Not too long ago if you worked hard and squirreled away part of your income in interest earning assets you could retire and expect a return of 8 to 10 percent (and even higher with a little bit of Google search). Today, interest rates are in the nether world--so, you might consider yourself lucky if you could find one percent return on saving deposits and CDs at your local bank. Why are interest rates so low? The reasons are legion. But two important ones come to mind. First, that was what the FED chairman from his Olympian perch said it was going to be for the next three years--i.e. low. Second, there was the unexpected unraveling of the U.S. and indeed the world economy in 2007 and the anemic recovery that followed. These two things are intertwined.
The FED (Federal Reserve Bank)
Interest rates are time sensitive reflecting varying degrees of risk. The rates of return on Treasuries vary--short-term rates differ from long-term rates. U.S. Government "t"-bills yield less than notes, which yield less than bonds. And prime rates are better than sub-prime rates that among other things are blamed for the meltdown of financial markets in late 2008. Closer to home are the "exorbitant" rates credit card users pay. At any rate, inflation affects interest rates too, by driving a wedge between nominal (market interest rates), and real interest rates (that is, nominal rates adjusted for inflation). Then, there is another meaning of the interest rate as the price of differed consumption. It puts a face value or premium on households making the choice to differ current consumption--put off buying a computer, a car, or a house in return for greater consumption of consumer goods in the future. What FED Chairman Ben Bernanke did keeping interest rate put meant that all the many influences on market rates are made inoperative. And they might have been inoperative since the recession started.
The FED drove down interest rate to near zero (and sometimes to negative real rates of return). There's economic theory or modeling for this action. By lowering interest rates and keeping them low, the FED hopes (because economics is not an exact science) to induce businesses to borrow and invest in new plant and equipment; to seduce households by low interest rates to purchase consumer goods--autos, computers, homes, furniture, refrigerators, stoves, washing machines, and so forth. You get the drift. Is this good? Yes, in theory . . . but has it worked? It seems not entirely. Money is cheap--but banks and businesses are awash with money they are not lending and investing. There is a kind of liquidity trap (M. Keynes) taking hold out there, so it does not matter how much the FED drives down interest rates, no additional investments or consumption will be forthcoming in the economy, soon, from this.
Yet interest rates do matter. They matter because of capital movements in international markets. They matter because differences in interest rates across nations can lead to the movement of funds from countries where the rates of return on money are low to countries where they rates are higher, all else being equal. This transfer of funds can change exchange rates--the price of foreign money. What this means at some level is that the value of foreign money will increase and that would make foreign goods more expensive. So imports in the U.S. for example, from China would decline.
China holds in excess of $1.2 trillion of the U.S. debt in the form of Treasury bonds. This is alarming but keep in mind that most of national debt is owned by Americans--you and me--about $10 trillion or about 68 percent of the debt. But China's holdings happened as a result of annual U.S. trade deficits ($295.5 billion in 2011, and $315.1 billion in 2012, according to the U.S. Department of Commerce) between the two nations over a long period of time. We Americans consume lots of Chinese made goods mainly because they are cheaper (due to lower labor costs and fewer environmental and safety restrictions), because we don't produce some of them or we produce some competing goods but not in sufficient quantities to satisfy our demand. This trade advantage of the Chinese is alleged to be also due to unfair trade practices by the Chinese government. In response, both the Bush and the Obama administrations have accused China of not playing on a level playing field. They have charged the Chinese government of being active participants in the effort to keep the Chinese currency (Yuan) low. They have asked the Chinese government to cease and desist deliberately devaluing its currency to exploit a continuing trade advantage. The Chinese government had denied that currency manipulation that keeps their Yuan undervalued with respect to the U.S. dollar is responsible for the US trade deficit vis---vis China. In October 2011, Congress attempted to take action against China by imposing duties on Chinese goods to offset the trade advantage China gets from undervaluing the Yuan. (AP, Oct. 1, 2011) This reflects the concern in this country over China's trade surplus. In October 2011 Ben Bernanke said that manipulation of Yuan prevents the global economic recovery from proceeding normally. Tom Friedman takes an interesting position on this debate on China. One salient observation he makes is that the dollars accruing to China from its trade surplus is used to buy U.S. government securities (like "t" bills) and keeps U.S. interest rates low. Another take on this recognizes that the Chinese economy is growing very rapidly. Chinese exports can explain part of this growth. More to the point, a rapidly growing China will have higher demands for foreign goods, including U.S. goods, leading to an increase in U.S. exports to China. Having said that, the conventional wisdom is that China's currency manipulation harms the economic recovery. This is the argument of many economists. (see U.S. Senate Democrats, Oct. 4, 2011) This is a case for currency appreciation by the Chinese for the good of the rest of the world but in the short term Chinese exports would suffer. They are hard-edged business people, only doing what is in their best economic interest.
Overall the trade deficit improved in 2012, which was $540.4 billion, $19.5 billion less than the 2011 deficit of $559.9 billion. (see United States Balance of Trade) This means either US exports increased because of trade demand for America goods--suggesting improving economic conditions around the world, or put slightly differently, the U.S. economy is not doing well and American demand for foreign goods suffers. In either case, one has to wonder if sequestration will ultimately jettison the U.S. economic recovery, and give us what Europe--the U.K. and Greece--is experiencing, a recession induced by austerity.
Firms might be people but they are not necessarily evil. They are motivated by the prospect of profits for stakeholders--CEO's, workers, and shareholders, to whom they are ultimately accountable. However, sometimes good people push the envelope a little--okay, maybe a lot--in ways that contributed to the recent financial meltdown that spawned taxpayer bailouts of the financial industrial. There was a staggering 702 recipients of bailout funds. (See ProPublica Bailout Recipients) The bailout tab was in the vicinity of $204.6 billion. The recipients included Fannie Mae, Freddie Mac, AIG (American International Group), which the government took over; Bank of America, Citigroup, JPMorgan Case, Wells Fargo, Goldman Sachs, Morgan Stanley, and SunTrust. Some companies did not survive in this crisis. Lehman Brothers Holdings Inc. was not bailed out and went under. This is old history and need not be litigated here, except that firms (companies) as people get treated differentially from real people with blood coursing through their veins. Taxpayers bailout firms that make strategic mistakes in operations. And oftentimes the people in the firms responsible for these mistakes get rewarded with massive severance payouts and parachute deals for failure. What did some of these firms do to merit this? They bought mortgage-backed securities some of which contained sub-prime loans. These new products where then used as collateralized instruments that investors such as pension, insurance companies, and mutual funds (including foreign governments, i.e. central banks) bought. As long as, the underlying mortgages were performing--people were making their mortgage payments, and the value of their homes were appreciating--all was well. Then the recession hit. People lost their jobs and could not afford to continue making their mortgage payments. The market value of their homes fell and in many cases was to less than the mortgage owed on their homes. The collateralized mortgage backed instruments became largely worthless because revenues going to their mortgage issuers dried up, and interest payments to collateralized bondholders dried up, too: hence, the bailouts. But households unable to meet their mortgage debt obligations received no bailouts. Instead, they faced seizures, foreclosures, and short sales on the homes.
Your mortgage is under water. There's no government bailout. What to do? Talk to your bank to ward off foreclosure by rescheduling your payments and renegotiating lower mortgage interest rates, holdout until the economy recovers, or walk away. None of these options is attractive but people who were unable to meet their monthly mortgage payments have used all the options. However, the problem for homeowners goes deeper. Households are hurt indirectly, too, by this financial debacle. If your mutual fund, pension fund, or insurance company holds large swatches of these underperforming collateralized instruments your losses are compounded. The falling value of your home, the loss of your job; and the declining value of your pension, mutual fund holdings, and the questionable viability of your bank and insurance company hurt you. In this environment, one finds that loans are difficult to come by--banks are reluctant to lend. Banks try to tack on hidden fees and other charges for their services, like Bank of America's failed attempt to charge $5 a month for their members for using their debt cards. They are not giving up on their revenues-raising schemes, however. "Bank of America Corp. is working on sweeping changes that would require many users of basic checking accounts to pay a monthly fee unless they agree to bank online, buy more products or maintain certain balances." (see WSJ, 3/1/12 ) Finally, there still is no relief for households that use credit cards and have difficulty with their payments. Some rates can be as high as 20.9 percent.
Real interest rates of near zero put the FED in the untenable position that renders efforts to stimulate credit and economic growth ineffective. But there is an upside, basement interest rates (i.e. very low interest rates) mean that the U.S. government can issue debt instruments with low rates--i.e. the government can borrow money cheap. For households mortgage rates are low as well, because of FED action and because the Chinese are buying U.S. government securities, which keeps rates low. Firms and households might be differentially responsible for the financial market crisis, but firms get bailed out and households are left holding the bag.