Interest rates have been falling for over three decades. Conventional economics has two things to say about this. One, inflation expectations are falling. Monetarists believe that the interest rate is set based on bond traders’ predictions of future price increases. Two, if employment and GDP are weak, then the central bank should increase the money supply. By increasing the money supply, it will cause rising prices, and somehow that causes workers to get hired. Federal Reserve Chair Janet Yellen wrote a paper defending this absurd claim (which I criticized).
Monetary policy is actually putting the hurt on labor. Let’s look at why.
Workers are employed by businesses, so we must look at the incentives that push on businesses. Businesses constantly face a choice among several alternatives. They choose based on the desire to make profit and avoid losses. Monetary policy affects their decisions, because it distorts the profitability of every path.
Consider one common tradeoff: hiring labor versus buying expensive tools. Management decides based on which costs less. The more expensive a tool, the more attractive it becomes to hire workers and vice versa. Since most companies borrow when they buy tools, the most immediate cost of a tool is the monthly payment. When the rate of interest falls, the monthly payment falls as well. This puts downward pressure on employment and wages (I wrote about this here).
A falling interest rate impacts the wage by a subtler, but more powerful process. In a recent article, Professor Antal Fekete describes it:
“First we dwell a little longer on the problem of the present value of a cash flow (defined as the sum of individual payments discounted at the prevailing rate of interest, each for the period of time between now and when it becomes payable in the future.) Since the rate of interest is being cut, discount at a lower rate is involved. Therefore the present value of the cash flow is increased…
What does this mean for the terms of trade of those who need a cash flow for survival, such as all pensioners and all wage earners? Well, the price they have to pay for the cash flow is just its present value. Any cut in the rate of interest by the central bank affects them adversely. Their terms of trade deteriorates. For example, if the rate of interest is cut in half, then they have to pay twice as much for the same cash flow as before the cut. In practical terms this means that wage earners have to work roughly twice as hard to continue earning wages at the same level…”
Let’s take a step back and cover some essential background material and then we’ll get back to this point. One differentiator of Fekete’s economics is in his concept of the loan. Others think of it as an exchange of present goods for future goods, but he had an insight. The essential characteristic of a loan is that it involves an exchange of wealth and income. Fekete describes one party, often a retiree, as having cash but not income. The other party, typically an entrepreneur, has income but not cash. The deal benefits both.
The retiree needs the income to buy groceries, without consuming his life’s savings. Earning interest provides him an income for the rest of his life, without fear of outliving his savings. The entrepreneur wants to build a business without having to waste years saving up for the investment. Borrowed capital enables him to quickly build productive capacity. This new production will increase his income.
We can think of the loan as the purchase of an income stream. Cash up front is traded for an income paid over time. By definition, and by nature, the amount of cash paid is equal to the value of the stream of payments to be made in the future. The value of this series of future payment is not simply the arithmetic sum. It is the sum of the present values of those payments.
Let’s look at the concept of the present value of a future payment. Suppose someone will pay $500 one year from today. Do you value it at $500 right now? No, a future payment is always discounted, to compensate for locking up the cash for a year, and of course the risk of nonpayment. We need a way of determining how much $500 in one year is worth today. To calculate the discount, we use the prevailing interest rate. If the interest rate is 10%, then this $500 payment is discounted by $50. It is worth $450 today.
The value of a future payment rises if the interest rate falls. For example, if the interest rate falls 5%, then the discount is only $25. That makes the payment worth $475 today. If this is not clear, then it may help to think through a few examples. Consider payments due years in the future. This idea—that present value varies inversely with interest—is a key principle.
Changes in the value of a loan are zero sum. If the rate of interest falls, then the lender gains at the expense of the borrower. This conclusion is counterintuitive and thus controversial, but it should not be. The income stream is worth more. This is the loss suffered by the borrower, and the gain enjoyed by the lender.
For example, here is a 5-year loan at 10% interest. If payments are made annually, then each is $263.80.
| Year | 1 | 2 | 3 | 4 | 5 |
| Start Balance | $1,000.00 | $836.20 | $656.02 | $457.82 | $239.80 |
| Interest | $100.00 | $83.62 | $65.60 | $45.78 | $23.98 |
The straight arithmetic sum of five $253.80 payments is $1,319. However the present value of the loan is less than that, because each future payment must be discounted. Here’s what that looks like.
| Year | 1 | 2 | 3 | 4 | 5 | Total |
| Payment | $263.80 | $263.80 | $263.80 | $263.80 | $263.80 | $1,319 |
| Present Value | $239.82 | $218.02 | $198.20 | $180.18 | $163.80 | $1,000 |
The present value of the income stream works out to be exactly the amount of the loan. The first table shows the loan amortization, with an annual $263.80 payment covering current interest plus fully amortization. The second table shows the discounting of each payment. This is an elegant validation of the theory.
Now, let’s look at what happens if the prevailing interest rate drops to 5%. The loan payments don’t change. However, the present value of those payments does.
| Year | 1 | 2 | 3 | 4 | 5 | Total |
| Payment | $263.80 | $263.80 | $263.80 | $263.80 | $263.80 | $1,319 |
| Present Value | $251.24 | $239.27 | $227.88 | $217.03 | $206.69 | $1,142 |
Discounted at only 5%, the same payments have a higher net present value—14.2% higher.
A loan with a longer term is more sensitive to changes in interest rate. The present value of a 10-year loan, for example, increases by 25.6% with the same change in interest rate.
The great economist Ludwig von Mises was aware of the impact of interest on long duration loans. He looked at the combination of two extremes, zero interest and a perpetual income stream. He wrote:
“If the future services which a piece of land can render were to be valued in the same way in which its present services are valued, no finite price would be high enough to impel its owner to sell it. Land could neither be bought nor sold against definite amounts of money…”
In other words, at zero interest the present value of land is infinite (as land produces income in perpetuity). For a perpetual income, each halving of the interest rate doubles the present value.
Accounting shines a spotlight on this phenomenon. However, it’s no moot abstraction. The loss to the borrower is real. No one would argue that the capital gain of a bondholder is somehow unreal. They should not argue against the loss of the bond issuer. It is the loss of the latter which provides the gains of the former.
Proper accounting should always match reality. So what, in reality, is going on?
Another way of thinking of the present value is the burden of debt. The more the rate falls, the more the debt load bears down on the borrower. The present value of an income stream is what any investor would pay to buy it. It is also what the debtor must pay to liquidate it.
Sometimes the best return for the owners is to sell the firm. However, that often requires paying off the debt. If that’s impossible, then the best option is off the table. The inability to liquidate debt causes many problems. So long as an enterprise has a dollar of debt, it’s an overhang. The lower the interest rate falls, the larger the overhang grows.
Let’s tie this all back to the worker. We can now see the connection between the wage and the loan. Both are an income stream, a set of payments to be made in the future. As with the loan, the present value of wages rises when interest falls. The employer is doubly squeezed, once by the increasing burden of debt, and twice when burden of wages increases too.
Something has to give. Either the worker must work harder, or else the employer must cut his pay. It’s a simple matter of survival for the employer. No firm can remain in business for long, if it allows liabilities to rise unchecked.
If productivity cannot be increased, and wages cannot be decreased, then the business must cut costs elsewhere. Often this amounts to substituting one form of capital loss for another, such as neglecting maintenance or research.
Now we’re ready to revisit the tradeoff of labor and capital, and tie our thesis together. The wages of labor are a series of future payments, but the price of a machine is paid up front. As the interest rate falls, the present value of both rises. That is, the present value of wages rises and the present value of the machine rises also.
When interest falls, wages subtract from the enterprise value and machines add to it. How perverse is that? How would you respond, if you were managing a business?
The central banks may say that increasing the money supply causes rising wages and increased employment. However, they increase money supply via bond purchases. This pushes bond prices up, which is the same think as pushing the interest rate down. It causes irreparable harm to employers, and consequently, to workers.
Keith, how did you get 239.82 from 263.8? I’m not clear on the calculation of the discount.
in my business wages are paid by current income. If I borrowed cash to fund wages on an overdraft then if interest rates are cut, then so are borrowing costs? i dont understand how wages are an income stream from a previous/ current loan am i missing something?
263.80 divided by 1.1 (110%) = 239.82
Put differently
263.80 times 0.909090909 (100/110) = 239.82
The next year the discount compounds, so 100/110 * 100 /110 = 0.82644 * 263.80 = 218.02
Keith, your article gives me the opportunity to ask the following:
What happens in case of NEGATIVE rate of interest?
At zero, present value goes to infinity. What is there beyond infinity?
What are the consequences for a country with negative interest?
Thank you for your well documented missives.
panos: Good question!
Clearly, there is no such thing as something greater than infinity. I still have to think about it more, but my first thought is that shorter-duration liabilities are not infinite and the present value can and does rise.
Sure there is!! Remember Buzz Lightyear -“To Infinity and BEYOND!”
I just did not realize that Mr Lightyear was talking about how much currency it would take to trade for actual money when the currency core melted down.
Great job, Keith. I’m loving this stuff.
We need to add a “like” button! :)
The negative interest rate is a farce as human nature is not disposed to accept deteriorating conditions on a long-term basis. By example a negative income stream discounted by a negative interest rate produces a positive valuation which is not a truth. The negative rate should be considered an additional cost of doing business within a certain system.
Yes. This is true! Indeed it is the reason debtors who believe they can hoard the value they’ve borrowed enjoy lower and lower (even negative) interest rates. at a -10% interest rate, say I borrow $100; in a year in a year I will pay you back with $90 (your deposit with me “earned” -10%). If I’ve stuffed the dollars in a mattress I have $10 in hand as my profit for investing your money safely for 1 year.
The mind reels at this not due to any discontinuities in the arithmetic, but because of the perverse kinds of human action negative interest rates incentivize.
If you mean “has a positive present value“, then: No. The sign on the interest rate does not combine multiplicatively. A -10% interest rate is calculated by a +0.90 multiplication factor. This does not change the sign of a negative present value to a positive one. If I will quite certainly rob you of $90 next year, at a -10% interest rate, my theft impairs $100 of your present net worth.
Negative rates of risk-free return incentivize hoarding of money. Ultimately that is bound to collapse the circulation of the currency in question. For such currencies the exchange of wealth for income has been reduced to hoarding and dishoarding, i.e. there is no longer an efficient indirect exchange possible.
It makes sense that, long-term, real wages would fall alongside interest rates – that is, alongside the declining return on real capital. But, I think, for different reasons than the ones given by this article.
Real income comes from productivity under the Division of Labor. That is, real income comes from the *efficient* (or high-quality) use of capital and specialized labor, together.
If the rate of return on capital is suppressed over time (financial repression), then there is less incentive to use capital efficiently. There is greater malinvestment and/or consumption of capital. The productive *quality* of capital degrades. I think we can observe this in the world around us, today.
As for the reasons put forth in this article:
– “When the rate of interest falls, the monthly payment [on tools] falls as well. This puts downward pressure on employment and wages” – I am not sure we’re seeing that, in the world around us. The suggestion is that, as interest rates are suppressed, laborers suffer from the greater substitution of capital. But elementary theory suggests that laborers should *benefit* from greater substitution of capital, as real productivity rises and new jobs/industries are created. (Unless quality of capital is indeed an issue, as I have suggested; that is, unless the so-called “capital” being substituted for labor is, in fact, low-quality or merely a mask for consumption.) Also, higher capital substitution should imply higher investment spending. Have we seen higher investment spending, as real wages have declined these last few decades? I think not, in the U.S. While China has indeed had higher investment spending – alongside growing real wages.
– Prof. Fekete’s theories: Probably too long for a quick comment here, but I’m not 100% convinced by his theories. For one thing, his point about declining interest rates burdening the borrower seems to ignore the borrower’s typical behavior of re-financing, to gain lower payments. Re-financing means early loan repayment and that is when the lender/saver loses in real terms, because his future income stream is lowered.
– “As the interest rate falls, the present value of…wages rises.” If that’s true, the real purchasing power of nominal wages should rise, under a regime of financial repression (fiat currency, QE). We have seen the opposite: Under the fiat/QE regime, asset prices are bid sky-high which transfers real purchasing power transfers from wages to the owners of assets.
When interest rate falls, jobs may be created, but only in a society which is predisposed to using capital towards productive ends.
Were the interest rate 10%, and if I wished to build a factory to make refrigerators, I would have to closely scrutinize my business plan and ensure that my return could support the interest payments (and make a profit). A decline in the interest rate would likely increase the probability that I could make this business work, so it would seem likely that more businesses would start.
If interest rates are very low–and if there are implicit guarantees that they will remain so, then I may find incentives to forget the refrigerator business, and just borrow a lot of money and gamble it on the derivatives market, or enter the exciting world of high-frequency trading. If I win, I win big; if I lose, I just borrow twice as much and try again. With a near-zero interest rate, I can cover the debt until I win.
The current low-interest-rate environment has directed all the creativity and ingenuity that used to go into making refrigerators and calculators and has directed towards financial speculation. Whereas every new refrigerator made can be argued to enrich society, profits from financial speculation only enrich the speculators. No jobs are created at the main street level. Lowering interest rates further in this environment merely encourages more speculation, not the creation of real businesses.
What we are observing is the equivalent of a state change in a complex system, examples of which are discussed here: http://www.worldcomplex.blogspot.ca/2012/06/origins-of-multistability-in-economic.html
“A decline in the interest rate would likely increase the probability that I could make this business work, so it would seem likely that more businesses would start.” – You’d think so. But in a world of government over-regulation? The rate of business formation stays low-ish.
Your larger point (which still holds) is that lower interest rates stimulate malinvestment in general – for example, the speculation that you’ve mentioned; or an existing business doing a marginal project; or an existing business extending consumer credit to sub-prime consumers. Also known as, (thinly-disguised) consumption of capital.
And again, real income comes from productivity which comes from capital formation / capital put to good uses. In a world of capital put to poor uses (or even consumed), yeah, real incomes are going to stagnate at best.
It seems to me that the ease of refinancing and the fact that a business’s customers benefit from the easy credit are significant counters to this effect.
Furthermore, during this period of diminishing interest rates, the proportion of income from corporate profits has increased nicely. And profits have increased nicely in absolute terms. This fits well with the substitution of machinery for labor encouraged by low interest rates. But not with the destruction of capital.
Yes, corporate profits are at high levels. That fits with the ready availability of (fiat) cash; the *lowering* of nominal debt-servicing burdens (again due to re-financing) as interest rates decline; and the lack of high-paid and/or full-time corporate hiring, in this business cycle.
The lack of high-paid/full-time corporate hiring obviously hurts workers. But it need not arise from capital substitution. Quite the opposite: Basic theory about the Division of Labor suggests that good-quality hiring should rise with the increasing use of capital, and decline as real capital erodes or dies.
Thus, the lack of high-paid/full-time corporate hiring may be evidence of (real) capital destruction rather than capital substitution. And/or, evidence of the anti-freedom / anti-hiring regulatory environment of this business cycle (example, Obamacare).
P.S. I do think that last factor (Obama administration) should not be under-estimated. Other things held equal, the employer burdens in Obamacare have somewhat biased today’s economy toward the creation of part-time jobs.
Here’s what I can’t quite reconcile: the Fed is paying interest on excess reserves currently, and has essentially said the mechanism by which short rates will be signalled into “lift-off” is by raising that rate! Yet the ECB has negative rate for the same facility as is headed in the opposite direction. If the Fed wants to juice the lending channel to SME etc, why not disincentivize the holding of these massive excess reserve accounts by lowering the rate paid? I can’t seem to follow the logic – (as if that word even applies in this context!). Thanks for your insights…
Well, the driving forces are actually much simpler than this… here’s how it works:
Economists have observed that ECONOMIC GROWTH under “normal” conditions (i.e. 1900’s correlations) lead to INFLATION.
In a similar manner that RAIN leads to WATER PUDDLES.
Unfortunately, the same economic “experts” somehow came to the conclusion that creating WATER PUDDLES will cause RAIN.
Not very smart, you may think, but that is the tragic reality.