Low Rates
[T]he young adults of the 1980s paid the highest interest rates in history on their mortgages and car loans. Now, they are approaching retirement - indeed the oldest among them have already retired. And today’s ultra-low interest rates seem like a major betrayal. Where have the returns on their savings gone?
This is a bigger problem than it might seem. In the 1980s, companies started to replace defined-benefit pensions, which promised an income based on final salary, with defined-contribution pensions, where the returns on investment provide an income in retirement. By the mid-1990s, most defined-benefit schemes were closed to new entrants.
Replacing defined-benefit with defined-contribution didn’t seem that big a deal at the time. Some people even thought it was better. After all, with the rates prevailing at the time, you wouldn’t need a huge investment portfolio to generate quite a decent income in retirement. It never occurred to anyone that interest rates would fall.
And yet they were already falling. All three charts show that interest rates have fallen steadily since their 1980 peak. In fact John Williams’s chart shows that real interest rates have fallen rather less in the UK than elsewhere: but it is nominal interest rates that people understand. Now, people are not going to get anything like the returns on their pension investments that they expected. Nor on any other form of savings, either. If anything, private pensions and life insurance schemes look even worse than defined-contribution corporate schemes, and the interest rates on liquid savings such as ISAs are approaching zero.
Over at Bond Vigilantes, Jim Leaviss has an excellent explanation of the rise and fall of post-war interest rates. I have shamelessly borrowed his charts. This one wonderfully shows how the anomalously high interest rates of the 1980s and 90s were entirely due to the baby boom [..]
And here is Jim’s verbal explanation: “The relatively low supply of labour in the 1970s gave power to those of working age. Trade union membership peaked in the late 1970s (when 12 million people in the UK were members) and wage growth outstripped productivity growth and inflation. Government debt burdens grew, and interest rates and bond yields hit double digits. There were talks of ‘buyers’ strikes’ by institutional gilt investors in the UK.
But as the baby-boomers entered the workforce after school or college, there was a significant improvement in the demographic trends. From that low of 40% in 1975, by the end of the 1980s the ratio of workers to non-workers was back above 50%, peaking at over 60% by the end of the 20th century. The developed world had become a world with lots of workers, keeping inflation low (trade union membership shrank), producing tax revenue to reduce government borrowing (at times in the US there was even discussion about retiring the national debt), and investing in paper assets like government bonds to provide future incomes in retirement. Inflation collapsed (you could argue that central banks, despite becoming fierce inflation fighters over this period, starting with Paul Volker taking over at the US Federal Reserve in late 1979, should take little credit here; the demographics did the heavy lifting) and 10-year US Treasury bond yields halved from nearly 13% at the start of the 1980s to 6.5% by the end of the 1990s”.
Now the baby boomers are leaving the workforce, we should expect interest rates to rise. So perhaps the baby boomers were not unreasonable in expecting their investments of the 1980s and 90s to deliver a comfortable retirement. Something has gone badly wrong. But what?
Jim identifies five reasons why interest rates have failed to recover. To many people, they will be all too familiar.
Globalisation: offshoring of jobs to cheaper locations and competition from cheaper imports, putting downwards pressure on wages and prices. In the UK, this was compounded by immigration from the EU.
The Great Financial Crisis of 2008: deliberate cuts in interest rates, interventionist central banks preventing buyers’ strikes, financial repression and poor wage growth
Technology: progressive replacement of humans with robots causes wages and prices to fall
Longevity and under-saving: people are living longer, and as already mentioned, older workers have not saved enough, so they are staying in the workforce for longer
China’s influence on the US Treasury bond yield (which influences all other government bond yields)
As Jim says, “the simplicity of demographic models was attractive, but what worked in a closed economy failed in a connected world”.
For young people, today’s low interest rates mean that they have to save much more and take more investment risk to achieve the sort of income in retirement that the post-war generation had. But those who were young adults in the 1980s and 90s don’t have enough of their working lives left to build up the size of pension pot now needed to generate a comfortable retirement income. They are looking at a much less prosperous retirement than they expected.
I suspect that the bleaker future facing Britain’s older working-age people might help to explain why a high proportion of them self-identify as “have nots”, according to a recent survey by Britain Thinks (bottom LH quadrant):
This might go some way towards answering Rick’s question - “why are baby boomers so angry”?Younger boomers - those now aged 50-64 - have reason to be angry, as indeed do their 40-something brothers and sisters. Their wages have been stagnant for a decade, their occupational pensions are stuffed and their state pensions are receding into the distance. They are frightened of cuts to the healthcare they will need in retirement and worried that they may have to sell their houses to pay for their care. Many of them blame their precarious financial situation on globalisation, immigration and bankers. And if Jim is right, they have a point.
So they want to shut the doors, cut the trade ties, kill the parasite financial services industry and jail the bankers. Then they can have their high interest rates back. After all, they paid those rates on their mortgages. Now they expect to receive them on their savings. It’s only fair.
And they paid in for their pensions and their healthcare, too. So close the tax loopholes, make the rich pay their fair share and honour the pensions and universal healthcare promises of the past. It’s only fair.
There are an awful lot of the baby boomers, and they vote. What they regard as “fair” will dominate political debate for quite a while to come. Resurgent populism now woos the old, not the young.
This leaves me with two unanswered questions. Firstly, why did people fail to see that the high interest rates of the 1980s and 1990s were anomalous? And secondly, why do Williams and others think low interest rates are here to stay? After all, if people in the 1980s could erroneously believe that high interest rates would last forever, people in 2016 can equally wrongly think that low interest rates are here to stay.
Let’s hope the final analysis is right. What does that mean for the policy maker? Well, maybe not “going to the people” for every damn decision that needs to be made, holding steady, and doing their job. In Columbia areas effected with FARC terrorism voted for the FARC deal, the ones not effected did not (deal was rejected). Was it a good idea to ask the voters about this deal? Or about Brexit which the old voted for more than the young, but it is a question about the “future” which the old has little of?
It seems to me we either have full democracy where decisions are made by people who are closest to the issue, demographically, regionally. etc. OR we have the current elite driven system where rulers do what they sign up to do, and don’t bother people with unnecessary questions (unless it is something that concerns all). We can’t have a little of both. Especially using people as a rubberstamp for decisions, or arbitrator for internal party feuds is the shortest way to fail.