There is something I never got about interest rates. There is a consensus across economists that interest rates have a very important impact on the economy. Economists of all stripes agree that lower interest rates boost economic growth and higher rates reduce growth. Some go as far as saying that it is through interest rates and monetary policy (not spending and fiscal policy) that governments should manage the economy. It’s a standard classroom exercise to draw curves showing the impact of interest rates on growth. Too low interest rates are one of the main factors blamed for causing the bubble and resulting recession. But I always felt that something didn’t quite add up and I began to doubt how important interest rates really are.
The standard explanation (like most economic explanations) is simple and relies on applying demand and supply curves to the market for loans. When interest rates are lower, the cost of borrowing is lower, therefore more people take out loans which leads to higher levels of investment and housing purchases and therefore higher levels of economic growth. When interest rates are higher, costs are higher, therefore the process works in reverse. The money for the loans comes from savings which are attracted to banks by higher interest rates and driven away by lower rates. I suspected something was wrong with this explanation because at the same time I was taught it, we had the lowest interest rates in history, yet borrowing wasn’t rising. If low interest rates caused a housing bubble after 2002, then why didn’t even lower rates not cause an even bigger bubble after 2008?
The first problem with the explanation is that it assumes that there is a market for loans just like any other product. But while I can walk into a shop and buy whatever is for sale, I can’t just walk into a bank and get a loan, regardless of the interest rate. To get a loan, you basically have to pass a test based on a range of factors (income, occupation, customer history etc). So the supply of credit is as important if not more so than the price of credit. Credit could be cheap but hard to get from the banks (like now) or expensive but easily lent out. In his paper on the bubble, Morgan Kelly argues that falling interest rates had little impact on house prices, which were instead caused by an increase in the supply of credit.
Secondly, getting a mortgage has more to do with where you are in your life than the rate of interest at the moment. No matter how low the interest rate drops, I’m in no position to get a house. However, were I considering marriage and starting a family, then I would need a house and whether the interest rate was 2% or 4% would make little difference to me (this is because we have a very strong home ownership culture in Ireland. I’ve heard that it’s considered normal to have a family in an apartment in France or Germany so things would be different there). If you need a house and have found one that suits you, you can’t afford to wait until the interest rate is just right for you. Most people looking for a house could wait a few months at most, which would lead to only marginal change in the interest rate.
Nor do I believe that the rate of interest drives the level of household saving. There are two main reasons for this. Firstly, few ordinary people know what level interest rates are at or how much they actually receive from banks after fees and charges are deducted. This can be seen in the large number of people who hold their savings in their current account, which gives little or no interest. A survey of Irish people found that barely half of them knew that the interest rate is currently between 0-2%. Secondly, saving is rarely a deliberate decision and more commonly the absence of a decision to spend. Most people spend their wages on bills and whatever is left over is saved. The idea that someone will decide against going out drinking or taking a holiday because the interest rate has risen from 2% to 3% is an idea so silly only an economist could believe it. Savings are far more dependent on a person’s characteristics and personality than the interest rate. Frugal people will save a lot of money at 2% and 5% and people who live for now will spend regardless of whether the interest rate is 4% or 8%.
The fact that saving is not a decision is a point I really want to emphasis. For example, my parents savings have gone down a lot since the start of the recession. But the interest rate had as little to do with it as the orbits of Jupiter and Venus. I went to college and they got hit hard by public sector pay cuts. Even if banks offered 10% on all savings, my parents wouldn’t increase their level of savings because they simply don’t have the money. On the other hand, I’ve been able to save a decent amount of money in the last few months, not through any deliberate choice or the rate of interest but simply because I’m a frugal young person with few expenses. Plus I only have a temporary contract so my future is uncertain.
But what about businesses? Do too low interest rates not lead to asset bubbles? Again, I doubt that they do. Interest rates are too small a proportion of a business’s costs to play an important role. Costs such as land, labour and materials far outweigh interest repayments, which are miniscule in comparison. Yet if lower interest rates reduced the cost of buying a house how come the price of housing in Ireland was rising for about 15 years? If house purchasing is cost sensitive why did higher prices make people buy more not less houses? Speaking of the bubble, how could higher interest rates have reduced property development when property was one of the most profitable industries in Ireland? How high would the rate have had to go to make it unprofitable to build houses, which for most of the Celtic Tiger was like the end of a rainbow? If anything, higher rates would have pushed people away from sustainable investments and into high risk speculation.
Far more important to investors is their expectation of the future. If they think the economy will be booming years from now (as they did during the Celtic Tiger) then they will be willing to invest a lot even at a high interest rate. If they think the economy will be doing poorly for the next few years (as they have for the last few years) then they will invest little, even at a low interest rate. After all, investment is useless unless someone buys the new production, so future demand is more important than just the interest rate. The thing is, people’s expectations are a lot more emotional and a lot less rational than economists would like. It is far easier to graph and model interest rates than confidence. Having been burnt badly in 2008, many investors have lost their confidence regardless of how tempting the interest rate is. Likewise during the Celtic Tiger, many investors become wildly overoptimistic. A final important point is that many businesses fund investments through retained earnings and savings of their own and therefore the borrowing interest rate is irrelevant.
To shed some light on the issue, the Federal Reserve asked more than 500 Chief Financial Officers what would be their reaction to a change in interest rates (economists get so caught up in theorising that it rarely occurs to them to actually ask businesses how they behave). They found that the interest rate is nowhere near as important as conventionally thought. Only 8% said they would increase their investments if interest rates dropped by 1% (or 100 basis points in financial terms) with another 8% saying they would if rates dropped by 2%. However, a massive 68% said no amount of rate cuts would induce them to invest more. They were somewhat more sensitive to increases in the interest rate with 16% saying they would reduce investment in response to a 1% rise while 15% said it would take a 2% rise.
When asked why they wouldn’t invest, the main reason was that they already had ample cash reserves followed by interest rates already being low and viewing product demand as more important than interest rates. The icing on the cake is that the researchers followed up a year later when interest rates were 1% higher and found that the businesses acted more or less as they said they would. Only 9% said they had reduced capital spending in response to the rate rise. When the remaining 91% were asked how they would react to another 1% rise, only 3% said they would reduce investment.
So despite the almost universal belief in the importance of interest rates, I just don’t see it. I’m not saying they’re useless, just nowhere near as effective as commonly thought. I have little faith in higher interest rates as a check on another asset bubble or to prevent high inflation, restrictions on the supply of credit would be far more effective. Despite the conventional wisdom, investment and the business cycle doesn’t seem to be that sensitive to interest rates. The simple fact is that interest rates are just too small a proportion of overall costs to be important.