Are Low Interest Rates Bad?

It is generally understood by economists and indeed politicians that low interest rates benefit the economy since they spur economic growth. I think this is a fallacy and shall try and explain why in this paper.

Two things happen when interest rates are kept low: the currency will decrease in value and money will become cheap.

This obviously creates winners and losers. Since artificially low interest rates have only really happened twice in modern times, in Japan and in America, I will spend some time on these economies. Comparing two different systems is like comparing apples and pears...they have modern and very liquid financial markets but they differ on two major accounts: America is a net spender and Japan a net saver. America's currency is also a save haven and so is better shielded from currency attacks.

THE JAPANESE EXPERIMENT

The economic mix of cheap money and a low currency proved to be very beneficial to Japan's leading export oriented corporations, the so called winners. Firms like Toyota (TM), Canon (CAJ), Sony (SNE), etc. where able to raise huge amounts of capital at artificially absurd low interest rates and buy new, more efficient machinery and equipment to greatly improve their competitiveness.

In doing so, they went to America and Europe and, loaded with a new competitiveness and low currency, they dominated whole industries. They had become so good that American law makers made regulations about steel imports, car import and put forth huge efforts to get Japanese auto makers to build car plants in America (otherwise we would probably have had a fully fledged trade war).

The losers of the Japanese experiment have first and foremost been small to medium size firms catering to domestic demand, representing some 75% of the economy and the general public. They are not export oriented and had paid a huge price for the low Yen since imported goods, services, raw materials and energy becomes more expensive. Japan currently imports all its energy.

The second big group of losers has been private individuals, and since Japan is a huge net saver nation it hurt almost every household when low interest rates lowered income from their savings. Household interest income from savings accounts was 39 trillion yen in 1991, roughly $444 billion, and fell to a mere 3 trillion yen in 2005 or roughly $34 billion using an exchange rate of 88.

So in effect, the policy of low interest rates is harming the consumer; ordinary folks and transferring their wealth to the banks. How and why? After the turbo-charged decade of the 1980's, banks were left with massive bad loans, loans which could not be repaid. This stopped banks from lending to otherwise healthy business putting the whole economy at risk. A situation very much like the current mess we have today.

The banks asked for government assistance and received a promise of low interest rates, that way their margins would increase dramatically (margin being the differences in what they pay savers and want they lend their money at) and over time they would be able to write off their bad loans and hence start lending to businesses in general. Consumers would then, as economic theory goes, spend more as loans become cheaper. The only problem is that the first part happened only to a degree and the second part actually never happened.

LOW INTEREST RATES IN JAPAN – A FINANCIAL STRAIGHT JACKET

Take a closer look at Japan's banks. Since Japan is a net saver nation they could take in savers' money paying them next to nothing and start buying the JGBs, Japanese 10 year government bonds yielding 1.5 to 2%. It was viewed by policymakers in Japan that the banks where in such dire condition that low rates would have to be kept until they had cleaned their balance sheets.

So this is what they did, and in return the banks bought JGBs in huge numbers, daily, weekly, monthly, and yearly. They kept on buying and now almost two decades later they hold such large numbers that the situation is so skewered that if MOF (Ministry of Finance) tries to raises interest rates these bonds will, obliviously, take a hit and thus seriously hurt the whole banking industry.

So Japan has locked itself into a position where it simply cannot raise interest rates, which in turn has altered its financial system. Since Japan is a net saver as described earlier and since the Japanese economy has been doing very poor ever since the housing bubble burst in the 1980's, savers did what they always do in trouble times - they saved even more. So Japanese banks were loaded with cheap money and that led to the next unforeseen event: the carry trade.

CARRY TRADE – THE BIGGEST DESTROYER OF WEALTH

Since Japanese consumers continued against all efforts to keep on saving, banks had so much money they started lending to the so called carry trade. Money was borrowed in Japan and banks had more money than they knew what to do with. Banks started lending to foreign as well as domestic corporations, financial institutions, brokers and investment banks via the money market and by issuing Yen dominated bonds which in return paid an interest rate at around 1-2% and went on a shopping spree around the world to find higher rates of return.

They did so in the economies of Australia, USA, England, Euro zone and New Zealand, and had higher interest rates and a solid western style financial banking system in case they had to sell their assets in a hurry.

When borrowing in one currency and placing these in another, you face a new risk: currency fluctuations. However since everybody was doing it, the Yen kept on falling and the US, Aussie and the Kiwi kept on rising, it only meant that more people got in on it as can clearly be seen on the Aussie/Yen chart below. (Click to enlarge)
Everybody started making money not only in the interest rate differences between the Yen and, for example, the Australian or New Zealand dollar.

They were also benefiting from the currency they borrowed in; the Yen lost value to other currencies. And since most if not all currency trading is geared, meaning a person can use a initial deposit of $10,000 and borrow up to 20 times of that amount, or even more, it meant that the initial $10,000 could be pumped to a $200,000 bet ever increasing the income as long, as the in the case above, the Aussie continued to gain against the Japanese Yen which it did from 2000 until 2008. The hardest hit countries in this export of cheap capital where Australia and New Zealand whom in order to stem the tide of incoming capital which created inflation the central banks actually raised interest rates to combat this making even more people join the carry trade and continuing the spiral; a new bubble was forming!

However everything changed in a few short months in late 2008. Since most investment was geared, it meant very little currency fluctuations had to occur before a trader would take a loss. In the example where a $10,000 investment would be geared to $200,000 a currency deviation of only 5% would take out the whole initial investment of $10,000, thus forcing the trader to force liquidate his position. This is what happened in late 2008, where the Aussie/Yen was trading at 103 until the end of 2008 where it traded again at 55. A loss of more than 46%

And it all came down to the initial idea of having low interest rates in Japan.

THE AMERICAN DREAM

The main difference between Japan and America as stated earlier is the fact that America borrows more than it consumes and that the US dollar is used in most businesses transactions and is seen as a world reserve currency. Thus the experiment was much more domestic, money was imported from all corners of the globe.

The Asian economies with huge currency reserves, the oil rich countries in the Middle East with huge oil wealth and so forth started lending in huge numbers and since the US dollar is used as a reserve currency they saw little risk. They also took their money and put these to work as I have already described in more detail in my paper called “Has the financial system failed?”

SQUEEZING MARGINS

What happens with banks in America in an environment of low interest rates? We need to take a closer look at the banking structure there. When the Fed eases rates it has the consequence of lowering rates from which banks can borrow, however the rates at which they fund themselves cannot fall much further.

That, in turn, means any decreases in lending rates squeeze margins. For example UBS expected the U.S. banks' net interest margin to decline between 0.07 and 0.1 percentage points in the fourth quarter and 0.05 to 0.07 percentage points in the first quarter of 2009, representing a nearly $10 billion annual drag to the industry's net interest income.

Banks generally speaking like safe bets – please turn a blind eye to the current financial mess, because I said 'generally speaking'. Therefore, banks will be forced to look for an alternative way of increasing their spreads which is the difference in what they pay savers and what they earn putting the savers' money to work.

They try to up sell new products, increase fees, lend more aggressively in order to achieve the same rate of return on their investment and since imported cheap capital is never ending and the house and stock market kept on rising they kept on lending, creating bubbles in almost every asset.

And the fundamental reasons are not that hard to figure out: when ordinary people like you and I are faced with low interest rates it makes us take a bigger risk in the chase for a better return. Most people will take a chunk of their money out of their savings account which is paying 0.25% and put them into the stock market, hedge funds, obscure IT ideas, housing and any golden boy with good ideas. In other words: a truck load of easy money will be chasing an ever limited supply of good ideas forcing even bad ideas to rise in value. And presto we have a bubble.

It is only natural and fully understandable. If you are saving up for your pension, getting 0.25% on your savings account is not going to make you retire in comfort. However a steady return of 5-7% is a whole different ball game. Sure there will always be people wanting to take risk and chase the new more risky ideas and god bless them for that because they are part of funding that next Google (GOOG) or Microsoft (MSFT). But the numbers will be more limited, and since capital is more limited only the very best of ideas with the best business plans and most talented management will get funded.

Remember the days of the IT bubble where kids at 18 with a website could attract millions in funding on a business plan written on the back of a napkin? I remember because I got funded on a business plan written in less than two weeks.

Or the NINJA loans of the the housing bubble? No Income, No Job and No Assets? Anyone could buy a house with no money down, without proof of income and no assets. Cheap money was flooding into every aspect of the economy.

AMERICAN TREASURIES – THE NEXT BUBBLE

At one point either inflation kicks in or the Fed raises interest rates to more “normal” levels and that will seriously hurt the bond market. The current environment with low interest rates are hurting the very basics of supply and demand. And the Fed is doing everything it can to mess things up! Some, including Nobel Prize-winning economists Joseph Stiglitz and Paul Krugman, assigned a large degree of the devastating Credit Crunch of 2008 to Greenspan because he kept interest rates too low!

So what is the Fed doing now? It is copying the situation in Japan; US treasury bonds are rising fast since they seem to be the only safe haven left. And the Fed has even talked about buying these assets, pumping up the price even more! They are slowly but surely creating a new bubble in the bond market with potentially equally devastating effects as we are witnessing today or putting the US into the same financial straight jacket as in Japan. Why anyone right now would lend money to the US government for 30 years at 2-3% is beyond me, and I am sure that when this becomes known on the street, people will demand more and the bond market will take a hit.

MOTHER NATURE AND MARKETS ARE QUITE ALIKE

There is an old saying that if you mess with Mother Nature, she will bite back. Well the very same goes for the financial market. For all its blessings in the distribution of wealth, raising incomes and stopping wars, it is also a monster when governments and politicians try to mess with it. And keeping low interest rates is one sure way to do just that.

Think of the Mexican Peso crisis, the flawed European ERM system, of which I was part of destroying, the Sterling Crisis, the Russian Ruble default crisis, the Filipino Peso, the Asian crisis, etc. All of these were due to the misunderstanding of the financial markets and politicians' lifelong pursuit of trying to tame these to their will and their benefit.

Money will always flow to the place with the highest possible return with the minimum of risk. If you try to alter this it can have a dramatic effect on all of us even when the intentions are good.

Here's the basics of economics: low interest rates make people chase a limited amount of ideas in order to achieve a better return on their money. And this in turn creates asset bubbles.

So what's the ideal level for interest rates you might ask? To be honest, I have no idea... I am not an economist, and I am sure some clever PhDs out there can amass some better math formulas on their computer to find a perfect equilibrium rate than I can. So I will not even try.

What I am trying to say however is this: low interest rates obscure the fundamental structures of the market; the supply and demand and in return creates asset bubbles or other unforeseen effects like the carry trade and does not help the economy in the long run!