The Fallacy of Low Rates as Stimulus (Opinion)

The classic retirement advice is simple: Start saving early and pay yourself first every month.

Historically, a person starting with a salary of $40,000 and saving 15 percent of his income could easily accumulate $1.5 million during a 38-year work span if he received 5 percent annual raises and 10 percent investment returns. But under more realistic assumptions for today of 1.5 percent raises and 4 percent investment returns, the same worker may only accumulate $500,000.

Low interest or investment returns pose a double whammy for people participating in government or corporate defined benefit plans. As interest rates drop, the present value of the employer’s pension liability increases dramatically even when the same annual contribution is made. Consequently, many underfunded defined benefit plans are either scaling back promises or forcing employees into defined contribution plans.

Still, these cuts and conversions do not address the underlying problem. Employees will have a hard time growing a reasonable retirement fund at today’s interest rates, whether it is through a sponsored or an individual plan.

Effective individual retirement planning needs to be supported by sound economic policies. Our current national economic policies rely heavily on the ideas of John Maynard Keynes, who advocated stimulus during recessions through reductions in interest rates, decreased taxes and increases in government spending. These techniques were applied in the aftermath of the Great Depression, during the inflationary period of the 1970s and are being tried again today.

Increased government spending on unemployment benefits does help stabilize the economy. Spending on needed infrastructure such as roads and high-tech projects provides short-term employment while enhancing the efficiency of businesses over the long run.

In contrast, tax cuts and spending for projects without a long-term component have weak stimulus effects while increasing the federal deficit. Cutting interest rates is not always helpful, with effects that can be counterintuitive. Interest rates are commonly said to be composed of three parts: an inflation element, a risk component and a small real return. As the inflation rate falls sharply or even becomes negative, interest cuts are no longer a useful tool.

The Federal Reserve has taken the position that interest rates should be kept as low as possible to make it easier for businesses to justify borrowing money. My experience from the high inflation years of the late 1970s suggests this is not the whole story.

When I graduated from college in 1979, the inflation rate was 12 percent, certificate of deposit rates were 17 percent and loan rates were 22 percent. You might ask who in his right mind would take out a business loan at 22 percent interest? But lots of businesses were borrowing money at these rates. Because prices were rising, businesses felt they had to invest in new equipment right away to get ahead of price increases.

Today, we see the opposite effect. As the price of real estate drops, business owners tend to delay investment because prices may decline further.

No one wants to see the return of 12 percent inflation, but under current conditions, the logic of using low interest rates to stimulate the economy is backward. A gradual increase in interest rates could actually encourage businesses to invest in new projects before the interest rates increase further. With higher interest rates, there would be greater incentive for people to save and less need for pension sponsors to cut benefits.

Individuals should continue to consult investment professionals such as CPAs to better plan the best investment and tax strategy for current conditions. Yet savings alone will not be enough without sound economic and interest rate policies that allow reasonable investment returns.

In our media-driven world, office holders and political candidates say and to some extent do what they think the voters want. Apparently, they’re getting the message that the majority of us still believe in low interest rates to stimulate the economy. In today’s environment, workers not only need to save toward retirement, but also need to have enough media and political savvy to be proactive in starting new, outside-the-box conversations on economic policy when old ideas have run their course.

Louella Moore is a CPA and emeritus professor of accounting at Arkansas State University at Jonesboro. She is a member of the Arkansas Society of CPAs and the Amegsrican Institute of CPAs.