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This diary is intended as a primer for those who may usually ignore economic discussions.  I will try to keep it simple because this is very important to you!  I'd like to give an easy to follow description of the trouble the US is in, and why you need to protect yourself.  

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)

Part 3. How low interest rates have destroyed America

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!

Other Impacts:

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.

In summary:

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).

Originally posted to taonow on Tue Apr 26, 2005 at 04:59 PM PDT.

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Comment Preferences

  •  If (4.00)
    If anyone has additional questions, please feel free to ask.

    Just because you can doesn't mean you should!

    by taonow on Tue Apr 26, 2005 at 05:17:58 PM PDT

  •  value of both consumption and inflation (none)
    You miss the good effects of more consumption and less savings- it adds work and revenue to the overall pie, and longer term, inflation makes todays borrowing cheaper since payments are made in the "old" dollars but money is earned in the "new".  If you look at the prime rate since 1946, while we are in a low cycle, its not unheard of and hardly way out of the range.   I dont know about the saying, but the USA has spent its way to prosperity many a time in its history.


    Out of my cold dead hands

    by bluelaser2 on Tue Apr 26, 2005 at 05:19:49 PM PDT

    •  I agree to a point (none)
      Extra consumption can be good at stimulating the economy, but as I noted in the second diary, an awful lot of this consumption has gone on record high imports. It is as if the stimulation from the low interest rates is "leaking" out of the US and into other economies around the world (kind of like trying to blow up a balloon with a hole in it).

      Just because you can doesn't mean you should!

      by taonow on Tue Apr 26, 2005 at 05:26:35 PM PDT

      [ Parent ]

    •  Read the earlier parts (none)
      The work has gone overseas, and wages have stagnated while inflation is starting to tick up. We're not going to spend our way out of this situation, this time.

      Hatred is murder (1 John 3:15)

      by dirtroad on Tue Apr 26, 2005 at 06:15:06 PM PDT

      [ Parent ]

    •  Not really, (none)
      That sounds good.....but when people finance consumption with debt what they are doing is, in effect borrowing the demand from the future. That is good in the now but makes the future harder as they won't need to buy that flat screen next year but they will have to pay a larger portion of thier income to the increased interest costs when rates do rise. That is the whole point. It may be good for today but at the expense of tomorrow.
  •  Thank you (none)
    I am a software developer working with accounting software. I got my degree in Business managemet:  took lots of Econ, finance, and accounting classes in college.

    I know all this stuff, thank you for putting it together in a way I can give to my fire fighter buddy, my mother, or my sister who is a stay at home mom where they might actually read it and understand it.

    I plan on sending it off to lots of people once it is complete (assuming I will not be violating any copyrights)

    Not everybody can read Brad Delong's Blog without nodding off.

    Red meat is NOT bad for you. Now blue-green meat, THAT'S bad for you! -- Tommy Smothers

    by KennyBabes on Tue Apr 26, 2005 at 05:20:35 PM PDT

  •  Monetary policy... (none)
    It's easy to second guess the Fed at this point... after all, hindsight is 20/20.

    It seems to me that in theory low interest rates could be a good thing if the Fed wants to stimulate the economy.  Lower cost of borrowing makes it easier for businesses to invest in new technology, etc.  Back in 2000/2001 could anyone have forseen low interest rates fueling another asset(housing) bubble?  Or consumers taking on unprecedented levels of debt?  By some measures on paper the economy is doing really well...  it's just too bad that we can't export $800k McMansions overseas.  

    I guess what I'm wondering, IOW, is that if the money that low interest rates made available to US consumers and businesses were invested into technology, infrastructure, education, etc. instead of mortgages to buy overpriced housing would we be better off?  And how could the Fed(or the federal gov't)have encouraged wiser use of this money in a macro sense?

    I'm so metal I have the unlisted Number of the Beast.

    by MjrMjr on Tue Apr 26, 2005 at 05:34:50 PM PDT

    •  Monetary Policy (none)
      I think there were more than a few people out there urging caution w.r.t monetary policy. Me being one, but who listens to me.

      Yes, the economy would be much better off if the low rates would have been used to invest in technology, etc at home. Unfortunately much of the investment has taken place overseas.

      Also, in the past, a lot of the consumption triggered by low rates would have been spent on domestically spent goods, giving a kick to the economy. This time a lot seems to have bled off onto imported goods.

      As for alternative policies, I think there should be limits on the issuing of credit. When people can buy $400,000 homes with no downpayment, interest only mortgages, and whatever other bell and whistle you can add on, plus having everything backed by Fannie Mae, I would say that you might just have a problem. Kind of like having piles of free booze at a party and wondering why people got drunk.

      Just because you can doesn't mean you should!

      by taonow on Tue Apr 26, 2005 at 05:42:38 PM PDT

      [ Parent ]

      •  Balance of trade... (none)
        Oh, I know that there were plenty of folks arguing caution.  I just-and this shows you how cynical I am-wonder essentially...  did the Fed act in good faith or did they know that cheap money would lead us to unprecedented levels of debt and a housing bubble?

        Your post makes me think of arguments about the balance of trade...   it seems to be 'common wisdom' that one of the side effects of a falling dollar is that it will correct the balance of trade by making our exports more competitive.  Well, we see how well that idea has been holding up.  I wonder-and I have only anecdotal evidence to back this up-if the weakening dollar not having a positive effect on the balance of trade is due to the fact that we don't really make anything here anymore so there's no exports anyway?  Doesn't matter how cheap our goods are overseas if we don't make any to begin with...

        I'm so metal I have the unlisted Number of the Beast.

        by MjrMjr on Tue Apr 26, 2005 at 05:53:24 PM PDT

        [ Parent ]

        •  Balance of trade (none)
          W.r.t the Fed, they may have acted in good faith, but it was evident early on that there were some serious side effects and they did nothing to mitigate them (would have hurt Bush's chance for re-election).

          W.r.t. the trade deficit, remember it is two way street. Not only is America not selling enough, it is buying too much. One heck of a lot of that buying is being done on credit. If the Fed raised rates and curbed consumption that would really help. Americans can't be out shopping and putting everything on their credit cards and at the same time be wondering why their income has not gone up to match.

          Exchange rates are a problem because the US dollar is the currency used for the pricing of most raw materials. So what happens is that when the US dollar drops, the price of say copper, in US dollars stays the same, but for other countries whose currencies have appreciated the price actually goes down, helping them gain back some of the compeitiveness they lost when their currency appreciated. A second factor is that the Chinese have pegged their currency to the US dollar, so the currecy adjustment mechanism can't work here.

          Just because you can doesn't mean you should!

          by taonow on Tue Apr 26, 2005 at 06:09:44 PM PDT

          [ Parent ]

      •  New Large homes in Chicago (none)
        are all the rage.  It is so good to read these papers since it shores up my own thoughts about the gentrification of our neighborhoods.  Those of us who have a home (modest, but perfectly fine) and garden in the city are being pushed out in a psychological sense.  Developers have voiced that our time is over.  It seems to enrage them that some of our houses are paid for.  Where do we get off?  Get out and let us make money.  When they build million dollar homes around you - many of us move.  I am holding on.  My mortgage is manageable but I feel that the financial pressures are for me to get out -- not to help me stay.  In the meantime, huge homes with huge garages are being built - no gardens, only cement.  This has got to hurt us environmentally in many ways. At any rate, the financial landscape is geared toward developers' - helping them to make more money and pushing us out.  A microcosm of the larger economy.    

        It sure the hell is heavy, father -- it's my grandchildren's share of the birth tax

        by xanthe on Wed May 04, 2005 at 04:45:44 AM PDT

        [ Parent ]

  •  You might want to read (none)
    Bonddad, Jerome a Paris, myself and London Ynak, since we've been writing on these same issues as well.
  •  Actually (none)
    Actually it has been reading what you guys have written that inspired me to try my hand. I just thought I would try to make it as simple as possible, with as few numbers or graphs, for the economically phobic.

    Just because you can doesn't mean you should!

    by taonow on Tue Apr 26, 2005 at 05:44:22 PM PDT

    •  all (none)
      people should be able to undestand all things.  it is the lack of explanatory abililty on the part of caretakers of technology that create the cognitive barriers that stifle a layperson's understanding of information.  Such is the tyranny of the Educated Western Elite (and a reason why Democratic party is getting it's ass handed to them by the rightwing nuts).  Intelligence means nothing without the wisdom and talent to articulate it by creating abstractions that can be intergrated by people with differing cognitive abilities.

      You got talent.  Keep it up.


    •  I would suggest graphs (none)
      Graphs, yes; tables, no.  A picture often helps comprehension, especially for the uninitiated.  Good diary; looking forward to future installments.
  •  Scenarios (none)
    Let's say you imagined that there was absolutely no way BushCo would allow things to collapse under their watch, if there were any possible thing they could do to prevent it
    Can you speculate for us some possible options they might employ to keep the ball rolling?
    •  They have been trying everything (none)
      They have, especially since 9/11, been doing absolutely everything they can do to keep the economy afloat. But that doesn't mean that it will work forever. It would be kind of like asking how the government could keep the Nasdaq at 5,000. At some point the Laws of Economics take over. Sometimes they take longer than others to reassert themselves.

      Bush and Greenspan have

      1. Run big deficits, with tax cuts (pumps consumer spending and government spending)
      2. Started a war
      3. Turned on the printing presses
      4. Very low interest rates
      5. Told people to spend.

      Unfortunately they are almost out of ammo and the bad guys are still coming over the hill. The US really needs a recession.

      I posted this in comment to a diary by bonddad in resposne to someone saying we should not impose trade barriers:

      You don't need trade barriers to solve this.

      Put interest rates up to where they should be, stopping juicing the money supply, have an intelligent energy conservation program, and stop running a huge budget deficit.

      Do these four things with strong leadership from the top you will get a balanced budget and a more balanced US economy. Of course you will get a recession first, but after you have been drinking so much you are going to get a hangover sometime, better earlier than later.

      This way you don't have to rely on the Chinese or anyone else. You solve your problem on your own.

      Just because you can doesn't mean you should!

      by taonow on Thu Apr 28, 2005 at 04:51:37 PM PDT

      [ Parent ]

  •  interest rates (none)
     This is excellent. What are your politics? Your economic views sound almost Austrrian/libertarian. I agree with what you say, but is a recession inevitable? That would hurt a lot of ordinary people.
      Personally I think the Fed will not normalise interest rates so the dollar will bear the brunt of the correction in global imbalances. I think it's going to fall very sharply particularly against Asian currencies.
    •  My politics (none)
      Kind of a mix

      • generally socially liberal but fiscally conservative.

      • pro choice, pro gun control, pro universal health care, pro strict campaign spending limits
      • anti death penalty

      I believe there is a definite role for government, but that governments, just like their citizens, need to live within their means. To that end if the government wants to bring in a new program it needs to have the money to do it. If it can't get the money (either from current revenue, or from increased taxes because the people support the program) then it should not happen.

      I also believe strongly in markets but I know that that they are only as good as the rules that run them. If you give a market poor information, you will get a poor result. So basically totally "free" markets are a mess. You need some guidance.

      Just because you can doesn't mean you should!

      by taonow on Tue May 10, 2005 at 06:45:23 AM PDT

      [ Parent ]

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