Low Interest Rates may help you buy your house or car on the cheap but are just storing up problems for long-term savings like pensions. Warning this is not an article to be used as a basis for dinner table chat..
The basic theory goes that lower interest rates will lead to more private borrowing which will in turn fuel growth. But what few people realise is that since 2008 private (and public debt) in the so-called developed economies have risen significantly without the usual match in GDP growth (just look at the chart below). The reality is that a large part of this cheap money has gone to buying up property at hugely inflated prices – does this sound familiar? So rather than growth in productivity (physical products or services) we have growth in property bubbles and debt. Low interest rates disguise the true risks associated with inflating asset price bubbles, as the risk premium which should be associated with asset fueled growth does not reflect the actual inherent risk in the project. It should be said through that assessing risk in terms of financial markets is somewhat of a black art.
As can be seen from 1995 to 2008 (approx) there was a relatively strong relationship but since then private debt has risen at a far higher rate than GDP. So have we reached the point where debt has a diminishing marginal return on GDP? If so then eventually the GDP level will be far too low to support the level of debt. Much like if you return to the UK in around 2003-2008 when the cost of property and mortgage payments rose far higher than the rate of salaries… We all know what the end game there was.
So you still don’t care? Yes it’s pretty boring.
Private debt is often ignored as the cause of economic problems by governments and the self appointed group of leading economists. So instead lets look at what the Tory government will tell you is toxic, public (government debt). It is worth noting that despite the UK government saying that they are cutting debt in reality since coming to power in 2010 it has almost doubled. However it is worth noting that relatively speaking Government debt in the UK is at a far lower percentage of GDP than it was from the 1920s through 1960s. But that is not the whole picture.
As we know with Greece once you go beyond a certain point of debt it becomes impossible for the state to repay it; even with relatively low rates of interest. The UK for example enjoys two major advantages low rates and the ability to print its way out of the mess; it has been printing more and more pounds since 2008. While the cost of borrowing is low and the UK tends to borrow for long periods of time, eventually it has to be paid off! Therefore as the debt rises relative to GDP it becomes in the longer term harder and harder to service. However, if inflation is left to run a little higher then over time the cost of paying it back becomes less in real terms. Furthermore, as tax rates are politically difficult to raise the only impact can be on public spending, which is why we see billions being removed from welfare. The other alternative is to sell off state assets at at discount, which in turn erodes the future ability to repay debt or maintain future expenditure. Right now in the UK, state-owned French, German and Chinese companies collect the dividends from what were state-owned British utilities.
The debt bomb has a mild benefit for normal people as the Government needs to sell this debt to borrow money. In reality this means financial institutions and funds are buying up this debt, even at it’s low rate. This in effect provides some safe (well for now) haven for your savings, even if the return sucks. It does however mean there are other problems in the pipeline.
And for you?
Low interest rates also erode the value of cash as the effective rate of return on savings is lower than the rate of inflation. This has the twin effect of lowering the value of your money (in future) but also means that pension funds etc cannot obtain the returns on cash and bonds to maintain their returns in the future. This forces them into ever riskier investments including property which is now clearly in a bubble phase again. The effect is that your pension is now even riskier and will most likely fail to return anything which is sufficient to provide you with a decent retirement. Indeed since 1995 the amount of money invested in other assets in pensions (property and derivatives etc) has increased from 5% to 25% according to Towers Watson. With falls across the stocks, cash and bond categories.
Ok so lets put up rates… This will almost certainly immediately lower the market value of existing bonds (public and private) as the rate of return on these bonds relative to cash and any newly issued bonds will fall. The only way this may not happen is if for some reason other countries are in a far worse situation than the UK, so relatively speaking UK Government debt is perceived as safer. Low rates have created an asset bubble into which pension funds have jumped. Rising rates will puncture this bubble, depressing, the stock markets, property and bond values thus lowering further pension fund values. For now the returns look great, even excellent but it is little more than a bubble (see article on defined benefit pension fund returns). The last economic shock in 2008 saw values that year alone fall by 13.4% in the UK (see Penions World Article Below).
Now the dual financial bomb strikes. Companies can offset their debt interest against tax payments, so if their profits are increasingly swamped by interest payments the government tax take will fall. So not only will Governments have to cut spending even more but at the same time the the debt repayments relative to GDP will start to rise again; further compounding the budget problems that they encounter. So any meaningful rate rise which would benefit savers would have real negative impacts on powerful wealthy individuals and governments.
Finally keep in mind that while average living standards have only now started to approach or slightly increase above 2008 levels, the top 1000 families in the UK have doubled their wealth. This in effect means that your negative rates of return are being used to finance the speculation and asset purchases of the super rich.
No doubt may “properly” trained financiers and economists will disagree with much or everything in this article. But then again these are the same people who used over simplified models until 2008 which totally ignored private debt or the other then elephant in the room short-term inter-bank lending. The author did however briefly study economics as part of a four year honours degree in accountancy and computer science.
Why do I care about all this? Pensions are hardly the most exciting dinner table chat but yet we do have to think about them. What worries is me is that we are all being asked to save into private or state funds but that in the end they will not be able to pay for our futures. Instead as usual a few at the top will draw out the profits gained from low rates leaving us (again) to pay for their greed.
Recession Rich, The Guardian
Debt to GDP Ratio, Wikipedia
UK Defined Benefit Pension funds return 11% – State Street, Investments and Pensions Europe
Global Pension Assets Survey 2015, Towers Watson. February 2015.
UK Pension Funds Post an Average Return of of 4.3%. Pensions Word 2012.