Tuesday, September 14, 2010

Low Interest Rates = A Hidden Bailout

A recent article in the New York Times talks about something which I have been thinking about for awhile now, which is that the current low interest rate environment is just another bailout for the banks who caused the financial crisis.

To understand this, you have to understand a little bit about how interest rates are set and what the impact of this is.  Every two months, a group of economists known as the Federal Open Market Committee (FOMC or more commonly known as "the Fed") meet to set the federal funds rate.  For all practical purposes, this is the rate at which banks can borrow money from each other.  A lower rate encourages banks to borrow more money, because they have to pay less interest on this money.  In theory, this encourages banks to invest more freely because borrowing money is cheaper.  When the economy needs a kickstart, the FOMC committee will lower rates as a way to stimulate the economy by making it less costly for banks to raise money to loans to business and consumers. 
As a result of the economic slowdown, the FOMC has cut the federal funds rate to practically zero  (officially the rate is "between 0.0% and 0.25%").  A rate this low is unprecendented.  What it means is that banks can borrow money practically interest free.  Can you imagine if you could get a mortgage or a car loan at such low rates?  You would probably refinance in a nanosecond at that rate if you could!

What impact does this have on the average person?  Borrowing money from other banks is not the only way that banks can raise money.  They also raise money by allowing savers like you and me deposit money in the bank, either through a CD or a savings account.  When you deposit your money in a bank, you are basically loaning the money to the bank.  In return the bank pays you an interest rate.  Now if you are a bank and you are able to get money from other banks at practically no interest, what is your incentive to pay your depositors a high interest rate?  Not much.  That is why bank interest rates are so low.

Because bank rates are so low, people looking to invest money might look instead to other relatively safe investments, like government bonds.  Because of the higher demand for government bonds, the U.S. governement can lower the interest rate paid on them.

This chain of events ripples through the economy so that the interest rates on everything are lower.

Lower interest rates are great if you are borrowing money, like a bank or a person looking to get a mortgage.  Think of all the money borrowers are saving because they don't have to pay as much interest.  Where does all that money come from?  It comes from the savers.

People who are looking to save money end up earning less and less on the money that they've deposited in banks, CD's, bond mutual funds, etc.  If you are retired and saved up a nest egg of $500,000 with the intention of living off of the interest, you have to live off of less.  A drop in interest rates of 2% means that you have lost $10,000 per year.  Multiply this across the millions of savers across the country, and you are talking about some serious money.

While I understand the logic in lower interest rates to stimulate the economy, the situation stinks.  First, you are rewarding the very institutions which caused the economy crisis (reckless banks and the reckless borrowers that they enabled).  Meanwhile you are punishing the people who did the right thing by being frugal and saving for a rainy day.  In a just world, it would be the other way around.

Second, this bank bailout doesn't show up in the Federal budget, so it does not get the same exposure as a bailout.  When the U.S. Government bailed out the banks, it was visible because it showed up in the budget and it is accounted for in the deficit numberts.  When the FOMC lowers interest rates, no tax dollars are being spent.  Instead it shows up in your bank statement every month.

The good thing, I suppose, is that the federal funds rate cannot go any lower, so there isn't any more gas in that tank.  Who knows, though, maybe they will make the rate go below zero and pay banks to borrow money.  What a topsy-turvy world that would be!

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