“Debt and the Consequences of Low Rates”

Sydney M. Williams

Thought of the Day

“Debt and the Consequences of Low Rates”

June 18, 2013

Simply put, low interest rates encourage borrowing and discourage savings. That, of course, is the Federal Reserve’s purpose in keeping rates low, as they hoped attractive rates would lubricate consumer and business spending. It worked with consumers, but has been less successful with businesses. And, of course, the federal government has stepped up their spending. Unlike most state governments, Washington is not subject to such inconvenient requirements as balanced budgets. Borrowing in this environment provides an immediate sense that money is cheap, but such debt will saddle future taxpayers when refinancings will likely have to be done at higher rates. Low interest rates, perversely, chase investors from “safe” investments into speculative ones, as investors search for needed returns. Low rates also promote profligacy – a bad habit for a nation that is retiring more than three and a half million people each year, the vast majority of whom have inadequate financial means.

One of the major disconnects is that, over the past three decades, businesses have migrated from defined benefit retirement plans to defined contribution ones, but governments have not. According to Towers, Watson & Co., just eleven of the Fortune 100 companies offered defined benefit plans to new salary employees in 2011. That would contrast to ninety in 1985. People are being forced to fund their own retirements, but, while most companies have 401K plans, most employees receive very little help from employers on the importance of saving and investing. At the same time, laws governing retirement plans are written by government employees, most of whom are covered by defined benefit plans where we, the taxpayer, are the guarantor of their plans . The situation has augured poorly for the financial health of the nation, and will continue to do so.

Consumer spending needs little encouragement. Despite the “worst financial crisis since the Great Depression” and with total employment lower than it was in 2008, consumption in 2013’s first quarter, as a percent of GDP, has remained about 70%, right where it was in 2007. While GDP dipped in 2008 and 2009, it is now about seven percent above where it was at the low point, in 2008. What makes the consumer spending numbers even more astonishing is that while the value of household financial assets are about where they were in 2007, the value of U.S. housing stock is approximately 10% below where it was five years ago. We continue to spend, while fewer of us work and our assets are worth less.

While it is easy to blame Mr. Bernanke for this state of affairs, the real responsibility lies with the President who has failed to lead and Congress that has failed to enact sensible fiscal reform. Thus far, the consequences have been a rise in speculative assets like equities, a build-up in bank’s excess reserves, a modest economic recovery at best and continued high unemployment. Not the worst of all possible outcomes perhaps, but certainly not the best.

With the build-up of government debt and obligations – municipal, state and federal – and the growth in student loan debt, it is the specter of rising interest expense, the actual real cost of debt, that is (or should be) concerning. Like all human responses, expectations that abnormally low interest rates will persist will have unintended consequences.

Human behavior is fascinating. Despite the fact that students of psychiatry and psychology can reasonably predict how we adjust to change, that fact seems to have little affect on our behavior. The predictable becomes the unpredictable. Human emotions, like love, hate, envy, greed, lust, are common to us all, though in varying degrees. Their consequences have been explored by writers, like Shakespeare, Tolstoi, Dickens, Austen and myriad others who understood the psychology of the human psyche. While not part of most business school’s curriculum, such writers should be read and studied, especially for those interested in investments, which, in this new world of personal responsibility when it comes to retirement, should be all of us.

Instinctively, but often wrong, I am not a momentum guy. The “trend is your friend” is an old Wall Street adage, but so is the concept of the “greater fool.” In my opinion, complacency is the enemy to investors. Is their complacency in bond prices? I don’t know, but I feel uncomfortable with the notion of limiting my return on High-Yield bonds to 6.2% for the next fifteen years. The idea of receiving 3.34% for thirty years for the dubious honor of owning the long U.S. Treasury bond doesn’t do much for me either.

Regardless of personal preferences as to investments, it is the fact that government, businesses and individuals are not paying proper attention to the threat that retirees face – a glut of people, longer lives, more expensive health coverage and a glaring need for assets, which should be of concern. Everybody is far too blasé about the sand traps on the fairway.

America is in a quandary. As Glenn Hubbard and Tim Kane write in their new book, Balance: The Economies of Great Powers from Ancient Rome to Modern America, the “primary threat to America is America itself.” Among the worst consequences of debt is that one’s options become limited. Total government debt, including that of state and local governments, at about 140% of GDP, rivals the experience during World War II. The difference is that seventy years ago the debt was caused by a massive build-up of our military forces in the successful bid to defeat Germany and Japan. When the war ended, everyone knew spending would come down. Today, our debt is largely a function of entitlements – wealth transfers, which are programs difficult if not impossible to slow down or stop. Mothers, wives, sisters, girlfriends wanted their menfolk home in 1945. Today one would be hard pressed to find any beneficiary of government largesse anxious to see their benefits reduced. Rising interest rates will have even more onerous effects on budgets. The very magnitude of our debt renders us close to being helpless should we again face a menace similar to what we faced in 1941. We may be more comfortable, but are we safer?