Go to Top

How Low Interest Rates Sap Economic Growth

Conventional wisdom tells us we need record-low interest rates to help the global economy recover from the Great Recession and bring about a more prosperous future.

Let me respectfully point out that, in this country, we have had low interest rates — ranging from pretty low to astonishingly, jaw-droppingly low — for the past 15 years, and we have arrived at a future that is not what we were aiming for. The federal government and many states are wallowing in red ink. Retirees and other savers get almost nothing for the money they put in the bank, while healthy businesses and prudent individuals cannot get loans. Why should banks pay interest to take your money and lend it to me, a mere mortal, when they can get all the money they want from the government at virtually no cost, and use it to make a fortune in proprietary trading and the corporate money markets? They shouldn’t, and they don’t.

So we have near-zero interest rates that do little to promote long-term economic growth. In fact, prolonged low rates are getting in the way of growth by discouraging saving, lending and investment.

Brazil, on the other hand, has had high interest rates since the 1990s. Its economy is booming, and its federal budget forecasts a surplus (I repeat, a surplus, not a deficit) this year of more than 3 percent of gross domestic product.

High interest rates encourage efficiency and innovation. Families, companies and governments that pay a lot for the privilege of using someone else’s money are naturally going to borrow less, and they are going to use the money for endeavors that have a high expected rate of return. The hurdle rate for investments is higher when money is priced as though it is actually worth something.

Low interest rates, especially when maintained for many years, promote wasteful and inefficient use of resources. Governments pile layer upon layer of debt because, with ultra-low rates, the annual interest expense is manageable — until rates go up or until the debt mountain is so large that, as in the case of Greece, lenders abruptly stop refinancing it.

Businesses that can borrow money at low rates often make ill-considered acquisitions and other bad investments, or pay exorbitant salaries, dividends and other outlays that the enterprise cannot sustain through its own earnings.

Individuals tie up cheap credit in oversized houses that they don’t need. Once the jumbo mortgage is paid off, the individual has a very large residence that costs a lot to maintain and does not generate any income, but the opportunity cost is low, because money in the bank would not be generating any income, either. You might as well put your money into something tangible, like a house, and hope for the best.

Of course, if the individual pays too much for that house, gets caught with an adjustable-rate mortgage that he or she cannot carry, or suffers a financial reversal, that cheap mortgage might still go bad. We have recently seen this happen on an unprecedented scale, made possible by year after year of cheap credit.

The conventional wisdom about low interest rates is wrong. Or, more precisely, it would be right once in a while, when low rates are merely a temporary stimulus in an era in which capital generally is priced fairly. That is a very different world from the one we inhabit, in which interest rates are artificially restrained most of the time.

The wisdom I like comes from a more timeless source: the Aesop’s fables that I read when I was a boy. One that comes to mind is the story of the ant and the grasshopper.

The industrious ant toils all summer, storing grain in the insect equivalent of a money market fund, while the hedonistic grasshopper spends the comfortable days singing, carousing and making fun of the ant.

When winter arrives, the grasshopper is hungry and homeless, while the ant is snug and secure. The grasshopper arrives at the ant’s door seeking a handout but is quickly turned away. Harsh, yes, but fair. Even a youngster could recognize that all the incentives were in the right place.

The ant might at least have lent the grasshopper some grain, but it was obvious that the grasshopper was not a creditworthy applicant. So the ant chose to enjoy the fruits of her labor, by consuming what she needed and saving the rest.

If this were happening today, the grasshopper would seek extended unemployment benefits and a cramdown of his mortgage principal. The enterprising ant might use her savings as collateral for massive cheap borrowing, with which she could get into the business of making and securitizing subprime loans to grasshoppers. Why not swing for the financial fences? Her money market fund would pay her practically nothing for her savings, and Congress would be hell-bent on restoring an estate tax to siphon much of her accumulated wealth (for the benefit of every grasshopper earning less than $200,000 a year) before she could pass it on as seed capital to the next generation of ants.

Or the ant might just give up and gorge herself on her stored grain all winter before spending the next summer singing with the grasshoppers. Either way, the insect economy would stagnate.

The moral of this fable is to be careful what you wish for.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

The views expressed in this post are solely those of the author. We welcome additional perspectives in our comments section as long as they are on topic, civil in tone and signed with the writer's full name. All comments will be reviewed by our moderator prior to publication.

, , , , , , , , , , ,