, the conventional wisdom was that you took the biggest mortgage you could afford, knowing full well that as your wages rose over time and your mortgage payments stayed constant, you would gradually have more money to spend again. And this made a lot of sense at the time.
But now inflation is much lower and wage increases perhaps even less. It is now much more likely that your monthly payments could go up more, as interest rates rise, than your salary does. The only way you can make money now is if your house also goes up in value...but as rates go up, people will not be able to afford as much for a house, so we should soon see a real cooling off in house prices. Oops!
There are a bunch of other negative impacts from artificially low rates and easy money. I will go through them very briefly or else this diary will become a book. If you want more info on these, post a comment below and I will try to add more.
a) Low rates mean that pension funds and other investment vehicles can not make the returns they used to make. As a result companies are falling behind in putting enough money into their pension plans.
b) Investors forget about risk. Because there is so much money floating around investors are aggressively looking for a better return, anything more than the measly 2% they are getting on government debt. So they buy junk bonds. These things should have very high interest rates because most companies will never pay back the bond, but because there is so much demand the rates have fallen to ridiculously low levels. It is like everyone is chasing to get a slightly higher interest rate but forgetting about getting repaid.
c) Lenders forget about risk. How else do you explain people buying houses for 0% down. Even an idiot knows that if the buyer can't make a down payment on a house, they probably are not someone you want to lend $300,000 to! But the banks have money to lend, and they want to grow, and well they issue the mortgage and then sell it off to Fannie Mae...but that is another nightmare.
Low interest rates are very good at getting the economy to grow. The problem is that low rates also cause people to make poor decisions that will hurt the economy in the future. Many of these poor decisions have already been made and the future looks more uncertain because of it. As they say, "No country ever spent its way to prosperity" (note: savings and investment are the normal route to prosperity - but artificially low interest rates have made savings and investment seem old fashioned).