Tuesday, 17 September 2013

Economic Myths: High interest rates encourage saving; low interest rates boost consumption

These platitudes are trotted out over and over again for example at Wiki.

There must be something in it, but Excel tells us otherwise.

1. The most important form of saving (apart from paying off your mortgage) is of course saving for your old age, i.e. a pension. Let's ignore tax subsidies/distortions and pension company charges (the two largely cancel out) and assume low and predictable inflation so all we need to consider is real interest rates.

2. Our idealised pension savers would like to have an annuity of £10,000 (the annuity company works on a remaining life expectancy of, say, 25 years) when they retire and start saving the same annual amount each year 25 years before they retire.

3. If real interest rates are 1%, they have to save up a final pot of £220,000, which requires savings of £7,798 each year. If real interest rates are 2%, they only have to save £6,095 a year to end up with £195,000. And if real interest rates are 3%, they only have to save £4,776 a year to end up with £174,000.

4. So if you are confident that real interest rates will be quite high, you can get away with saving £3,000 less every year than if real interest rates are going to be very low (they are currently negative, of course).

Of course, mortgages work the other way round.

5. Again, assuming a minimum spread for the banks of 1%, in a low real interest rate scenario, real mortgage rates are 2% and paying off a £160,000 mortgage over 25 years costs £8,200 a year. If interest rates are 4%, it costs £10,200 (£2,000 more).

6. So in a high real interest rate scenario, our typical saver couple is 2 x £3,000 better off for the 25 years they are saving for their old age and £2,000 worse off for the 25 years they are paying off their mortgage (there will be ten or twenty years in the middle where the two overlap).

7. All things considered, they are on average £4,000 a year better off with high real interest rates - they can spend £4,000 more each year - and that's ignoring the fact that they could optimise the position further by paying off the mortgage a bit more quickly and then saving more towards their pensions over a shorter period.

8. The real beneficiaries of low interest rates are of course banks and bankers, but as they are not producing anything, merely consuming other people's output (or do not produce anything extra, merely because interest rates are lower), total production is not increased whether real interest rates are high or low.

And if production is unchanged, then consumption is also unchanged, it is just that with higher real interest rates, the relative share of total output consumed by banks and bankers drops quite considerably and our hard-working hard-pressed etc. couple gets to consume more (of their own output).

10. UPDATE - as Bayard points out in the comments, large landowners benefit enormously as well because they can sell off bits of land for much higher prices.

Just sayin', is all.

Bayard said...

"The real beneficiaries of low interest rates are of course banks and bankers,"

I can't see how they benefit more than (or even as much as) landowners.

Lola said...

Quite. That's why the banks always plead for the continued existence of state owned central bank and that CB having the monopoly of interest rates.

If the Central Bank was simply a bankers bank and banking was 'free', interest rates would be end up at the market clearing level and vary bank by bank according to how risky the market felt each was. Which would give banks a much smaller spread. (I also recognise that the current model of FRB would ideally be reformed at the same time).

The whole thing is scam, or rather the 'New Feudalism'.

Bayard said...

Mark, I think you are making the mistake of assuming that people act rationally, when most don't. Given the current zeitgeist that you should borrow until you are up to your eyes in debt, then low interest rates indeed encourage spending, as people have more (borrowed) money to spend. Also, given the zeitgeist, if your example couple had £4000 a year spare then they are likely to use it to take out a bigger mortgage and buy a bigger house. With low interest rates, people feel richer: they can borrow more and their house is "worth" more.

I would still disagree with Wikipedia that higher interest rates encourage saving because if those high interest rates come after a period of low interest rates, then no-one will have any money to save: all their spare cash will disappear in interest payments.

Lola said...

Bayard

Higher interest rates are not their to discourage spending, they are their to discourage borrowing and lending.

If a 'proper' bank paid you a higher than market average interest rate for your savings it is because it is, or is perceived as (same thing), a 'riskier' bank (e.g. iSave).

I think the problem is that the current way the central bank sets interest rates is simple market manipulation. It destroys the price signal, which is what interest rates are.

Also it confuses entrepreneurs as to the the time scales of production, so that when the central banks sets interest rates too low entrepreneurs increase the time horizon of their investments, which leads to (is?) malinvestment.