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Here is the heads-up on the cause of the next financial crisis: interest rates.
No, I don’t mean higher interest rates but lower ones. I know that sounds counter-intuitive because ‘everyone knows’ that lower interest rates are good for the economy, prompting spending and investment, generating growth and jobs. Regrettably, what ‘everyone knows’ isn’t the full story.
Let me explain.
Here is the heads-up on the cause of the next financial crisis: interest rates.
No, I don’t mean higher interest rates but lower ones. I know that sounds counter-intuitive because ‘everyone knows’ that lower interest rates are good for the economy, prompting spending and investment, generating growth and jobs. Regrettably, what ‘everyone knows’ isn’t the full story.
Let me explain.
First off, investment and spending, be it personal or business, is impacted more by confidence than borrowing costs. If you are confident that your return will exceed your borrowing and risk costs, you will invest whatever the rate of interest. Lower interest rates only make marginal investments more tempting but you still have to have confidence they will work.
It’s the same with salary workers. Unless you have confidence in your job and your future prospects, lower rates won’t prompt you to go into debt. What lower rates will do is spark asset bubbles which prompts the fear of missing out which leads to irrational investment choices which often end badly for those arriving late to the party.
But a bubble or two won’t be the primary cause of future financial pain. The real problems will start with a global pension crisis.
In previous decades, the defined benefit pension has been the norm for many employees. Put simply, you work for 20 years and then qualify for a portion of your salary for the rest of your life. Companies would set aside money to satisfy these future liabilities based on expected rates of investment return and life expectancy. The sums are done by highly qualified actuaries based on historic norms.
In some countries, these funds are required by law to invest a certain percentage of their assets in ‘risk free’ government bonds as a means of protecting the fund assets. This is where the problem begins.
As interest rates drop to record lows the return on government bonds gets smaller. Austria recently issued a 100 year bond paying a little over one per cent interest. In Europe, governments have even issued bonds that pay a negative interest rate – that’s right, you pay them for the privilege of buying their paper! In the United States 10 year treasuries yield a bit over two per cent versus the long term average of more than twice that.
Therein lies the problem for the trillions of dollars in defined benefit pension obligations around the world. These funds are deemed solvent based on the actuarial assumptions underpinning their ability to pay future liabilities. These assumptions are often built around historical investment returns in the region of seven-to-nine percent per annum.
Many of these funds are forced to buy government bonds with a dividend return far below those returns which immediately raises solvency questions. The simplistic response is to raise interest rates but this applies a different pressure to the economic system.
Firstly, if interest rates rise then the lower yielding bonds will actually lose market value which will prompt the pension balance sheets to be reduced. Higher rates would also imperil the business and consumer sector which are both hugely indebted and, in many cases, already struggling with repayments at lower rates.
It’s a classic catch 22. Higher rates will shatter the indebted global economy but keeping rates low will result in many of these massive pension schemes going broke. We’ve already seen cities like Detroit declare bankruptcy in part because of their pension obligations. Some huge United States Union funds have predicted they will only be solvent for another few years and have slashed promised benefits in the hope of delaying the inevitable.
Pension obligations have sent governments in the Eurozone to the brink of bankruptcy. They now threaten to do the same to corporate and industry defined benefit funds which will impact the lives and financial wellbeing of hundreds of millions of people across the globe.
As the world grabbles with sluggish growth and ever lower interest rates, the near boiling pot of pension obligations could be the catalyst for a new financial crisis the likes of which we have never seen before.
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