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
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.
Financial Firms
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.
Households
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.
Wrap
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.
