The down side of lower interest

Robert Kuttner

January 03, 1992|By Robert Kuttner

WILL the Fed's interest rate cut be enough to revive the economy? Don't bet the farm on it.

While rate cuts produce interest savings for some consumers, they take money out of the pockets of others. Tens of millions of retirees, with their savings in Treasury securities and bank certificates of deposit, see their income dwindle with every rate cut.

Moreover, banks hard hit by the loan losses of recent years are slow to pass the rate cuts along to the borrowing public. While the prime rate has come down in lock-step with Federal Reserve discount rate cuts, fixed mortgage rates are still above 8 percent. Last week, when the Fed dropped discount rate a full point, to 3.5 percent, mortgages dropped only about half a point. Interest rates on credit cards still average 18.8 percent.

Bankruptcies are projected to hit a record one million this year. Consumer interest rates stay far higher than they should in order to compensate bankers for the poorer average quality of consumer debt. In effect, you are paying more for your loan because some other loans don't get repaid at all.

Nor is it likely that lower interest rates will ease the credit crunch. Bankers still perceive a lack of creditworthy borrowers. And with the economy still mired in recession, businesses are not lined up to seek capital for expansion.

The most intriguing obstacle to cheap money producing a recovery is the connection between the large federal debt and foreign borrowing. For the first time in more than a decade, interest rates in the United States are now well below rates in Japan and Germany.

Throughout the '80s, Germans and Japanese were heavy purchasers of U.S. Treasury debt. In 1988 and 1989, Japanese investors alone bought about $70 billion of Treasury debt yearly. In large part, they were willing to invest in Treasury securities because of the relatively high U.S. interest rates. It was widely assumed that U.S. interest rates would have to stay high to keep attracting that foreign capital.

During the period after the September 1985 Plaza Accord, which established a system for coordination of exchange rates among major currencies, the United States, Germany and Japan

carefully coordinated interest rate cuts, so that U.S. interest rates would remain high enough to attract foreign capital but not so high that the dollar would be overvalued.

In the past year, however, this approach has collapsed. Today, ++ there is no coordination of interest rate policy, and national monetary policies are going in opposite directions. Washington, worried about recession, is doing everything possible to drive rates down. Bonn and Tokyo, concerned about inflation, are driving rates up.

Short-term rates on German marks and U.S. dollars were about equal as late as mid-1990. Today, three-month rates on dollars in the London market are about 4 percent; on German marks they are about 9 percent. Japan has the world's lowest inflation rate, yet Japanese interest rates are now higher than dollar interest rates, too.

If the dollar is falling in value, and U.S. interest rates are at a 15-year low, how can we keep attracting that foreign investment to finance our public debt? The answer, of course, is that we can't.

Foreign purchases of Treasury debt have dwindled to a trickle. In 1990, there was actually a net outflow of Japanese purchases of Treasury securities.

But the federal deficit was $268 billion last fiscal year, and it is projected to exceed $350 billion this year. Somebody has to finance it. So who is buying all that government debt?

American commercial banks, that's who. As banks have become more and more nervous about ordinary lending, Treasury debt has looked like a better and better investment. Banks now hold about $500 billion worth of Treasury debt, according to the Federal Reserve Board, up more than 10 percent since last year.

The bankers' impulse to put their assets into safe Treasury paper has been reinforced by a little-known 1988 agreement called the Basel Accords, which seeks to harmonize international rules for bank capital. Under the Basel Accords, banks must hold capital equal to 7.25 percent of assets.

However, the capital requirement is waived on assets held in government securities. That operates as a potent incentive for banks to invest in Treasury debt rather than in commercial loans.

Thanks to the changes in the international financial climate, which no longer provides significant foreign funding of the government debt, that debt is now creating a classic form of "crowding out." With bankers nervous and private borrowers hesitant and unreliable, Treasury borrowing displaces private borrowing.

This is one more way in which the legacy of the 1980s borrowing spree precludes an easy solution to the recession. We can either have high interest rates and attract foreign capital -- or have low interest rates and watch while government borrowing crowds out borrowing to finance investment.

By all means the Federal Reserve should continue to ease money. But the effect will be modest at best.

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Robert Kuttner writes regularly on economic matters. 1/2

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