Government policy since I can remember has been to keep interests rates low. It sounds like a good idea on the surface, but when you look a little deeper, it turns out that is may not be. That is the point of this blog.
Years ago, I used to administer a very large capital budget involving many companies in different countries. As the administrator, I had to set the policy and make the decisions on individual projects. It sounds like a very difficult job, but in fact, it was a lot easier than you might think. The key to my system was based on the interest rate and the risk. Each project proposal had to calculate the rate of return or profit on the project in terms of the compound interest rate. The probability of project earning the stated interest had to also be calculated. Based on these two primary points, I either approved or rejected the project. Now let me explain the process a little further.
Nominally, you could rank the projects in terms of profit yield by interest rates and start approving the projects from the top down until you were out of money. If all projects had equal risk, this would be all you had to do. The next step was to move projects up and down on the list based on risk. High risk project were moved down and low risk were moved up on the list. I think you get the idea. Now how does this apply to government interest rate policies?
Realize that we have a limited amount of money to manipulate interest rates. That is right, "manipulate". The Fed manipulates interest rates by "buy" bonds on the open market and thus driving down the interest rates. It is just like any other auction where there are more buyers than there is product for sale. The Fed pays "more" for a bond than it is worth, thus driving down the affective interest rate. It is all as simple as that. Now to the point.
Good managers want the "best" investments (projects) to get funded and the "best" projects are those that yield the most profit at the lowest risk. If the interest rate goes down, it allows poor investments to get funded. Poor investments are bad for the economy in the end and low interest rates encourage more poor investments. Need some examples?
How about a home loan? If the interests are high people will have to buy smaller homes and if they are low, they can buy bigger homes. Now why did we have the big real estate crash? Simple, people bought much bigger homes than they could afford and when "flipping" stopped paying off, they could not make their mortgage payments. Now, risk. The biggest risk in home mortgages liquidity. That means it may take a very long time before you could sell your home to pay back your loan. Compare the home mortgage to Gold or the Stock Market. You could sell all your stock or gold in 24 hours, where as, it could take months to sell your home. During that time, the value of your home could keep going down. Home mortgages are risky for everyone. That is why the government got into the picture with FHA and other government insurance programs. If interest rates had been higher, we would never have had the housing crash. Interesting?
Student loans are next. Like home loans, the lower the interest rates, the more loans will be taken out and that money will be spent on worse and worse majors and by poorer and poorer students. One quick point on home loans. the low interest rates caused the prices of homes to "inflate" which also contributed to the problem. Why do you think the tuition rates have gone up so much? Same as for homes, low interest rates. How about liquidity of student loans? They are worse than home loans that were themselves very bad. You could sell the home and get some or all your money back to pay back the loan. In the case of a student loan, there is nothing to liquidate. Further, if the loan is ever paid back, those payments will not even start for at least 10 years after the loan is made. It is hard for me to even think of a loan as bad as a low interest student loan. If the interest rates had been higher, we would have made only of a fraction of the loans that we made and those would be to students who were better students and who took majors that had a much better chance of earning enough to pay back the loan. If we had not had the flood of students into our colleges, the cost of college would not have inflated so fast. Simple isn't it.
I could go on and on, but I think you get the idea. Low interest rates can have a serious down side.
PS----Government loans to people gambling in Las Vegas or in football pools would be a better investment than most home and student loans. Think about that!
PS---The financial crisis has also made our business managers lot better managers. I was not surprised that profits have held up so well during our recession. It made us better managers who got rid of marginal workers. Now the government is feeding these marginal workers. See the problem?
PS---Today I tested the concept that low interest rates can be bad against one of my cool-aid drinking liberal friends. You know what he came up with? Nothing!!! He did not see anything bad about low interest rates. You try testing your friends and see if they can come up with anything that is bad about a government policy that drives down interest rates. What you will find is that most are not very smart or they are cool-aid drinkers.
