October 29th 2009

Why indefinitely low interest rates will hold recovery back

David Cameron’s belated conversion to very low interest rates and QE means we now have the makings of a political consensus on the issue. But as with so many opinions held by the political elite, it is based on the past, rather than the current reality, of UK demographics.

Reducing interest rates as one goes into recession seems at first sight like a no-brainer. Credit is important to the younger earners, who will be encouraged to carry on spending. And cheap investment funds for business mean in turn manufacturers will be encouraged to invest - and risk higher production outputs. They in turn see consumers buying again – voila: we climb out of recession.

The one flaw in this is that it hasn’t happened this time. Mostly, the reasons given for this have been first, family-rearers have woken up to the magnitude of their debts and the possibility of unemployment; thus they have dramatically pulled in horns – all the data confirm this. Second, the banks have become so nervous (and remain in such a dreadfully weak position) they’re not lending much to anyone. And third, commercial demand for credit has fallen off. Paul Krugman was right on the money when he told Will Hutton earlier this year ‘The fall in business investment is at least to a large degree a response to excess capacity, which is the result of falling consumer demand and the housing bust’.

One can make a strong case for low interest rates having staved off full-scale depression. But once that’s been achieved, they will hold back medium term recovery – as they have for over a decade in Japan. In the UK, it will do so largely for one simple reason: those most likely to kick-start a recovery don’t want low interest rates. The reason is that they’re over 55 – and heading towards retirement, or already in it.

Obsessed as our political Establishment is with YouTube, Twittering and showing a human side on Face book, the economic power now lies firmly with over 55s. And this telling influence presents in two key ways.

First, in times of stock market uncertainty, they would normally invest huge sums of money with the banks. To state the obvious, while banks make more money from lending, they need seven times more savers than lenders to do it. Anyone over 55 in the UK today with a bank savings account is either shrewd enough to have found a good deal, or insane. And as foreign investors currently lack any confidence in UK banks, without the wrinklies, banks are stymied.

Retired people do not have the flexibility of wage earners – who can at least juggle the numbers and change buying habits to make ends meet. Those on unearned income don’t have that option: if the income goes down to 0%, all their normal discretionary spending will come to an abrupt halt.

Second – and this is the paradox that the political set has missed – older people exist in greater profusion and with greater wealth than ever before. Over a third of the population is at or very near to retirement. And as Abbey (now Santander) bank found in 2007, they own 75% of the nation’s wealth. We are talking over four trillion Pounds today (and yes, it has dropped since the year before last): but nevertheless, the only GDP in the West bigger than that amount is America’s. What’s more, the group’s spending power has increased 50% since 1999. Four in every ten pounds spent in the UK comes from this group.

But the spending power comes substantially from investments….because most have seen their pensions fall in value in the last three years. As it happens, a fair proportion of their net worth comes from the property in which they live. Usually having no mortgage debt, not only do falling interest rates reduce their spending power, they will not need a mortgage in order to ‘downsize’ - as they almost inevitably will. Overall, they rarely use credit anyway. Thus ‘cheap’ borrowing is not of any great interest to them.

In short, giving this group the confidence to spend and move would be the best way to apply an initial shock to the economy’s failing heart and ensure a housing recovery continues. And that means raising interest rates. It would also improve the monies available for commerce (and mortgages) at the banks – and lest we forget, the empirical evidence shows that availability is still the biggest stagnation factor in that sector. Last but not least, it would help prop up Sterling….and thus keep our AAA borrowing status secure.

It must be said in conclusion, however, that saying ‘the retired’ is rather like saying ‘black people’ – as a generalisation, it’s meaningless. Those approaching or in retirement divide starkly into two halves: potentially well off, and potentially poverty-stricken. In this latter group, a cap on State pensions, 0% interest rates, cuts in services, and the inflation which could follow QE, would all be socially disastrous. Paradoxically, fiscal policy must at one and the same time encourage the comfortably-off oldies to spend – in order to ensure their poorer contemporaries do not become a disgraceful social problem.

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