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  • Low Interest Rates and Side Effects

    Posted by Carl from Chicago on December 21st, 2012 (All posts by )

    I was recently at a bank as part of a non-profit (else I rarely step foot in a bank) when I was talking to the banker about setting up a new account and we started discussing the interest rates that each of the potential accounts would receive. After a bit of discussion I said

    At these rates, it doesn’t matter

    Basically interest rates on savings accounts and non CD accounts are effectively zero unless you have an immense amount of money in that account. For example, the Chase “savings” account offered .01% – which means that if you have $100,000 in the account all year long, you are going to make $100. That is the definition of negligible. Certainly you can shop around a little more and get a higher interest rate, but you aren’t going to get near 1% unless you buy some sort of vehicle with other conditions (i.e. locking up your money for a period of time). The woman at the bank was apologetic but I knew that there was no reason for her to be – it wasn’t her fault that the nation had undergone a massive ZIRP experiment.

    One side effect is that banks have now effectively become a vehicle for 1) making transactions 2) providing services. They are no longer really a vehicle for making money (i.e. earning interest, especially compounded interest, that is meaningful over time). Thus your money now is more of a way to avoid charges on those services (free checking, or avoiding low balance charges, or access to certain types of transactions without fees) than a means of making money.

    The traditional function of banks is to take your deposits and turn around and “leverage” that money to make loans to others. Since banks can count on not everyone to show up and demand their deposits back on the same day (unless there is a bank run), and they should be able to earn money on the difference between the cost of the money to them (they can borrow at the lowest rates) and what they charge loan customers, this should fund much of their profits.

    The newspaper industry is dying because they provided journalism as a service but made their money selling advertising (effectively as a local monopoly for many years). When businesses and individuals stopped buying advertising (hello, Craigslist), the “service” that they provide, journalism, had to pay the bills. As a result this industry has gone into free fall since then.

    Banks and many other financial institutions generally do a lot of services but make their money on the spread between what they pay you and what they pay for interest in terms of their cost of money. Then they take that difference and it generally subsidizes everything else. If that difference becomes negligible, then the financial institution has to make money in some other manner, or see their profits wither like the newspaper industry.

    With interest rates so low and money washing into their doors, banks should be able to make up for everything on loans. However, everyone is conservative about loaning money right now unless it is secured, and the home equity loan pipeline has mostly dried up since many houses have lost their equity buffer. I don’t have direct experience with this but have heard that it is generally not easy getting a business loan, the type of loan that is riskiest unless it too is essentially secured in some other manner (property, receivables, etc…).

    As a customer, if in the medium to longer term, if you assume that interest rates will stay very low, then you have options that you probably wouldn’t have considered otherwise. For one – you may just want to consider taking a portion of your money out of the bank and just convert it into gold in your safety deposit box. The biggest argument against gold historically is that it doesn’t produce a return – it just sits there, and has storage costs to boot. While both items are true, a safe deposit box is cheap to rent each year (mine is about $100) but on top of it keeping your money in a financial institution has transaction costs, as well. You can do the same thing by buying GLD the Gold ETF which may have other advantages with regards to transaction costs and sales taxes.

    Another alternative is to purchase foreign currency and put it in your safe deposit box. This traditionally has been a terrible strategy because it earns nothing but in an era of almost zero returns on major currencies around the world the side effects of this strategy are lessening almost by the day.

    Since the banks can only make so many loans that are basically secured and there hasn’t been a lot of impetus by them to move into more risky types of business loans, they are basically awash in cash. In some circumstances, they have considered paying negative interest rates for large blocks of cash, and this has happened with short term debt instruments quoted in some markets, as well.

    The last part of this is to strip the concept of “compound interest” out of your heads. One of my blogs is for teaching kids about investing and if I was starting this years ago I would have made a big pitch for the advantages of investing your money for long periods of time and watching it grow with the “magic” of compounding interest. It is hard to make this case with interest rates far below 1% unless you have large quantities or buy specific vehicles which take you near 1% and even that is a gigantic time frame to “double” your money. If you assume 1% / year then it takes about 70 years (give or take) to double your money – better than the straight-line model of 100 years but in all cases virtually irrelevant for practical purposes (nice calculator here).

    Thus some interesting side effects for me are

    1) the lost “opportunity cost” of holding cash in gold is now negligible

    2) the lost “opportunity cost” of physically holding non-US currencies is now negligible

    3) the margin that financial institutions receive on interest is now very low and they will need to either expand into riskier non-secured loans (which they haven’t done) or start charging for services and transactions (or see their margins crumble)

    4) with 3) above and interest rates near zero the real “value” of your money with the bank is in avoiding / minimizing transaction costs and being able to take advantage of better services

    5) the concept of “compounding interest” is basically dead on risk-less instruments, and for riskier instruments it is but one component of total return (probably the least essential component)

    Cross posted at Trust Funds for Kids

     

    13 Responses to “Low Interest Rates and Side Effects”

    1. Mrs. Davis Says:

      Some other effects:

      Those who save their whole lives cannot move assets from higher risk to lower risk and live off the interest. The elderly can only invade capital, increasing the risk they will outlive their savings.

      Those who are young learn there is no benefit to saving.

      This is all part of the conversion of the US from what I call a debit culture to a credit culture. The other major component has been inflation resulting from a constantly debased fiat currency. The whole apparent intent is to stimulate demand through debt. The possibly unintended result is a loss of control in the individual’s financial life and enslavement to the creditor. Who owns your non-dischargable student loan? And how soon will the same recourse come for FHA/Fannie Mae/Ginnie Mae loans?

    2. david foster Says:

      I don’t think Bernanke is being intentionally malicious in keeping the interest rates low; quite the contrary. He’s trying to use the only lever he has to save the economy, which actually faces a lot of issues beyond his control. Attempting to solve the employment crisis purely via monetary policy is, as I’ve suggested before, like trying to force more air through a hose that a lot of heavy people are standing on…eventually, you just break the hose.

      Or, to use an even more sinister analogy, it’s like trying to hold altitude on an airplane by pulling back on the yoke without adding power. Eventually, you’re going to get an aerodynamic stall, a rapid descent, and, quite likely, a spin.

    3. Bill Brandt Says:

      It really hit home for me when last year my bank did not send me a 1099 (interest made) because the amount was less than $10. And yet my old habits persist – keep it in the saving account until you need it the next day – then move it to the checking account.

    4. Jason in LA Says:

      “One side effect is that banks have now effectively become a vehicle for 1) making transactions 2) providing services. They are no longer really a vehicle for making money (i.e. earning interest, especially compounded interest, that is meaningful over time).”

      From an investor’s perspective, in terms of money center banks (JPM, BAC,CITI et al) revenue and earnings growth are expected to come from FICC or “fixed income, currency, & commodities”. Their deposit taking franchises, and all the real estate and personnel it requires, is becoming worthless without prop trading.

      In terms of business loans, a good friend of mine is a banker providing credit lines to firms with revenues of $50MM-$200MM. He tells me the money centers are turning away from them and smaller tier banks such as PNC and USB are focusing on that segment.

      Once the fed allows the yield curve to steepen you may see a change. Until then the Financial Repression continues.
      http://en.wikipedia.org/wiki/Financial_repression

    5. david foster Says:

      Seems clear that there is a lot of demand for business financing which is not being met by the banking system. Part of this gap is being filled by “Business Development Companies” which obtain their money not from deposits but from a combination of equity plus debt (1:1 leverage limit.) They use the money to make business loans, often with an equity kicker in the form of warrants.

      I suspect that much of the traditional banking human infrastructure in the form of loan officers who have good judgment, AND are allowed to use it, has eroded. In any event, I think BDCs probably have a good future and have made some investments based on that belief. Not making recommendations here, but for any serious investor I think the segment is worth looking at.

      The mainstream banking industry more and more seems to resemble a huge Rube Goldberg machine (“Heath Robinson machine,” for Brits) which flails around dramatically, consumes considerable floor space and power, and doesn’t really accomplish all that much in the way of useful work…

    6. grey eagle Says:

      When interest rates on loans are 0% it is better to be a borrower than a lender. If inflation rates are at 10% or higher when interest rates are nearly zero, then it is wise to buy assets using borrowed money.

      In the 60s there was a market basket of 30 items and the prices of the items in the basket were taken from 20 diiferent towns/cities in the U.S. The basket was priced every month. Measurements were available back to the 1920s. This was how inflation was measured in the good old days.

      Read the Wikipedia article on measuring inflation today. It is incomprehensible. Using the old method we have 20%/year inflation and it is increasing. Undeer the new method it is 1%.

      The ruling class says that the economy will do well if the people have faith. The ruliing class says that there is no God and therefore religion is based on lies. The ruling class rules that if people will believe one set of lies about God, then they will believe another set of lies about the economy. etc.

      In the 50s the Fed Chairman said “You can’t push on a string”.

    7. Roy Says:

      No interest effectively means free. Can not continue indefinitely. Violates first law of thermodynamics.

    8. Subotai Bahadur Says:

      As a customer, if in the medium to longer term, if you assume that interest rates will stay very low, then you have options that you probably wouldn’t have considered otherwise. For one – you may just want to consider taking a portion of your money out of the bank and just convert it into gold in your safety deposit box. The biggest argument against gold historically is that it doesn’t produce a return – it just sits there, and has storage costs to boot. While both items are true, a safe deposit box is cheap to rent each year (mine is about $100) but on top of it keeping your money in a financial institution has transaction costs, as well. You can do the same thing by buying GLD the Gold ETF which may have other advantages with regards to transaction costs and sales taxes.

      Holding physical precious metals is not a way to offset loss of interest income, in my view. It is an attempt to preserve capital. The increase in dollar price per ounce of PM is not income, it is a measure of the decline in value of the dollar. While it is a rational defense against inflation, it has another drawback. Physical possession of gold or silver is subject to … regime uncertainty.

      Without any due process, they are subject to seizure by the government. It has been done before, and the current legal/political environment is not one where any statutory or self-imposed limitations on government actions can be assumed. See Executive Order 6102 signed by Franklin Roosevelt on April 5, 1933.

      Thus, if you choose to hold physical precious metals; holding them in a financial institution may be counterproductive. And if you make the choice to hold precious metals in these times, there is the implicit acceptance that you may become a Federal felon by doing so.

      And investment in Gold EFT’s may be easier and avoid some costs; but it also avoids the benefits. In these uncertain times, how much will the paper shares be worth if there is either private fraud or government intervention? Ask the bondholders in GM and Chrysler.

      Subotai Bahadur

    9. IGotBupkis, Legally Defined Cyberbully in All 57 States Says:

      I’d point out that I believe time-cost is probably THE best way to argue one way or another over how “prosperous” a society is, screw “inflation”, screw “income inequality”. How long do I have to work at an average job for basic needs? How long do I have to work at an average job for secondary needs? THESE measures define the real cost. Money is just a proxy, and when the government is ephing with the value of, and the information regarding, that proxy, then just cut out the proxy when making the analysis.

      We’re generally still doing well, those of us that still have jobs. THAT’s the only real reason why life sucks for many people — no $#%^%$# job.

    10. IGotBupkis, Legally Defined Cyberbully in All 57 States Says:

      }}} Using the old method we have 20%/year inflation and it is increasing. Under the new method it is 1%.

      The problem with the old method is that food is a fairly small percentage of one’s monthly income/cash outflow now. Back from the 20s through the 50s, and even into the 60s, it was a very significant portion of one’s monthly income/cash outflow…

      As a Share of Household Spending, U.S. Has Most Affordable Food in World & It’s Never Been Better

      Other things have dropped substantially, too:

      The ‘good old days’ are now: Today’s home appliances are cheaper, better, and more energy efficient than ever before
      Money quote:
      In 1981, the dishwasher pictured above from a 1981 Wards Christmas catalog sold for $359.88. The average hourly manufacturing wage then was $7.42, meaning that it would have taken 48.5 hours of work at the average hourly wage for a typical factory worker to earn enough income thirty years ago to purchase the dishwasher above.

      The new Frigidaire dishwasher above is currently listed on the Best Buy website for sale at $299.99. At the current average hourly wage of $19.79 for production workers, the average manufacturing worker would only have to work about 15 hours to earn enough income to buy today’s energy-efficient dishwasher, which is less than one-third of the 48.5 hour time-cost for the 1981 model.
      (The article also points to a related post @ Cafe Hayek which compares time-cost for a number of appliances)

      I will ack that Dr. Perry is very much an optimist, but I find his data compelling, if not beyond reproach.

      I’d also note:

      Matt Ridley’s 17 Reasons to Be Cheerful
      A related quote:
      4. The important stuff costs less
      One reason we are richer, healthier, taller, cleverer, longer-lived, and freer than ever before is that the four most basic human needs-food, clothing, fuel, and shelter-have grown markedly cheaper. Take one example: In 1800, a candle providing one hour’s light cost six hours’ work. In the 1880s, the same light from a kerosene lamp took 15 minutes’ work to pay for. In 1950, it was eight seconds. Today, it’s half a second. In these terms, we are 43,200 times better off than in 1800.

      This is a couple years old but strikes me as likely still relevant, too, along the same lines:

      Food, Clothing, Housing Costs at All-Time Lows?
      (That’s probably based in part on the CPI which we all doubt, I presume… but not completely just from the above)

    11. tyouth Says:

      Well, clearly the rate of inflation is somewhere between 1 and 20%!

      In my small business I note that product and misc. materials have increased about 7%. I infrequently grocery shop so when I do shop it seems that prices have increased dramatically but I’m not sure that’s true.

    12. David Foster Says:

      Re the long-term trend of prices: Just about anything that can be made in a factory and shipped in a freight container OR can be grown on a farm, OR sent over a telecommunications link, has gotten cheaper over the decades. Things outside these categories, not so much.

    13. PM Bug Says:

      If you’re going to safeguard yourself with Precious Metals the main choice would be to physically possess them, a safety deposit box in a bank you have no other accounts with is wise, a safe at home wiser still.

      It can be confiscated and has: yes. I have no advice to offer victims who see it coming. Nothing pleasant anyway.

      GLD – stay away from GLD and SLV. They’re leveraged out the wazoo. GLD/SLV = JPMC & HSBC.

      If you insist on holding gold paper look first at AGOL, it’s in Asia and not leveraged. After that would be the Swiss ETFs; SGOL and SIVR.

      It’s still better to be holding the metal yourself. If you have any option don’t put it where it can be easily noted and seen.

      We suffer under a corrupt and desperately bankrupt government conducting the largest control fraud in Human History. I mention this to hopefully answer anyone about to bleat about Law, the system, and obeying the rules. You want to obey the rules? Fine. Baaahhh….