Another paradox of thrift
Why low interest rates could also encourage saving
Sep 16th 2010
“JOHN BULL can stand many things but he cannot stand two per cent.” That aphorism, quoted by Walter Bagehot, a 19th-century editor of The Economist, expressed savers’ traditional distaste for very low interest rates.
For the first three centuries of the Bank of England’s existence, 2% was indeed as low as the central bank was willing to let interest rates fall. Not even the Depression, nor the long Victorian period of stable prices, induced the bank to go any further. Some minimum return on capital was deemed to be required.
All that changed with the credit crunch of 2007-08. Interest rates are at 1% or below in most rich countries, and there seems to be little prospect of their rising soon. The futures market believes that American rates will still be below 1% in July 2012.
Investors seem to have two reactions to the prospect of a prolonged period of low rates. For the bulls, it is a sign that investors will eventually decide to reject the safety of cash in favour of the higher returns available from riskier assets. The net effect will be familiar: central banks will have underwritten the markets as they have so often in the past 25 years. Rates were cut in response to market wobbles in 1987, 1998 and 2001.
For the bears, low rates are a sign of the desperation of central bankers, and an indication that economic growth will be subdued for some time to come. They predict Japanese-style stagnation.
Not everyone accepts the Japanese parallel. But there is a reasonably broad consensus that growth will be more sluggish than it might have been, thanks to the lingering effects of the financial crisis and to deteriorating demography, particularly in western Europe.
A long period of low rates has profound consequences for savers. Take pensions. Whether pension schemes are funded by the public or private sector, or are structured as defined-benefit (final-salary) or defined-contribution plans, the fundamental principle is the same. Schemes try to build up a capital pot, which is used to buy an income in retirement, for example in the form of an annuity.
Low rates increase the liabilities of pension schemes. Or, put another way, you need a much larger capital pot to buy a given level of income. According to Nick Horsfall of Towers Watson, a consultant actuary, British liabilities have risen by 15% over the past three years, thanks to lower nominal government-bond yields.
In addition, deflation is a hidden risk for pension schemes. If it occurs, it will cut the nominal incomes of those (companies, public-sector bodies) that have to fund future pensions, creating another potential gap between assets and liabilities. It is possible for pension funds to insure themselves against deflation in the derivatives market. But the cost of this has risen sharply in recent years, as deflation has become more likely.
However pensions are funded, the consequences are clear. More money will have to be put aside to pay for them. In other words, savings will have to go up.
Some will argue that pension schemes will simply cut benefits instead. But that would still leave the individual with an expected pension shortfall, to which the rational response would be to save more.
The effects of low interest rates do not stop there. Rates are low in real as well as in nominal terms, which makes it harder to accumulate a given capital sum. Since less of the work is performed by investment returns, more of the work has to be done by the saver.
Here again, Japan may provide the template. Its investors have been so eager to save that they have been willing to buy government bonds even with nominal yields of just 1-2%.
Indeed, the rich world may be due for a cultural shift. If the motto of the past 25 years was “borrow now, pay later”, then “save now, rather than starve later” might soon be the more appropriate philosophy. Many people are unprepared for retirement. A staggering 47% of British women of working age do not have a pension plan, according to a survey by Baring Asset Management, and 22% of all adults aged between 55 and 64 are in the same position. If they think they will have a comfortable retirement on state benefits, they are in for a nasty surprise.
Interest-rate cuts hurt savers’ incomes even as they make borrowers better off. If this income effect were to become powerful enough, it would be a nice irony. Low interest rates, which have the main aim of encouraging spending, could have the perverse effect of encouraging saving.
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