investment and low interest

[morganist]

investment and low interest is something i find difficult to swallow. i understand investment rises with low interest rates as the cost to borrow is low. however is this false investment. when the interest rate rises again unless the debt has been paid off the gains seen from the low rate are negatives caused by the higher rate. surely the more sensible position would be to pay off debt when the interest rate is low.

it also concerns me that the increase in the demand the lower rates creates could counteract itself when the market adjusts and the extra demand impacts on the price of goods in short inflation could hit although delayed.

could it be said this principle is a false premise. although there is investment any gain it creates is quickly taken away so is the investment real or simply for show. also does the investment go to where it is needed. when the interest rate is low banks do not lend money out as easily like at the moment so does it have a real impact on businesses that need the money.

there are other consequences of low rate of interest due to the lack of income it provides savers like pensioners. what do you think is this a position of a bygone economic age or do you still think it has its place in modern economics. or is the fact that this position is not occurring the textbook expectation evidence the old economic way of thinking is not dealing with the modern world.

 

[splinter7]

If interest rates are low, take 30 year treasuries for a nearly riskless example of a long lived asset , investors who need to maintain earnings must seek more risky long term ventures to get the desired nominal returns. These investments could be in private, small business or anything else as these investments would only need to provide small returns relative to what they would be required in an enironment where the long lived low/no risk treasuries had a higher rate of return.


Opportunity Cost

So, projects that do not have much growth/return potencial to get looked at more frequently in the low rate environment. I think the idea is that smaller projects that do not benefit from economies of scale would be more viable than at any other time as long as the evironment that produced the low rates did not impact the potencial of the projects too much.

Hope that makes some sense

 

[morganist]

Quote from splinter7:

If interest rates are low, take 30 year treasuries for a nearly riskless example of a long lived asset , investors who need to maintain earnings must seek more risky long term ventures to get the desired nominal returns. These investments could be in private, small business or anything else as these investments would only need to provide small returns relative to what they would be required in an enironment where the long lived low/no risk treasuries had a higher rate of return.


Opportunity Cost

So, projects that do not have much growth/return potencial to get looked at more frequently in the low rate environment. I think the idea is that smaller projects that do not benefit from economies of scale would be more viable than at any other time as long as the evironment that produced the low rates did not impact the potencial of the projects too much.

Hope that makes some sense

i still don't agree with that. i think part of the problem with the amount of debt is due to low interest rates. the market is saturated so it is difficult to sell it. this is part of the culture we have the concept that it continues to grow but it has its limits.

there has to be real investment other than credit. it cannot solve the problem of a saturated debt market by enabling more debt. the interest rate will have to rise and when it does the businesses that benefited will lose.

it is negative in other ways. low rates mean low returns so pensioner poverty among other things.

 

[splinter7]

rebuttle.

1.that investors would not want to invest when the returns/interest is low...but what else can they do, lose ground to the average market while they hold cash. They must be invested somewhere. In real terms the market rate of interest is not important unless it does not match the rate of change for CPI. if better rates come along after investing they can sell the investment and move to the higher return one. Plus all the businesses/people that take loans when the rate is low benefit as the rate increases in the future as they were able to secure cheaper capital when other are later are paying loads for it.

2.Debt saturation... I am not sure I belive in debt saturation, but I will entertain it. What happens when a country goes into too much debt and defaults...World Bank or IMF bails them out in the form of more debt/loans. Since personal debt is not passed to the next generation I only see debt saturation when a person does not have enough life left to pay back the debt. For a business or country well they have eternity to pay back.

3. High debt is due to low interest rates... I don't think i understand this. The market rate was high in 2006/07, people took on much debt in every form possible. It could be the other way around low interest rates are due to unsustainable debt which results deflation.

4. There has to be real investment other than credit... but that is exactly what credit is, its an investment or an investment is a form of credit. When you want to start a project you either make a loan ot yourself or sell a bond to an investor to pay him back later at some rate. He has extended credit to you or your project. That is why when people use cridit to buy things that are not investments they are subject to incredible rates of interest since the risk of default would be much higher.

5. Pensioner/ Fixed income. Not relavent to the topic, unless that is your real point. If you don't actually work for your money you can only expect what the market will provide. Its a risk and a trade off.

If I am misunderstanding one of your points please expound on it.

 

[FCCT]

The govt doesnt not create the interest rates. It does not matter what their target goal is, the free market always determines the rate.

We are entering a phase where banks will be bombardied with low credit but wont have anyone credit worthy to lend to. Notice how long term mortgage rates arent going down.

About the value of investments. A textbook answer would be as interest rates lower the value of the firm increases. This is because a company's value is derived by discounting future cash flows at X rate(risk free rate plus risk premium rate). The reality is the opposite due to the boom/bust cycles we are prone too. During the boom from 03-07 all rates were rising and so were asset prices.

 

[splinter7]

FCCT,

THe government has a great impact on the interest rate. They use monetary and fiscal tools to affect it though the Fed and congress. They can also use influxes of funds to free up capital. Yah, they don't say "this is the new rate", but they do control much of it.

I have wondered what happens when the credit rating system fails us in that all/many people have been assessed as a credit risk on a personal level as result of default. If you haven't screwed up your life this way, no worries, banks will still lend. People will still lend and so on. Its been that as far back as man knows. If it does come to this, the credit rating system will be redefined to meet the needs of the lenders and consumers.
The only way I can think of to make true what you said is that Gov would have to raise taxes enough to erode capital or transfer it to the Gov and the Gov would then have to stop lending.

Credit is not the problem. As long as there are rich people that don't want to work, there will be credit/loans at some price.

Regarding the statement about value of investments and company value. When there are low interest rates there could also be low commodity prices (just like now), which crowds out the effect of a lower discount rate. Hopefully your text book doesn't say what you said it says. It should say all other things equal or ceterus paribus just after that statement. If it doesn't throw it away.

 

[morganist]

hi splinter 7 you have given some good answers. i am still not sure if i agree with you on them. my real point is is interest rate useful at all. why do they have to use interest rates to control aggregate demand why not look at another way of controlling it that does not have an impact on the rest of the economy. regardless of the consequences of interest rate position it does have consequences why not look at mechanisms that do not. why even use interest as a mechanism for incentive for investment there are other ways i myself have devised a incentive called feps. it does not have negatives.

in response to your first post. i found difficulty with your position that if the interest rate increases the company is not stuck with it. the investor can invest in something else but why, they would receive more money then. the company or business would only be able to get rid of the debt if they bought it off which is more expensive or if they went insolvent a bad situation to be in. the low interest rate will create a dependency on cheap debt and when it stops businesses will not be able to function like they did before if at all. it sets it up for future problems especially if the business expects continuation of low rates.

i guess part of what i am saying is is this assumption just an assumption because of the paradigm we are in. another part of that paradigm might be that we have to produce as much as we can. the debt makes people insecure and have to work so it creates more but is that good. another paradigm is we should conserve resources in that paradigm credit is not beneficial. although i still disagree with even in this paradigm the low interest rate will in my opinion have negative affects on investment and society in the long run.

thank you for your reply.

 

[morganist]

i forgot in your response related to pension income. the fact of the matter is pensioners need a income in the free market that is from the return from their savings. in a command economy it is from the state. either way it is a social security mechanism as much as a fuel for economic growth. pensioners need a certain standard of living a minimum to live and if they do not get it from the investment return the state will have to pay or there will be a humanitarian crisis.

what it means is that social security system of the free market is failing. it is not a luxury it is the equivalent to the state paying. i am not socialist before you say that what i am saying is using the interest rate to control aggregate demand and investment and saving return is going to have an impact on the needs of the economy. by setting a low interest rate whether to increase investment (assuming it does) or to control aggregate demand means the business sector is gaining priority over the needs of society. i understand that business is needed to provide that return but does it have to be at the expense of pensioners or savers.

the whole point of economics is to meet the needs of the people. to distribute the resources to feed and cloth people the fact that this model puts enormous amounts of people into poverty proves that it is failing and cannot meet what is required by society. this is the way it is because of the economic and social paradigm that has been set that business comes first, and production is increased and credit is low. but what quality of life.

i hope you understand what i am really trying to say.

 

[piezoe]

In an inflationary environment the idea is to borrow at the longest term possible at very low fixed rates. The mortgage and the corporate bond markets are used for this purpose.

Long term US treasuries while having virtually zero risk of default, have high risk of inflation. For that reason, they are not nearly so riskless as is supposed. They will have a negative return in constant dollars if held to maturity in a highly inflationary environment. This is the equivalent of paying the government to use your money. Not a very attractive proposition.

TIPS do not protect against inflation very effectively, because the formula used to compute the inflation rate underestimates the real rate by a significant amount.

 

[morganist]

Quote from piezoe:

In an inflationary environment the idea is to borrow at the longest term possible at very low fixed rates. The mortgage and the corporate bond markets are used for this purpose.

Long term US treasuries while having virtually zero risk of default, have high risk of inflation. For that reason, they are not nearly so riskless as is supposed. They will have a negative return in constant dollars if held to maturity in a highly inflationary environment. This is the equivalent of paying the government to use your money. Not a very attractive proposition.

TIPS do not protect against inflation very effectively, because the formula used to compute the inflation rate underestimates the real rate by a significant amount.

good post. do you agree that low interest is not a good thing then.