Ultra-low interest rates come with a high price for future generations

This article was first published in the Times, and is reproduced here with permission.

Many things determine our living standards. Most important is what goes on in the labour market. In the end, levels of employment and earnings matter more than anything. Then there are the taxes and social security benefits set each year by the chancellor. The consequences of all these for households, and in particular the distributional consequences, are pored over in great detail.

But there is a third leg supporting and determining our living standards. That is the monetary policy followed by the Bank of England. At 0.5 per cent the base rate was already at its lowest level since the Bank was founded in 1694. It had been stuck there for an astonishing seven years. But last week the rate was cut further to just 0.25 per cent, while the programme of quantitative easing — buying government and corporate debt with money created for that purpose — was extended.

With the limited tools at its disposal, this may well have been the Bank’s best strategy for supporting the economy. But these monetary tools cannot fully offset the impact of a faltering economy on our living standards. And they will have quite different effects on different groups of people.

Some immediate effects are pretty obvious. Most of those who had a substantial mortgage prior to 2008 will have seen a big easing in their interest payments, often more than enough to make up for falls in their real earnings. Conversely, anyone relying on interest from savings will have seen their income from that source decline. In general the first group is made up of better-off workers; the latter group tends to be better-off retirees.

That may sound like an important counter balance to the more general improvement in the living standards of pensioners relative to people of working age. For some, in the short term, that has been the case. So it may seem that last week’s base rate cut will be another boon for workers and a blow for pensioners.

In fact that is a much too simplistic take on the distributional consequences of this policy. Over the long term it is younger generations who will suffer the most. Persistent low interest rates damage the long-term living standards of young people. Headlines suggesting that pensioners are the big losers from the latest monetary loosening are plain wrong. The biggest losers by far will be the young — those who are setting out to accumulate assets, to buy a house, to save for a pension.

There are two sets of reasons for that. One is contingent on the way pensions happen to work in the UK, the other is a necessary result of low interest rates, at least where workers have to fund their own pensions.

The contingent reason is that much the most important non-state source of incomes for pensioners in the UK is not interest on cash accounts or even investment income in total, it is income from defined benefit occupational pensions. This is about four times as important as all investment income. And for current pensioners, income from these pensions is wholly unaffected by monetary policy — or, indeed, just about anything else. If they have a pension then they have a legal right to an annual payment.

Someone has to pay for that right in a world in which returns on investments are much lower than expected. That someone is the generation of working age, through lower pay or higher prices or lower returns on shares. Vast quantities of money — about £50 billion a year — are being ploughed into private sector schemes to keep them solvent. As interest rates fall, more money needs to be diverted into these pension schemes. In the private sector nearly all these schemes are, of course, closed to younger workers. They effectively have to pay for them but don’t benefit from them.

The necessary result of lower interest rates is even more important. Lower interest rates increase the cost to individuals of providing for their own retirement. If real interest rates are 3 per cent, then £100 saved now will provide me with over £240 in 30 years’ time. With real interest rates at zero, £100 saved now will provide me with precisely £100 in 30 years’ time. I need to save more than twice as much to get the same income later on.

That is why low interest rates imply a big reduction in the long term living standards of younger generations. The economist John Kay has pointed out that if long-term real interest rates are just two percentage points below their historic level, the additional cost of pension funding corresponds to a 10 per cent fall in income. And the drop in interest rates since the 1980s has been much bigger than that.

The low interest rate does make servicing debt much cheaper. That certainly helps those who already had a substantial mortgage when rates started to tumble. But it is of little comfort to those in their 20s and 30s looking to get on the housing ladder. Asset prices have been kept high by loose monetary policy. And of course the big deposits now required to obtain a mortgage are even harder to accumulate when returns on savings are so low.

Ultra-low interest rates are a response to the underlying weakness of the economy. They help us weather the short run problems, and the economy will do better than it would have done without this policy response. But they are not costless. Many of those in their 20s and 30s today will be paying the price for a long time to come. Persistently low returns on savings will mean they cannot possibly aspire to anything like the incomes in retirement enjoyed by their parents.