When interest rates go down, it means safer investments become less attractive. For example, lets say you have 1 million dollars in the bank account. if the bank pays you 0% then you're not very likely to keep your money there. You're much more likely to put it in the stock market, a hedge fund, a high yield muni bond or anywhere else. What all those "anywhere else" have in common, is that they're all higher risk. So, collectively by reducing interest rates you are incentivizing risky behavior.
And it's not just individual players. Think about all those pension funds and insurance company funds that need to make returns to fund people's retirements. Collectively they have trillions of dollars on the line, and no choice but to invest in increasingly risky funds. Once you understand the connection between low interest rates and risk, as a follow up, watch this: https://www.youtube.com/watch?v=k9_bWbrYPKg Brian Reynolds has a ton of experience working in the pension industry and this is an extremely fascinating interview (though a bit advanced, but you can still understand some of it)
So literally pay investors so they can get richer without risk?
"A legal mandate requires these funds to generate 7.5% returns, and when they fail to do so, taxpayers foot the bill." - it sounds like it would be much cheaper for taxpayers to pay pension funds directly, instead of paying all investors, and hoping some of that money finds its way to pensions.
Actually, let me get back to "by reducing interest rates you are incentivizing risky behavior". Phrased this way, it sounds obvious that 'of course you should try to reduce risky behavior'. But risky behavior of what? Is a car manufacturer going to take more risks because of low interest rates? No - they make a profit from selling cars. Same for farming, mining, pharma, advertising... literally every industry, except the purely financial ones. So... are we just paying tax money to bankers, and getting nothing in return? Because they convinced us that if their profits were any lower, they'd start taking so many risks banking would collapse (instead of more prudent banks emerging)?
> So literally pay investors so they can get richer without risk?
No. it's exactly the opposite. When government steps in and offers 0% interest rates, it's subsidizing the money lending by handing out cash like it's free candy. It's preventing the natural lending that would have occurred if it didn't step in. Hence offering 0% interest uses the power of government to force people into riskier assets.
If government paper has a return of 0% while private market marginal safe and liquid assets returns are in the negative (which can easily happen) 0% is an above market rate and a subsidy to people holding on to government paper instead of investing in the real economy.
If you look at long term history, negative real returns on stores of value were the norm. Before financial systems existed, almost all investments had negative returns if you didn’t put work and energy into them. To store value, you had to accumulate stuff, buildings or land. Most options either had high maintenance costs, were subject to risk of damage from natural causes and theft, were very volatile or required hard labor to get production out of.
Even in societies with financial systems, getting low risk, hassle free, liquid, positive real returns has been difficult for most of history. This just reflects the natural laws of thermodynamics that tell us that everything tends to decay without a constant supply of work and energy. In general, most things require maintenance to keep their worth.
The 20th century was probably the most notable exception. Because of unprecedented demographic and technological growth, positive risk free real returns were easy to find. The recency effect probably explains some of the confusion people have about this. It is possible that under favorable conditions, wealth can have positive returns and even compound into very good long run returns but it is not a guarantee and there is nothing natural about it. It may not continue forever, particularly amidst an aging and retiring population in a world no longer as rich in easy to exploit natural resources.
While people are used to get negative returns on very short term purchases, you buy fresh vegetables at the supermarket, even if they degrade over time, many can’t seem to accept the normalcy of negative returns on longer term assets. In nature, squirrels’ nut caches have a certain percentage of losses from theft and spoilage. Real returns tending towards the negative is natural even if they can seem unusual for humans just out of the 20th century.
How are 0% interest rates 'handing out cash'? I thought bonds worked in the following way: Buy bond at N% interest. When it matures, government pays you original price + N%. So 0% would be bond buyers handing cash to the government, no?
Fed interbank interest rates aren't the same thing as treasury bond interest rates. Yes, when money is cheap bonds become almost worthless, that can be seen in the market right now. However the cash party isn't for people buying bonds, it's for people with access to the inside track of low-interest money.
Yes, that's the interest rate that impacts the money supply (along with other factors) by greasing bank's balance sheets. Treasury interest rates are set by the market, they are whatever they have to be to get people to buy government debt.
The Fed operates on a shorter time scale than T-bond maturities.
Basically, every night banks are required to make loans to each other to ensure that they meet the reserve requirements on deposits. If they made more loans than they took in deposits, they must borrow on the open market to settle. If they took in more deposits, they can lend. All of these transactions are for extremely short-duration securities (when people talk about repos and money market accounts, they usually mean this). The security itself is simply an agreement to repay $X + interest in the near future, usually the next day. And just like the stock market, there's a market for these: banks with excess deposits offer repos at a variety of interest rates, and banks with excess loans take the best available interest rate, and eventually the market converges on a particular market-clearing rate (the "Fed Funds Rate").
The Fed is a participant in this market. But unlike a normal bank, they aren't subject to reserve requirements. They have an effectively infinite balance sheet consisting of the T-bills etc. that back all the other repo agreements. So when they say that they're setting a Fed Funds Rate of 2.35%, what they really mean is that if banks are fearful that day and want a market-clearing interest rate of 4%, they will sell enough securities in the overnight market that the interest rate goes down to 2.35%. And if banks are greedy and are willing to sell securities at 0%, the Fed will buy enough of them to push the rate back up to 2.35%. This serves to anchor the rate, because if you know that it's going to be in that vicinity, there's no incentive to try and push it higher and lower.
It's very much like a stablecoin in the crypto markets. When Facebook pegs the Libra to a basket of currencies or Bitfinex pegs the Tether to $1, they are effectively trying to become a central bank. Decentralized stablecoins like Dai try to distribute that power among a number of ordinary people: the holders of MKR collectively act as a central bank for Dai, with their collateral being ETH rather than T-bills.
When you have 0% interest rates, it basically means that banks can borrow as much as they want for free. So it literally is "handing out cash". The actual bonds backing them are held on the Federal Reserve's balance sheet, which is why you might've heard about the Fed's ballooning balance sheet in the last 10 years. The Fed's under no obligation to pay these back, though: its mandate is to keep employment high and inflation low, and so its job is to release just enough of those securities as to soak up inflation.
* And just like the stock market, there's a market for these: banks with excess deposits offer repos at a variety of interest rates, and banks with excess loans take the best available interest rate, and eventually the market converges on a particular market-clearing rate (the "Fed Funds Rate").*
With the small and pedantic correction that the Fed Funds rate doesn't measure repos, because it measures unsecured lending, and repos are secured. It's the Secured Overnight Financing Rate that measures repos.
But yes, when the Fed wants to push the Fed Funds rate around, it does it by getting involved in repos - because if banks can borrow from the Fed at 2.4% through a repo, they aren't going to borrow from other banks at 2.41%. You'd think there would be a bit of a spread between the rates, because banks don't have to put up collateral for unsecured borrowing, but in practice there doesn't seem to be.
deogeo wrote:
> Is a car manufacturer going to take more risks because of low interest rates?
It seems possible. Vehicles change every year. The amount and ways they change must be affected by available funding, perceived risk, and probably lots of other factors. A lower interest loan could make a risky prototyping project more attractive.
Even if car companies were really stuck doing one thing, shareholders are not. If car companies produce a slow, steady profit, and other investments are producing higher profits on average, chaotically, people will divest from cars and invest in a diverse portfolio of chaos.
I agree with what seems like your point, though. I don't understand propping up markets and businesses in order to help people, when we could just help people.
This is exactly why defined benefit pension plans need to be eliminated. They're just too risky for everyone concerned and create a huge moral hazard. Defined contribution plans like 401(k) with named individual accounts are much safer.
They're only a moral hazard if the plan is permitted to make promises without requiring the promisee to deposit enough funds. And that can only happen for government employee pension plans; private employee pension plans are required by Federal law to follow strict accounting rules which keep the pension fully funded--at any point in time the future expected liabilities must be backed by deposited funds sufficient to cover the liabilities according to a moderately conservative rate of return (e.g. 5-6%).
Private pension plans can and have failed, but that's because corporations sometimes devise clever ways to drain funds. They usually have to do this quickly, though, so it often occurs during mergers and acquisitions where the CFO can shift funds and pay them out as dividends, stock buybacks, or bonuses. Then when the Feds come knocking on the door six months later the CFO moans and cries to the regulators and shareholders[1] about how their pension liabilities are a crippling burden, which is total B.S. because if they hadn't played games the pensions should represent a $0 liability at any point in time. Actually, because of the way the market works--long runs of above average returns followed by sharp below average returns--CFOs just as often claim that their pension funds represent idle money. Of course it's not idle, it's invested in the market, and while those funds are nominally controlled by the employer in reality they're an expenditure no different than the paycheck the cut their employees every other week.
Public pensions, however, aren't required to be fully funded. Politicians are happy to promise huge pensions to placate employee unions without giving a second thought to how they might actually fund those future liabilities today. (Notably, unlike state-government employee pension plans, Federal employee pension plans are kept fully funded as required by separate Federal law, notwithstanding the USPS, which has a complex, unique story of its own.)
A defined-benefit pension is basically just an annuity, and any economist will tell you that annuities are one of the most rational and efficient retirement devices around. The real retirement crisis that we'll see (and which we got a glimpse of during 2008-2010) is when people realize how risky and poorly funded their 401(k) plans are, especially during economic downturns. It's going to be epic particularly because most people only invest 4-5% of their wages into a 401(k) at best, whereas for somewhat historic reasons defined-benefit pension contributions usually represent 20-30% of compensation. Things are going to get nasty....
What we should be doing is incentivizing pension plans, not disincentivizing them. Pension plans should be the dominate retirement strategy. But because the potential for moral hazard is significant when governments make these promises (there's no higher authority to ensure promises are backed by commensurate present funding), we can't rely on government to do this directly. Social Security is very similar to a defined-benefit plan in the sense that there's a set formula for benefits based on wages, and it's a very important safety net we should strive to maintain. But it's just a safety net and we shouldn't expect anything more of it.
A great book explaining the history of pensions and the shift to 401(k)s is "Retirement Heist: How Companies Plunder and Profit from the Nest Eggs of American Workers", https://www.amazon.com/Retirement-Heist-Companies-Plunder-Am.... The author was an investigative journalist for the Wall Street Journal, and the book explains in interesting and somewhat technical detail the legal and financial machinations of defined-benefit (pension) and defined-contribution (401(k)) plans.
[1] Investors who conveniently forgot or had no interest in understanding where that windfall they received 6 months earlier came from.
That's a terrible idea. We've seen many cases where companies failed and pensioners had to rely on reduced payments from the PBGC. Sometimes pension liabilities even drive otherwise viable businesses into bankruptcy, which benefits no one. Pension funds also usually assume unrealistic rates of return.
By contrast 401(k) plans are very safe. Once the money is in my account it's mine and can't be taken away without a court order. Even if my employer or the brokerage holding my account go bankrupt I won't lose anything.
You hear about pension failures but you rarely hear about the retirement failures of 401(k)s because it's a distributed problem. There were plenty of these stories during the Great Recession, but you mostly heard about pension crises even though pensions by their nature are designed to and in fact did weather the storm much better.
Plus, as you point out pensions are insured by the PBGC, primarily funded by premiums paid by pensions. Where's the insurance for your 401(k)? There are a lot of problems with the PBGC, some of which relate to the Republican strategy since the 1970s of killing the system of private employee pensions through neglect, but it's still there.
There are many problems with pensions we could identify, but these are fixable problems using the type of technocratic, regulatory work we know how to do well and are still perfectly capable of doing, even in our bitterly divisive society. And in any event the system doesn't need to be perfect, just better than the alternative. Leaving everybody to fend for themselves isn't an actual alternative--it's an ideological position that denies that a problem exists instead of addressing it.
A 401(k) may be the best choice for you, but the social problem we face isn't figuring out how to maximize nradov's retirement wealth, it's how to maximize population wide outcomes.
As I said, annuities are one of the best vehicles for a secure retirement. It's becoming increasingly common for people to invest in variable annuities through their 401(k)s, but these aren't the same thing. For one thing they don't offer the same security as a fixed annuity. For another their payouts will be lower because healthier, long-lived people will self-select into annuities while other people will live shorter, harsher lives than they otherwise would have. It's a collective action problem--everybody is worse off.
Much like with health insurance, in the aggregate and over time (everybody is an outlying insurance risk at some point) people are better off purchasing insurance and annuities through group plans. Well, that's exactly what a pension is--a group fixed annuity!
To be clear, my point is that pensions are misrepresented; that they're not only useful but desirable. What I'm not saying that we should only have pensions or that 401(k) and other investment schemes don't have a place--they're just a very poor mechanism to provide minimum retirement security at scale as compared to defined-benefit schemes.
And it's not just individual players. Think about all those pension funds and insurance company funds that need to make returns to fund people's retirements. Collectively they have trillions of dollars on the line, and no choice but to invest in increasingly risky funds. Once you understand the connection between low interest rates and risk, as a follow up, watch this: https://www.youtube.com/watch?v=k9_bWbrYPKg Brian Reynolds has a ton of experience working in the pension industry and this is an extremely fascinating interview (though a bit advanced, but you can still understand some of it)