An exploration of interest rates

Vernon economist explores money in its many forms

  • Feb. 14, 2018 10:30 a.m.

How interesting are interest rates?

Good question, I’m glad you asked! Interest rates, when allowed to float freely in the marketplace, usually indicate the degree of risk in the money lending/borrowing business, from bank loans and mortgages, to government borrowing to finance deficits, and so on. Long-term average interest rates for non-risky ventures are about five per cent. Around 1980, when inflation was in the realm of 18 per cent, prime rate interest was about 20 per cent to cover inflation costs and provide a net two per cent return on money loaned.

More recently governments around the world have been inflating their money supply, and their central banks have been buying much of their debt, sufficiently to push interest rates down to close to zero, and even into negative territory in some cases. This means that when buying government bonds or depositing money in banks, these institutions actually charged interest to store the money for the depositor. This situation has never happened before in history. It is a manifestation of serious mismanagement by the economic engineers who are trying to stimulate the economy by encouraging the public and corporations into borrowing in order to spend, and thus create more economic activity. What are the unintended consequences?

First, interest rates will inevitably revert to the norm, or increase even more depending upon several factors: the rate of inflation; loss in confidence in the government’s ability to manage the economy successfully over the longer term; other unexpected “black swan” events such as war, bank failures, oil prices rising to US$100/barrel, currency collapse. Should interest rates move much higher, most of what is termed the “western industrial countries” will be bankrupted because they cannot afford to pay normal or higher interest rates on their debt. That is, their interest payments would be larger than all the taxes they could collect.

Second, retirement funding, whether organized funds or individuals saving for or already in retirement, cannot earn enough money via extremely low interest rates to remain solvent. Organized retirement funds are required to invest much of their money in “safe investments” such as government and high quality corporate bonds rather than riskier stock shares, etc. In fact, there are a number of municipal and state retirement funds in the U.S. which are bankrupt.

Third, individuals and corporations of all sizes are borrowing to live beyond their normal means. Individuals are being encouraged to invest in the stock market to increase returns, or to travel, or just to spend by borrowing against the equity in their homes at artificially low interest rates. Corporations are borrowing at low rates, often to buy back their shares to make their earnings per share look more favourable without actually improving the profitability of their operation. When interest rates revert to normal or higher, most of these loans will likely default, increasing the rate of bankruptcies, and thus generating an increasingly rapid decline in the economy.

There are credit rating agencies such as Standard & Poor’s which establish credit ratings of corporations and government entities based on their risky debt, taxation and spending levels. Other agencies assess our individual credit ratings. In all cases, the higher the risk, the lower the rating, and so the higher the interest rates charges for those entities. We are being subjected to the Chinese curse, “May you live in interesting times,” which include disorder and conflict. All too interesting!

RELATED: Money

Fred Aurag has been studying economics and the world scene from Vernon’s perspective for more than 30 years.

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