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It is thought experiment time.
Let's say short-term real interest rates are -2%. That means you lose 2% of your purchasing power every year by investing in short-term interest paying treasuries. That's pretty much the case now and it was pretty much the case in the 1970s.
Scenario 1: 1970s Style Inflation
3-Month Treasury Bills: 6%
Inflation: 8%
Real Interest Rate: -2%
Scenario 2: 2000s Style Inflation
3-Month Treasury Bills: 0%
Inflation: 2%
Real Interest Rate: -2%
The end result is pretty much the same, right? Just look at oil prices.
Now let's assume you can borrow at 5% above the 3-month treasury bill rate. If nothing else, it could be a home mortgage.
Scenario 1: 1970s Style Inflation
Borrowing Rate: 11%
Scenario 2: 2000s Style Inflation
Borrowing Rate: 5%
This is not the same clearly. What implications would this have?
Let's assume that you can devote $10,000 per year to interest payments, that you would like to make a leveraged bet on "sure thing" inflation, and that the bank only cares about your ability to service the interest on the money you borrow. Call it an interest only loan if you will.
Scenario 1: 1970s Style Inflation
Speculation Loan: $91,000 ($91,000 x 11% = $10,000)
Scenario 2: 2000s Style Inflation
Speculation Loan: $200,000 ($200,000 x 5% = $10,000)
Is it any wonder we had a stock market bubble, a housing bubble, and at least one commodity bubble over the past decade? In this theoretical example, our ability to speculate has more than doubled since the 1970s.
Let me sum up this theory.
Real interest rates determine the desire to hoard assets. The lower they are the greater the desire to hoard/speculate (be it houses, oil, precious metals, toilet paper, and so on). Low real interest rates certainly influenced my behavior.
Nominal interest rates determine the ability to hoard assets. The lower they are the greater the ability to hoard/speculate (be it houses, oil, precious metals, toilet paper, and so on). This did not influence my behavior because I am not a big fan of debt. It did affect the behavior of investment banks and home buyers though.
There is severe bubble danger when you combine both the desire to hoard and the ability to hoard. I do think we have seen this bubble effect play out over the last decade in stocks, housing, commodities, and perhaps even stocks and commodities again.
This is why I am not a fan of lowering interest rates and taking on more debt to solve our problems. They ARE the problems. They encourage speculation. It did not end well in the stock market. It did not end well in the housing market. It did not end well in commodities (think 2008). Apparently we're going to keep trying until it ends well. Good luck on that one!
These are just my opinions of course.
Real Estate Newsletter Articles this Week: Existing-Home Sales Increased to
4.15 million SAAR in November
-
At the Calculated Risk Real Estate Newsletter this week:
[image: Existing Home Sales]*Click on graph for larger image.*
• NAR: Existing-Home Sales Increase...
16 hours ago
20 comments:
One more thought.
Those who borrowed at 11% to bet on "sure thing" inflation in the late 1970s did not make out like bandits. The banks did.
Those who borrow at 5% to bet on "sure thing" inflation right now might also not make out like bandits. The banks might though (assuming those borrowing at 5% can make their payments and/or we bail the banks out again).
In other news, do check out There Is No Switch. It reminded me so much of South Park. See the comments. Hahaha!
One more thought.
I do not think that the dotcom bubble was brought on by this mechanism. I think that bubble was going to happen no matter what. Real interest rates were high then. I-Bonds paid a whopping 3.6% over inflation at their peak and you could lock that in for 30 years.
The response to that bubble was to create new bubbles to replace it though. I think history will show that it was a big mistake. I could be wrong. Let's see where we are in 10 more years.
Mark,
How about a comparison of longer term rates during the same time frame? Say, 10 yr and 30 yr rates. Over time, I would suspect that the rate of inflation would average lower relative to the rate of interest. What was a 30 yr treasury rate in 70?
It did end well. Look at the redistribution of wealth over the last forty years. You think policy decisions and actions by the Fed are inteneded to create a bottom-up growth scenario?
He comments on his own posts... I love it!
Hi Mark. I observe that nowhere on this page can I find the word "profit". Methinks, if profit was better in the productive sector, there would be less inducement for money to flow into speculation. Moreover, if the rate of profit was higher, the rate of interest wouldn't have to be so low to keep the spark of economic growth alive.
I came to this post from JzB's Retirement Blues because of your comment there: "The difference in leverage between now and in the 1970s can be explained by the difference in nominal rates. If interest payments alone constricted the ability to borrow ... then we could borrow 10x more money to speculate at 1% interest rates than we can at 10% interest rates."
In your post you posit borrowing rates of 11% and 5%, with speculative loans of $91k and $200k respectively. Okay. These scenarios are microeconomic: They consider the individual and his bank in a single representative transaction.
Your comment at JzB's is also a micro analysis. By contrast, my view is always macro. Let's take your borrowing rates as national averages, and use the particular dates 1970 and 2000.
In 1970 total debt was about 150% of GDP. In 2000 total debt was about 270% of GDP.
150% of GDP at 11% interest is 16.5% of GDP. 270% of GDP at 5% interest is 13.5%.
A 5% interest rate is less than half an 11% interest rate. But 13.5% of GDP is only a slightly smaller piece than 16.5% of GDP.
And 1970 was an anomalous year. A couple years before or a couple years after, the interest rate might have been half as much. In that case, the total cost of debt at the later date would be greater than at the earlier date, despite the general decline of interest rates.
...comment-too-long warning...
yours (without the snark)
ArtS
nanute,
I can't find the 30 year treasury rate in 1970 but I can find the 20 year.
Here's how you would have done investing in January of 1960, 1970, and 1980 and holding the full 20 years. Inflation data can be found here.
1960
20 Year Treasury Rate: 4.42%
20 Year Inflation Average: 5.00%
Average Real Interest Rate: -0.58%
1970
20 Year Treasury Rate: 6.92%
20 Year Inflation Average: 6.26%
Average Real Interest Rate: 0.66%
1980
20 Year Treasury Rate: 10.65%
20 Year Inflation Average: 3.95%
Average Real Interest Rate: 6.70%
Locking in a nominal rate for 20 years is clearly its own form of speculation. It worked out great if you invested in 1980 though.
This also partly explains why I was comfortable locking in more than 2% over inflation on my most recent 30-year TIPS purchase.
Here are the extremes.
May 1965
20 Year Treasury Rate: 4.21%
20 Year Inflation Average: 6.34%
Average Real Interest Rate: -2.13%
Ouch! Note that it was roughly when we removed silver from our coins.
October 1981
20 Year Treasury Rate: 15.13%
20 Year Inflation Average: 3.27%
Average Real Interest Rate: 11.86%
If I was forced to bet (I'm not), I'd bet on disco balls long before I'd bet on the 1980s and 1990s repeating. Unfortunately, the 1970s trade may be fully priced in (or more). It isn't like oil, gold, and silver are sitting in the bargain bins right now (relative to actual toilet paper anyway).
Fatboy,
It did end well. Look at the redistribution of wealth over the last forty years. You think policy decisions and actions by the Fed are inteneded to create a bottom-up growth scenario?
Alright, I admit it. You got me. Back at you though!
Are you sure it ended? Forty years of "success" doesn't seem like a reason to stop. Sigh.
One more thought.
I'm not trying to imply that the 1970s trade is the most likely. I don't think decades of low interest rates, low real interest rates, low growth, and low overall inflation is out of the picture by any stretch of the imagination.
Maybe I've watched too many Japanese horror movies though.
Mark,
Thanks. Your theory sounds plausible, as long as borrowing is part of the equation. In the current state of affairs, there seems to be an excess demand for money. (Is this hoarding?) The banks seem to be using the near zero bound rate of borrowing to both repair balance sheets, and take the float on excess reserve deposits. It would be interesting to see what would happen if the Fed stopped paying interest on excess reserves. Furthermore; the excess reserves may in fact be illusory. Suspending the rules of mark to market have, in my opinion, overstated asset/balance sheet values. No?
The Arthurian,
Your comment was caught by Blogger's SPAM detector and has been released. Sorry about that!
In your post you posit borrowing rates of 11% and 5%, with speculative loans of $91k and $200k respectively. Okay. These scenarios are microeconomic: They consider the individual and his bank in a single representative transaction.
It was my ultimate intent to show how speculators (as a group, macro) could rationalize high prices by pointing to seemingly reasonable monthly payments. Double the price but half the interest payments and you pretty much end up even.
The flaw in this thinking is that high home prices were not sustainable compared to the price to create them (or even the price to rent them). Supply eventually therefore overwhelmed demand.
nanute,
Your theory sounds plausible, as long as borrowing is part of the equation.
It would be nice to know just how much the borrowing is part of the equation. It is somewhere between 0% and 100%. My investment decisions would be easier if I could pin it down.
Let's say we invested in a hot stock. We then read a report that says that 99% of all investors in that stock used credit card debt to fund their purchases. Would we still find the investment just as attractive? I wouldn't.
"Let's assume that you can devote $10,000 per year to interest payments": why is that a fixed annual amount in an inflationary world?
dearieme,
"Let's assume that you can devote $10,000 per year to interest payments": why is that a fixed annual amount in an inflationary world?
Just to make the math easier to follow. Nothing more. I did think long and hard about adjusting the amounts for inflation but decided it muddied the point I was trying to make.
If you prefer, think of the $10,000 as being adjusted for inflation (in today's dollars). It would therefore be the equivalent of borrowing $10,000 in either era.
Put another way, the $200,000 isn't larger than the $91,000 due to inflation, just due to interest rates.
Free at last from the SPAM filter. Thank you, sir. Now I know what it looks like from this side :)
Hey, your two red lines of text, re the desire and ability to hoard assets, these are great! Clear, and definitely quotable. Good stuff.
"It was my ultimate intent to show how speculators (as a group, macro) could rationalize high prices by pointing to seemingly reasonable monthly payments. Double the price but half the interest payments and you pretty much end up even."
True, I did say your post considers "the individual and his bank in a single representative transaction." But even if there are 300 million individuals in the U.S. making such transactions, I still want to say it is micro... Let me quote from your post of the 21st: Since we are a debt-based society, I would argue that there is debt chasing any investment that appears to be a "sure thing".
Debt is still a useful tool for speculators. That is what you are saying, I think, and I agree. Debt is still useful for all those individuals.
But debt is no longer so useful for the debt-based society. That's why the economy sucks.
I think I'm making a big deal of something off-topic to your post, and for that I do apologize.
Requoting you: "Double the price but half the interest payments and you pretty much end up even."
Yes, and perhaps the individual need look at nothing else. But the policymaker must. Double the price at half the interest rate, and three times the amount of borrowing compared to GDP, or compared to M1 money maybe. As a society, a debt-based society, we end up choking on debt. Meanwhile, those individual investors of whom you write are borrowing more than ever.
I don't know how to focus your attention on my concern, except by distinguishing my concern as the macro case.
If I have been clear and you have understood my concern, I want to ask if you see any merit in it.
ArtS
The Arthurian,
"If I have been clear and you have understood my concern, I want to ask if you see any merit in it."
I absolutely see merit in it and I agree with all of it. When I say "debt-based society" it is not with admiration. I want to make it clear that I am not defending the idea that borrowing twice as much because interest rates are half as much is a good plan.
When insane mortgage offers filled my mail box in 2004 they were all definitely micro anecdotal events. They pointed me to severe macro problems.
I think if you were to read more of my posts you would see that I toggle between micro and macro. Here is a sampling of posts that might interest you.
Normal Times?
Real Net Worth Per Capita
Cumulative Trade Deficit Nightmares
And lastly, off topic comments are welcome here. I see the comments as a place to chat.
Thanks, Mark.
"I want to make it clear that I am not defending the idea..."
Oh, yeah. That was clear. Thanks again. Gonna go read some of your stuff now. (Better late than never:)
It is probably best to keep this in mind too! ;)
Mark -
I've skimmed this a couple of times, but have yet to give it the careful reading it deserves.
However, I think you are making a fundamental error in mismatching maturities. You can't borrow for a mortgage at T-Bill rates. Today I see 30 yr fixed at 4.25 (4.81 APR)and 15 tr fixed at 3.375 (3.7 APR)
I don't have my number-cruncher head on today, though, so I'm not sure how this effects your argument.
Rehearsal tonight. Gotta run.
Cheers!
JzB
Jazzbumpa,
"However, I think you are making a fundamental error in mismatching maturities. You can't borrow for a mortgage at T-Bill rates. Today I see 30 yr fixed at 4.25 (4.81 APR)and 15 tr fixed at 3.375 (3.7 APR)"
I said...
* "Now let's assume you can borrow at 5% above the 3-month treasury bill rate."
* "Borrowing Rate: 5%"
It was simply a ballpark estimate for simplicity's sake.
I am mismatching maturities but I am not the only one. Ben Bernanke enticed people to speculate on long-term investments based on short-term interest rates. We'll see how that works out.
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