Governments around the world have been keeping interest rates at record low levels for about four years now. In the wake of the great banking crisis of 2008, closely followed by the worst global recession in 80 years, central bankers have adopted an easy money policy. The economic theory is simple: make it cheap to borrow so companies can invest and grow their businesses, employ more people, and help the economy recover. Stock markets view low interest rates as the greatest thing going. Lower borrowing costs means higher corporate profits, and at least in theory, low yields on bonds makes stocks more attractive for investors. However, a protracted period of low interest rates is not an unalloyed good. For every winner there is a loser, and there are a number of unexpected consequences.
Low interest rates transfer income from the old to the young. Older people have accumulated savings, which need to be invested. Typically, older investors are looking for security of capital in preference to higher returns at the price of risk and volatility. That means buying bonds, guaranteed investment certificates or money market funds. The returns on all of these investments are very low now. On the other end of the age spectrum, younger people typically have high debt. They have student loans, take out mortgages to buy homes, arrange car loans and often, carry credit card debt. Low interest rates are a huge benefit to this group, but directly at the expense of their parents or grandparents.
A secondary effect for older people is the impact of low interest rates on pension plans. Pensioners with “defined contribution” plans, where the monthly or annual benefit is not guaranteed, but instead depends on the returns inside the plan, are being hurt by lower than expected payouts. Those with “defined benefit” plans, where the amount of the payout is guaranteed, are now worrying, and with good reason, that the company or fund responsible for paying the benefit will go bust, since very few pension plans are earning the amount necessary to fund their pension obligations. Persistent low interest rates are thus lowering living standards for the old.
Low interest rates also transfer income from the rich to the poor, since the poor are borrowers and the rich are savers. Whether this is beneficial or not is of course open to debate in a world of increasing income and wealth disparity between the rich and the poor. Nonetheless, when considering policy options, it must be recognized that keeping interest rates low is much like a progressive income tax, and has a vastly higher cost to the wealthy.
One perhaps unexpected consequence of very low interest rates is that it encourages companies to displace labour through investment in capital equipment. My recent trip to the Yukon provided a very vivid example of the effects of capital investment on a previously labour intensive industry. In 1898 the population of Dawson City, Yukon, was 40,000, and was mostly composed of pick and shovel miners. Over the next ten years large mining companies built giant dredging machines, each of which was capable of doing the work of about 1,000 men, and required an operating crew of less than a dozen. By 1911, the population of Dawson had fallen to 615. The dredges operated for another 35 years.
Nothing quite so dramatic is going on today, but cheap money allows companies to buy industrial robots and similar machinery, thus displacing employees. This process increases productivity, which is defined as output divided by labour input, but it hardly helps the employment situation, one of the persistent and lingering problems of the recession.
Government borrowing is another area impacted by low rates. On the face of it, low rates are a great benefit to governments. New borrowings are cheap to carry, and old bonds can be rolled over at much lower rates than the original issue, saving the government money on its debt service payments. However, the very fact of lower interest payments tempts governments into underestimating the cost of future debt service, and in addition, allows governments to increase debt levels at minimal current cost. Canada’s federal debt is about $590 billion. If interest rates rise (and they will) to historic norms, the cost of servicing this debt will rise by $18 billion per year or more. This throws the budget deficit projections for future years into doubt and threatens to impose very substantial tax costs down the road. The same is of course true for all the provinces and municipalities. It is a case of short term gain but long term pain.
Finally, low interest rates distort investments in all asset classes. The recent purchase of the Bank of Nova Scotia tower is an example. The price paid for the building is so high that it produces a very low return on capital, much lower than would have been reasonable before 2008. When interest rates rise, the purchasers may well find themselves with an uncompetitive rate of return for years or decades. Similarly, the prices for utility, telecommunications and pipeline stocks have been bid up to what look like very high prices based on earnings, simply because investors are attracted to their dividends, which are very high in relation to interest rates.
We know that interest rates will remain low for at least the next year to eighteen months, since the central bankers here, in the US and in Europe have committed to keep them low. No one knows what will happen after that, but history suggests that rates will be much like they were before 2008 within a few years. When that happens the investment environment will change, perhaps quite rapidly. We remain vigilant.