Guest Post: The unintended consequences of ZIRP

Note from Ben:

This entry is actually a re-post (with permission of the author) from an entry over at Vancouver Condo Info.  I have repeatedly warned of unintended consequences of excess government intervention in capital markets.  The Zero Interest Rate Policy (ZIRP) at the US Fed, and our own low interest rate version has produced such unintended consequences.

I have been warning of a coming pension issue within the next 5 years for virtually all government defined benefit plans.  One of the many problems is that most plans use an anticipated annual return of +8% in calculating their funding status.  Going forward, this will be exceptionally difficult to achieve for funds that hold between 40 and 60% of their assets in fixed income given the current interest rate environment.  And a rapid readjustment in interest rates doesn’t help either in the short term as it decimates the face value of their bond holdings until they mature.

This same dynamic applies equally to seniors on fixed incomes and to the few savers left in our society.  These policies have the effect of robbing from seniors and savers in order to subsidize debtors in an attempt to keep the economic growth illusion going for a little longer.  Our consumers are maxed out.  Household credit is at all time highs while savings are at all time lows.  In a consumer-driven economy such as our own, the normalization of interest rates would gut consumer spending and immediately plunge us back into a recession.

And so the government leaves interest rates at these levels, forcing pensioners, pension funds, and every day investors to embrace higher levels of risk in an attempt to achieve adequate returns.  This drives up the price of risk assets such as high yielding bonds, commodities, and certain stocks, effectively setting the stage for potential bubbles.

But can the government keep interest rates at these levels indefinitely?   The bond market will eventually take the whip to us if they try to, driving the cost of fixed interest rates skyward.  We’ve seen that any country that turns a blind eye to the excess debt levels at the government, corporate, and consumer levels will face a harsh rebuke in the form of higher borrowing costs.  If the BoC left overnight rates at such low levels in such a scenario, it would essentially be an open invitation to our banks to take advantage of an easy arbitrage opportunity:  Borrow cheaply from the BoC and invest in government bonds of short duration.  Pocket the hefty premium.  It would be a defacto taxpayer subsidy for our big banks.  I can’t imagine that this would last.

At any rate, enough of my musings.  I relinquish the floor to Jesse:

 

Less money for us

I thought I’d share a situation with you that in many ways epitomizes some underlying issues with the current economy. I am involved in a volunteer organization that regularly gives out scholarships to university students. Since I was involved in the organization in the mid-90s, up until a couple of years ago, the scholarship fund has managed to sustain a reasonable, though not profligate, level of scholarship and bursary awards to students. These monies came mostly though not exclusively from interest on the principal fund. The fund was topped up each year through small transfers from the organization’s general operating budget, and through these two mechanisms has managed to have its award amounts keep pace with CPI inflation for the past 15 years.

Until late 2008 that is. At that point interest payments started to dwindle. Now, two years in, more and more higher interest investments have matured and the only option available for the cash, given the scholarship fund’s requirement to retain capital, is re-investing in (now) lower interest vehicles. This has led to the organization scrambling to solicit private sector donations to the fund to cover the shortfall, or consider reducing the number or value of awarded scholarships.

The experience of this organization is, in many ways, akin to any other business or family who is using its capital to produce income. As interest rates remain low, incomes start to dwindle and the tough choice appears: start eating into the capital to fund operations, take more risks with this capital, or find other ways of producing income such as taking on another job, accepting donations, or delaying retirement. The difference with a volunteer organization, perhaps, is there isn’t any finger to point for past mistakes. This is simply a case of trying to manage ongoing operations of a conservative fund and there’s no easy way out.

In itself, the financial issues of this scholarship fund are deflationary: more money must be sucked in, ex dwindling interest income, to maintain existing operations or operations start to come under pressure. I think, in general, this background deflationary meme is hidden from most of us still young who aren’t overly concerned with funding retirement in the near future. The longer low interest rates remain, however, the more stressed those with fixed income will feel. If interest rates don’t rise soon, funding the future will start to become a more prevalent concern, realized through reduced spending, increased risk, delaying retirement, and, to the glee of many here I’m sure, accelerated liquidation of existing assets.

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One Response to Guest Post: The unintended consequences of ZIRP

  1. LRM says:

    Jesse says ” If interest rates don’t rise soon”
    Well, is there a free market in interest rates ? If Ireland wants to borrow in the free market the best they can do is about 9%. No one in the free market will offer their money to Ireland for less. But in the central planned economy that is the European Union, Ireland can obtain funds at about 5%. If you are a small Canadian business going to the bank for a loan the rate is probably higher Prime + 3% =6%
    However, BOC is not a player in the free market. It can set it’s own rate so if you want to participate in this controlled market, you take what is offered. In our modern monetary system, Canada is not constrained in any way by what can be obtained in the bond market. If the treasury ( Flaherty) wants to spend money, he does not ask anyone if there is money in his account. He just spends it into existence. The real question is why does Canada even need to issue a bond ? Why do we the tax payer pay interest on money ? Who is the biggest beneficiary of this bond market? What is going to stop the BOC from lowering rates further over the next several years if Ben is correct and the Canadian economy has a bit of a setback ?

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