The great interest rate scam

David Bullard says the US and UK govts are reducing pensioners to penury

My wife can't stand Bob Diamond, the recently departed CEO of Barclays Bank. She doesn't actually know him and I doubt whether her dislike stems from anything as mundane as the enormous amount of money he awarded himself for running somebody else's bank. She just doesn't like his mouth because she thinks it makes him look smug and self satisfied. So while she is much too nice a person to celebrate his fall from grace for allegedly rigging the London inter-bank offered rate (LIBOR) she will be relieved not to see his pursed lips on TV so often, not to mention his dreadful taste in neckties.

I happen to agree with my wife that Bob Diamond has the sort of face that you might want to punch for no other reason than it seems the right thing to do. But I have to leap to his defence on this charge of interest rate rigging which seems a little unfair in a world where interest rates have been rigged by people far more powerful than Bob Diamond.

Those of us who did a bit of economics at school will remember that scarcity of a product drives up the price of that product providing the demand remains constant or rises. An obvious example is oil and we all know to our cost that if supplies are threatened then the price of oil rises because it's a commodity we simply can't do without. Conversely, an over supply of something usually leads to a fall in price and wine would be a reasonable example in this instance.

So if you think of money as a product or commodity then the price for it is the interest rate you are charged to borrow it. High interest rates means a high cost of money and low interest rates means a low cost of money. So far so good.

I think it's fair to say that demand for money currently far outstrips supply which is why countries like the US and the UK have gone in for what they euphemistically call "quantitative easing",  the posh phrase for printing money. One of the reasons the Eurozone is in such a financial mess is that they couldn't resort to quantitative easing because there are so many member countries with different economic strengths that use the Euro as their currency. I have no doubt that Greece and Spain would dearly love to be able to print money to get them out of the hole they find themselves in but that wouldn't help Germany much.

As various members of the Eurozone have got themselves into ever deeper financial dwang the cost of their borrowing has risen. There are at least two good reasons for this. The first is the good old economic reason of demand for money exceeding supply therefore the price of money has to rise. The second is the risk attached to a loan to a country desperate enough to borrow at a higher interest rate. So, part of the high cost of borrowing relates to the price of money and part relates to the inherent risk of lending to a country that may not be able to repay on time or at all.

While what is happening to Greek, Portuguese and Spanish borrowing sort of makes sense, what is happening in the US and the UK doesn't.  What the governments of both those countries have done is to pull the most amazing confidence trick of our time by rigging interest rates and keeping them artificially low. They've managed to do this by printing money and pumping it into the economy to give the illusion that all is well.

As the US debt hovers around the $15 trillion level it would suggest that the US should be paying a much higher price to borrow money than it does. And the same goes for the UK. But keeping interest rates artificially low is in the interest of both the UK and the US administrations. Not only does it mean that government has access to very cheap money but it also allows the governments of the US and UK to pretend they are keeping interest rates low to encourage borrowing and stimulate the economy.

Since it is excessive and indiscriminate borrowing that caused the financial mess the world found itself in in the first place it hardly seems prudent to encourage already indebted people to borrow even more. But why would such things bother mere politicians?

Most people like lower interest rates because they think they will enable them to buy things that will impress their friends and neighbours. But low interest rates are very bad news if the return on money lent remains artificially low. The obvious example is of a pensioner living on a fixed amount of money and dependant on the interest earned. As the amount of monthly interest falls it becomes necessary to eat into capital to maintain the same lifestyle. Over the past five years in SA that amount would have more than halved with the fall in interest rates.

It's not just pensioners who suffer though. If you are due to retire within the next few years you should be very worried because that pot of money in your company pension fund isn't going to keep you in any sort of luxury. Assuming you are risk averse and want to buy a fixed annuity, thanks to low interest rates you will be lucky to get R750 per R100000 invested every month in perpetuity. So if you have R2 million to invest into an annuity that's R15 000 of taxable income a month for the rest of your life. Even if you retire debt free that doesn't leave much for discretionary spending and by the time inflation takes its toll the spending power of that R15 000 is further whittled away.

It gets worse though. Most people with steady jobs don't give much thought to retirement but the unrealistic low returns on money market instruments in the UK and US are already having a negative effect on company pension schemes being run for people who are still some way off retirement.

Precisely the same thing applies here in SA and one of the biggest problems facing a future government will be the number of formerly comfortably off citizens who will find it quite impossible to live off their pensions.

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