How Interest Rates Work

While it is no doubt presumptuous to advise Nobel Prize winners, It seems to me that in an additional response to Paul Krugman's blog post, a little basic economics is called for. 

The level of interest rates sends basic signals to investors, and if they are kept artificially low the signals are false ones. That rate affects all prices and all investment decisions. If an investor is considering an investment, the Return On Investment, ROI, is a crucial part of the investment process. Let's say that the interest rate is 5%. If the investor estimates that an investment will generate a return of 4%, the investment will not be made. Even at a return for the investment at 6%, this might not be enough margin for an investor to decide to invest. 

Here Are Some Effects of Lower Interest RatesWhy then is a lower rate of interest bad? Doesn't that mean that more investments are made? Yes, lower value investments are made for the "big boys." They are the ones that can borrow money at 2 to 3%.  But there is a huge risk because of the mismatch that exists in modern investment between the maturity of a loan and the maturity of an investment. When an investment loan rolls over and needs to be renewed, the borrower will pay what ever the current interest rate is. But the investment is not necessarily something that can be sold quickly. So a borrower may suddenly be paying 6% for an investment that only pays 4%. Unless the investor has other income that can be used for the bank payment, foreclosure is in the future.  

The result will be hugely deflationary. 

Will interest rates rise? Interest rates are not just low for recent times, they are not just low in living memory, they are the lowest they have even been in the history of the world. 

A rise in interest rates is inevitable. 

So if this rise in interest rates is deflationary, why am I predicting 50% inflation spread over 5 to 7 years? The reason is that the Federal Reserve will not allow the market to work and will re-inflate as the negative consequences of higher interest rates happen. In other words the Federal Reserve will over compensate. Then after the inflation occurs, the Federal Reserve will deflate again to prevent hyperinflation. 

We will have a very rocky time for the rest of the decade and a good part of the next decade.  

Get Ready. 

Ceased To Exist

Yesterday I mentioned that I found Casey's comment that America has ceased to exist as false, for it never "existed" in the first place. Obviously America exists. But what Casey means is that the American Dream has ceased to exist. My point was that it never did exist. Sure some can pull themselves up by their own bootstraps, but throughout most of the US's history, well...their boot straps were broken. 

Rather than "reinvent the wheel," I thought I would point you to the blog of my friend and the beloved editor of the Prophecy Podcast. Pam Dewey has been blogging about the Myths of American History. Here's a link to the introduction to one of her blog series related to evaluating the American Dream, Painting a Rosy Past.  Many other mythperceptions about American History, on a wide variety of topics, are linked from her Introductory page to her Meet MythAmerica blog. 

This does not mean that you as an individual can't improve yourselves. Nor does it mean that you cannot prepare for the coming crisis. You can and should do both. 

Has America Ceased to Exist?

In a word, no. The statement imples that the American Dream actually ever existed in the sense that Casey means. This is a rather naive view of history. 

While I do think a crisis is coming, it will not be the zombie apocalypse. I have been accused of predicting hyperinflation. I have not. I am expecting 50% inflation over a number of years. But all of us "hard money types" tend to underestimate the power of the state and the Federal Reserve. 

All Empires fail. But the process is long and drawn out and after the empire falls, the country often continues to exist--Spain, England, and Holland each had thier empire that no longer exists, but these countries continue to survive and even thrive.  

So I disagree with Casey, but I found his comments interesting. 

His Middle Name is Versatile

Yes, that would be musician, comedian and yes dancer Steve Martin.

Savers Are Evil

We live in an odd world where Nobel prize winning economists do not understand the economy.

Why save? In today's economy there is no reason to. NY times columnist Paul Krugman:

Complaints about low interest rates are usually framed in terms of the harm being done to retired Americans living on the interest from their CDs. But the interest receipts of older Americans go mainly to a small and relatively affluent minority. In 2012, the average older American with interest income received more than $3,000, but half the group received $255 or less. The really big losers from low interest rates are the truly wealthy — not even the 1 percent, but the 0.1 percent or even the 0.01 percent. Back in 2007, before the slump, the average member of the 0.01 percent received $3 million (in 2012 dollars) in interest. By 2011, that had fallen to $1.3 million — a loss equivalent to almost 9 percent of the group’s 2007 income.

In a sense Krugman is right, interest is paid to the wealthy, but this is due to a degree to low interest rates. Let's say that one wants to live off one's savings—not a bad goal for a retired person. Let's also say that $30,000 a year is your retirement income goal. In the current rental world in San Diego a modest apartment rents for $1200 or so a month, so this is not a large amount of money. Older investors should invest conservatively, so the rate they get is at most 2%. In fact that is too high. How much capital would this older person need? So here is the math: X * .02 = $30,000. This person would need $1.5 million to live off the interest. Yes, I think we would all agree that Krugman is right and this person is "wealthy." Yes, Social Security will provide some income. Personally that will be $880 a month or so for me. Let's say that Social Security will provide on half of that $30,000. That means our hypothetical retired person will need $750,000 in savings. This is still by most people's standards "wealthy." But is an income of $30,000 a year wealthy?

You tell me.

What purpose do interest rates serve? And who benefits from lower interest rates? I will leave these questions for the next few blog posts.