Low interest rates, jobs and the economy

September 11, 2012

3 Decades of lower interest rates


Interest rates have been trending lower the past 3 decades. At the end of the Carter administration, interest rates (as tracked by treasury notes) were an astronomical 15%. Today the treasury notes are just over 2%. The drop in interest rates to very low levels has triggered asset bubbles because it becomes cheap for the population to loan money and speculate. One of the largest financial bubbles was the bubble in housing that started to inflate in 2003. In Mountain House alone nearly $1,000,000,0000 was lost when the housing asset bubble collapsed in 2008. The hardest hit in terms of net worth percentage were minority families. Many families were able to buy their first home (the American Dream) when the lending standards were relaxed as the bubble expanded. Compounding the problem, many took out home equity loans. These families were financially crushed when the bubble collapsed leaving the net worth of minority families at the lowest point in decades.

Politicians often praise low-interest rates and take credit for keeping them low. Low interest rates do help industries such as housing, commercial real estate, the stock market, and Federal, State, and local governments. However, low-interest rates are not a panacea and in fact may hurt job growth and our faltering recovery and so I’d like to present a contrarian view of low interest rates. This is not to say I’m in favor of high interest rates. I believe that there are ditches on both sides of the road and there is a Goldilocks region where interest rates are “just right.”

Young companies rarely have access to low-interest debt

Remember, most job growth comes from young companies. Twenty-one percent of the US economy was developed by companies that have started since the Carter and Reagan administrations cut the capital gains tax rates. This triggered a massive venture capital investment boom. Source(NVCA). Young companies are most often funded by investors and high-interest rate personal lines of credit. In other words, the very companies who will lead us out of this second Great Depression in jobs are NOT the entities that benefit much from the low interest rates available to large companies, governments, and real estate development.

Big companies have access to low cost debt

Big companies with extensive real estate holdings, large accounts receivables, and long corporate history can access low interest rate debt. When the Federal Reserve lowers the interest rates these companies can often swap out their old higher interest rate debt with new lower interest rate debt thus increasing their profitability without becoming more competitive. This is one reason why the Dow Jones Industrial Average goes up when there is economic news bad enough that the market traders believe the Federal Reserve will push down interest rates again.

Low interest rates help job killing mergers and acquisitions

So what do big companies do with their advantage in the cost of debt as compared to small companies? Big companies focus on “scaling” as the way to achieve higher profits. In other words, they want to use as few people as possible to generate high volume products. Hence big companies focus on automation and process improvements which are often net job killers not job creators. More often than not, the employment growth at a big company comes when they acquire a smaller company. After the acquisition, the big company quickly eliminates all the redundant positions such that after the acquisition, there is a net decrease in jobs. Low interest rate loans allow big companies to increase their automation and process improvement which is good for prices and thus the economy, but often not good for job growth. Low interest rate loans also allow big companies to eliminate competition by purchasing young nimble competitors further hurting job creation.

Imagine the US economy if Apple, Microsoft, Google, Amazon, etc. had been acquired by big slow moving companies instead of going public on US stock exchanges.

Small banks which provided some access to lower cost debt to young companies are disappearing

Since the financial collapse of 2008, banks that were too big to fail are now bigger. Big banks prefer to loan to big companies. According to the FDIC only 5% of commercial loans from banks greater than $50B in assets go to small growing businesses. In contrast, banks that are $500M or less in assets make 15% of their loans to small business. Unfortunately, dozens of small and medium size banks have been shut down since 2008. Finally, despite all political comments about easier access to loans for new and small businesses, the total number of loans to these job creating American companies has dropped since 2008.

Sadly, small community banks are disappearing. Only 3 new community banks were chartered in 2011 (source ICBA) down from 190 in 2006. Community banks usually loan money to local business, loan money based on reputation, etc. Big banks, while a necessary part of the economy, are formulaic when it comes to small business loans.

Low interest rates help less competitive big companies

New innovative job creating companies do not have the advantage of size/scale as compared to old big companies. An old big company has high volume production, low cost supply contracts, and depreciated factories resulting in a significant cost advantage for their non-innovative products. Therefore, the innovative company needs to have a very special product to win in the market. Low interest rates make it even tougher for young innovative companies to win because old big companies can borrow money cheaply, drop their prices, and deal with the losses until the innovative product is driven from the market.

Low interest rates hurt savers

The incentive to save money disappears in a low interest rate environment because bank account and bond interest rates are so low. This dis proportionally hurts those saving for retirement.

Low interest rates hurt innovation

Part of my job is to come up with innovative ideas that can be turned into profitable products. It is a fun job, but financially riskier than most people assume. Companies strive to make as much profit as they can with the least risk possible. Another part of my job is to determine how risky a product idea is and what will happen if the idea does not work or the market doesn’t want the product.

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When the cost of debt is high, a company using debt must seek a higher return or in other words, take more risk on more innovative products. Conversely, when the cost of debt is low, a company can build a factory to make another me-too product and still remain profitable.

Low interest rates tend to move money into non-wealth creating parts of the economy

When interest rates are low people have more of an incentive to purchase a home. Homes are great, but homes don’t create wealth the way a new factory, mine, oil well, energy plant, road, or innovative product does.

So what is the solution?

The solution is competitiveness as is most commonly found in young companies.

Jobs are most often created by young companies. Young companies are created by investors and entrepreneurs. The government should provide more tax incentives for company creation and reduce the regulations that prevent these companies from going public on stock exchanges. Today the number of companies going public due in part to the Sarbanes Oxley Act and the Frank Dodd Act is down 75%.

Perhaps interest rates should be kept within a narrow band between 5% and 7.5%. Real competitiveness is driven by innovation. Innovation and efficiency is what creates long-term wealth – not the manipulation of the currency. It would be okay to drop interest rates in a crisis to stabilize a market and allow governments to adjust their budgets. However, long term low interest rates can do as much damage to the young dynamic job-creating part of our economy as they are doing good for the other parts of the economy.

Hopefully some food for thought …

John McDonald

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