Wednesday, August 7, 2013

Risks of Persistently Low Interest Rates

Low interest rates for any period of time are a drag. They discourage saving — you can’t make any money in interest by having a larger amount of money in the bank. Indirectly, they discourage labor — there is no benefit in making extra money just to stash it in the bank at 0 or 1 percent interest, and there is little incentive to pay off mortgage loans early when interest rates are near 4 percent. Of course, with less work, less happens, and the economy stagnates.

Central banks in both the United States and United Kingdom have signaled their intention to keep rates abnormally low for the foreseeable future, which I think means for another seven years. The way businesses plan, they will feel that they can rely on low interest rates forever. The business perception of long-term low interest rates creates a separate set of risks.

Most directly, some businesses will just never get around to paying off their debts. When interest rates rise they may find themselves in bankruptcy, unable to meet the rising interest payments.

But there are hidden risks wherever business plans are built on the assumption that the current conditions will persist, and assumptions about interest rates are surely being written into plans all over the world. If the current depressed interest rates persist into 2020 as planned, there will be corporate budgets being written and approved by executives who can’t remember 11 percent interest rates, never mind 36 percent — and to an extent this is happening now. It is the unconscious, unexamined assumptions that are most dangerous, because decision-makers have no idea of the risks they are taking.