Low Interest Rates Forever?

This article in the NYT is the sort of thing that I normally blow right past but, maybe because it’s a slow Saturday morning, I took a moment to glance through it. It about how to modify the “cash for clunkers” legislation to conform to the author’s vision of a just society. 

I’m not particularly interested in debating her position as I’m pretty sure we would never cross the chasm that separates us but the central point of her proposal did spark some thoughts that I want to pursue for a second. Here is what she has in mind:

The barrier for most consumers is credit, which has become expensive and elusive as subprime lenders have gone out of business, and as the average consumer credit score has been downgraded from prime to risky. Consumers are so fearful of being rejected for a car loan that CNW estimates that 800,000 eligible auto buyers didn’t even bother to apply in the first three months of this year.

Congress could address the credit problem by creating a federal loan guarantee program for autos, much like the ones we have for homes and businesses. The $4.5 billion destined for the clunker credit could be used to provide loans at very low interest, leveraging taxpayer money to create as much as $90 billion in credit — enough to provide $15,000 loans to six million households. That’d be an enormous stimulus for the economy.

The program could be administered by commercial banks, credit unions and auto lenders like G.M.A.C., but the loans would be guaranteed by the government, much as Federal Housing Administration and Small Business Administration loans are. Of course, to prevent fraud, the government would need to set strict guidelines for borrowers, auto dealers and lenders. It should also require that the loans be used to buy cars that get at least 32 m.p.g. To push innovation, this fuel economy threshold should increase each year.

Nationally, exchanging vehicles that get 20 m.p.g. for those getting 32 m.p.g. would reduce annual household gasoline consumption by more than a third — conservatively about 225 gallons. Multiplied by six million cars, that’d be a total savings of 1.35 billion gallons of gas a year, or about 1 percent of total American consumption — as well as a significant reduction in carbon emissions. It would send a strong signal to the oil markets that the United States finally intends to do something about gasoline demand.

And it would save families money. A household with a guaranteed loan for a new 32-m.p.g. car at a 3 percent annual interest rate would pay about $1,800 a year less on financing and gasoline (at the current price of $2.24 a gallon) than one that had a subprime loan at, say, 18 percent interest on a car of average fuel economy.

With such a loan program, Congress could demonstrate that it’s serious about reducing oil consumption, make the car industry more competitive and insulate American workers against the higher gas prices that will inevitably return.

Don’t worry I’m not going to go into a rant about the government encroaching on the private sector or the folly of thinking that the fraud that would accompany this program could be controlled but I do want to reflect on one thing — low interest rates.

Notice that the author’s plan revolves around loans at an interest rate of 3%. I don’t know what the logic behind that rate might be but it sounds good when mortgage rates are below 5%, Congress wants to cap credit card rates at 15% or less, the Fed is pumping out money to securitizers through TALF at a couple percent and banks borrow from each other at virtually no cost. Free money for all.

The problem is that consumers are becoming hooked on the idea that the cost of money should be negligible. As the government has manipulated interest rates down to zero an entitlement mentality is taking shape that assumes borrowed money naturally comes with practically no cost. Uninformed as to how credit market operate, they are going to be intolerant of a return to anything resembling a normal interest rate regime.

As interest rates inevitably do start to increase — perhaps quickly if the Fed is forced to move them due to external events — the political class is going to have one of two options. Withdraw support from the credit markets and permit rates to rise as they naturally should or continue and in fact increase the subsidization of interest rates.

Since we’ve never before been in an economy in which the government has so delved so deeply into the credit markets in order to reduce consumer interest rates, it remains to be seen what the response might be. Normally, you would expect that government would fade out of the picture but this might be harder to do than it would appear for a couple of reasons.

First, entitlement mentalities couple nicely with populist politics and that we have in plenty right now. Low interest rates might well become just another variation of pork and earmarks. Delivering cheap money to favored constituencies may be just another tool in the politicians’ bag of tricks.

Second and probably of more concern is the fact that consumers have gotten pretty savvy at figuring out the system. When the car companies started offering 0% downpayment loans, cars flew off the shelves. As soon as the spigot was turned off, the cars started gathering dust on the lots. Car buyers gambled that the manufacturers would blink before they did and they were right. Eventually, the auto companies caved in brought back the incentive plans and that’s pretty much how you have to sell a car now. 

Take away the low interest rates and the consumer might just go on strike. No low mortgage rates, well we’ll just rent for awhile until you come to your senses. High installment loan rates, fine I’ll stick with the old flat screen. A couple of months of that in the middle of a recovery and you can count on the special interests climbing all over the backs of their bought and paid for legislators.

At some time in the near future we’ll probably know the answer to the question of whether interest rates are going to be allowed to function normally. I suspect or at least hope that the Fed has held onto enough independence to begin raising rates when circumstances warrant. The ball will then be in the political court and we’ll have to see if they have the spine to take on the American consumer.

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