Let’s not play the interest rate game

In a March 28 interview, Finance Minister Arun Jaitley revealed his bias towards lowering interest rates. Reacting to the announcement about reduced interest rates for Post Office Savings Accounts and Public Provident Fund investments, Jaitley said, “Low interest rates in the long run will help everybody.”

Everybody? Wrong, Mr Jaitley, low interest rates only help borrowers. They destroy savers and the country’s iconic savings culture, short-circuiting economic growth as a result.

Messy situation In a perfect economy, the private market decides what the interest rate would be and removes the government from the equation. But in an imperfect world, where the government acts as judge, advocate and jury, things can get real messy.

First, as a monopoly that has the sole power to tax and spend, the government becomes not just any player but the big gorilla in the room. When the government runs deficits, it becomes a borrower like the rest of us. The size of its borrowings pales in comparison to every other player. For example, the deficit for the April-February 2015-16 period was a whopping ₹5.72 lakh crore!

The second reason that the government is all-powerful is that it has the power to print money and regulate how much of it to print. The Reserve Bank of India, as the arm of the government that decides monetary policy, controls the nation’s money supply. One should not have complaints about a central bank, however, especially if it is deemed independent from the government. A modern economy simply cannot function without an independent central bank.

But ever since the world adopted exchange rate mechanisms that are determined by fiat and not in relation to a fixed quantity such as gold, central banks have become powerful institutions enabling, and often partnering with, their governments to pick winners and losers in the battle for money. And nearly always, governments have ended up favouring borrowers over savers because governments are borrowers themselves. In effect, governments are in the weird position of acting as both player and umpire of a cricket match. It is just not a fair game.

When interest rates are low, the government has the ability to borrow and spend, providing services to citizens without requiring them to pay higher taxes.

On the other hand, when the central bank sets interest rates high relative to inflation, savers and retirees love it because they have extra cash to spend. The government sees little benefit from this latter scenario because it is not doing the spending, so it prefers the former scenario — that is, lower interest rates.

The Fed case There has been no better case study here than that of the US Federal Reserve Bank during the last eight years. Faced with the worst financial crisis since the Great Depression, the Fed began to print money out of thin air — a whopping $6 trillion — to prime the pump. Interest rates fell to zero and stayed there for seven years. The Fed hoped that companies and individuals would take advantage of free money, borrow and spend on new factories, housing, cars, vacations and goods. The idea was that this would jumpstart a sick economy and kick it into high gear.

The record, however, is mixed. US economic growth has been anaemic, averaging about 2 per cent. True, the government reports low unemployment numbers each month but nearly 40 per cent of the workforce has retired or stopped looking for work altogether. And millions of retirees, who depend upon interest earnings from their deposits, have been severely impoverished. The average five-year bank deposit pays a return of an after-tax, inflation-adjusted rate of 0.27 per cent. This means that a $10,000 deposit will yield a paltry $27 a year in interest, not sufficient money to pay for a restaurant meal. No wonder the average American’s anxiety levels are so high.

But the US government certainly benefited because it could refinance its existing debt at near-zero interest rates and continue to borrow and spend heavily. The total debt that the government owes now has ballooned out of control and is close to $19 trillion, nearly $10 trillion more than when President Obama took office.

The stock market has benefited tremendously as well. Investors are diverting every last savings dollar looking for any return larger than bonds, driving up stock prices higher and higher. On March 6, 2009, the Dow Jones average hit a low of 6,626. Today, it hovers around 17,685 giving Obama bragging rights that the private economy is doing well. A big reason for this meteoric rise, however, can be attributed to Fed policy.

In contrast, India’s record of economic accomplishment has been remarkable in part because we have always been a country of savers. Economic growth is being created from the ground up, not because of a burst of artificial adrenalin pumped in.

Saving grace The country’s conservative lending systems protected us from global financial crises. High interest rates have served as an automatic check and balance against risky investments by both people and companies. The jugaad innovation model is firmly entrenched and the country is poised to become the fastest growing nation in the G-20 because of high interest rates, not despite high interest rates.

There is an old American saying to not fix anything that is not broken. Jaitley should perhaps pay heed to this wisdom rather than that of the Fed’s.

The writer is managing director of Rao Advisors LLC

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