Tan Kin Lian's Blog: Low interest rate

Sunday, November 15, 2009

Low interest rate - the underlying cause

Why is interest rate so low? The simple answer is there is a big supply of money and insufficient demand for money. What cause this imbalance?

The low demand for money is caused by low consumption. The low consumption is caused by low wages and high unemployment, which has affected a large part of the population, and brought out a large disparity in income distribution in recent decades. The lower and middle class people have to work harder to earn enough to survive. They have fewer children, which also contributed to the drop in demand over the years.

The supply of money has also been increased by governments through their monetary policy and recently, through stimulus spending. With so much money in the economy and little demand, interest rate is likely to remain low for a long time.

This is bad news to retirees who have to depend on their investment income to live on. With low income from their savings, they have to spend their capital sum, which will deplete over the years.

What can retirees do? They have to invest in equities to earn a higher return. Although equities have a higher level of risk, it can be mitigated by investing in a low cost fund, such as an exchange traded fund. The return on equities is likely to be around 5% to 7%, which is much better than 2% on government bonds.

In the past two decades, there was demand for money but they were used to create asset bubbles, especially in housing. This helped to boost the world economy for some time. The recent collapse of the asset bubbles brought about the economic downturn. However, the asset bubble is being revived, but this is not a long term solution.

In my view, the solution is to generate demand by giving people a chance to work and enjoy fair wages, so that they can feel secure about their future, raise a family and spend time on leisure. With a sound economy, there will be a demand for money which will give a fair return on their savings.

Tan Kin Lian

9 comments:

Anonymous said...: Another very obvious solution:

Reduce the overflowing glut of money supply. There is extremely too much out there now that even if you remove the froth, the interest rate will still remain low.

Current HDB prices is evidence of this glut.

I really dun want my local coffee-shop kopi to cost $5 per cup anytime soon.; November 15, 2009 10:26 AM
Anonymous said...: REX comments

In the last year or 2, foreigners increased our population by 30% or something like that. The foreigners who settle down, they also have kids and they have demands for TV, fridge, consumer goods etc. and in theory demand would already increase because of the influx of foreingers on permanent basis.

Wouldn't this be same as your solution of stimulating the economy and generating demand? Why isn't there an improvement in the interest rate now that the demand should be increasing?

Or is the interest rate fixed by the greedy rich banks who make too much money and yet are very stingy and keep the money for their CEOs and just like to give low interests to the common man in the street?

REX; November 15, 2009 11:01 AM
Anonymous said...: My view:

The interest rate is low because Fed is targeting interest rate to combat deflationary pressures, so other countries have to adjust its interest rate in response to Fed's policy.

Unlike 2001 recession when low interst rate helped to turn the US economy around, this time it is different as we are seeing a severe drop in consumption due to high unemployment and also deleveraging of corporations and individuals to clear their debts.

However, with so much liquidity pumping into the world economy, expect a bubble to be formed. This time around, since it is like a global govt effort, the bubble has to be deflated MANUALLY (unlike previously bust due to market forces) once there are warning signs of irrational exuberance.

The questions are: how do you identify irrational exuberance, secondly, can the various govts really work together (as it is now, some countries raise rates whilst others stay put), and finally will this be a hard or soft landing, since this is the first time a global govt effort in meddling with free market which is really unprecedented.; November 15, 2009 9:46 PM
wjsim said...: Hi Rex, I believe governments are generally trying to stimulate demand for present consumption through low interest rates. So I don't think it's the other way round as you've described.

I'm quite confused. "The low demand for money is caused by low consumption." Low consumption means high demand for money, no?

I believe when Mr Tan said "demand for money", he's referring to "demand for consumption". Demand for money would mean people are hoarding and saving? It would not really lead to asset prices if people had demand for money.; November 15, 2009 10:58 PM
Y said...: wjsim, low consumption -> low level of transaction -> low demand for money. There's no confusion. Liquidity preference is another way to think demand for money (Md), transaction is 1 of the motives given by Keynes. Anyway even b4 Keynes, the quantity theory of money has Md proportionate to the level of transaction (or nominal income).; November 16, 2009 2:26 AM
Anonymous said...: rex comments again
hello wjsim,
We seem to have two theories, the original theory of mr tan that low conusmption causes low interest rate, and your theory that low interest rate are the government's doing to stimulate demand. These two are really profound ideas and i suppose an economist could write a book on either case....

For simple minded people like me, i stick to my theory - low interest rates on deposits are the result of the greedy banks. They could well afford to give more but they just don;t like to do it! I remember receiving letters from my bank at least twice in the last 6 years, telling me that my housing loan interest rate has gone up due to blah blah . WHY the banks still did not adjust my housing loan rate downwards when F.D. rates has gone done to 1% and savings rates to 0.125% ? Alternatively since the market is presumably better, why are the deposit rates still low? So all these Keynesian mumbo jumbo are rubbish. Main reason for the low interest rates - the banks are not willing to pass down some of the rewards to ordinary people in spite of the fact that they could well afford to do so.

REX; November 16, 2009 8:19 AM
YZ said...: Rex, the 2 theories u mentioned are in fact 1, not mutually exclusive. The 1st on money demand side, the latter on money supply. Both work towards low interest rate. Both are explained by Mr Tan in 2nd & 3rd paragraphs respectively.; November 16, 2009 1:53 PM
wjsim said...: Hi Y, thanks for the clarification. I would think high demand for money is a preference to delay consumption, which is opposite of what it meant in the post.

Hi Rex, I think the ideas are similar. It's just low consumption prompting governments to stimulate it by further lowering it. You're right though about Keynesian being rubbish :) It's a political tool for governments to rationalise irrational spending.; November 16, 2009 1:54 PM
Anonymous said...: Ask the elite at MAS what they want to do to reduce money supply. It's their job for drawing super high salary.
In this country, when things are good, it's the gahment's credit. When economy crash, it's because of external factors. Try this explanation in another country and see if you get throw out of office. We need more and stronger opposition to balance this, not more NMP or puppets.; November 21, 2009 7:59 PM