FJ Challenges the Conventional Wisdom: Who Really Benefits From Lower Interest Rates?

If you ask your average economist, it will be taken as gospel that lower interest rates are a good thing. Lower interest rates lowers the cost of money for consumers, businesses and governments. When money is cheap, people and institutions spend more of it and that helps the economy.

It sounds like a pretty good arguement, and it sounds so benign. However, my argument is that lower interest rates benefit the banks much more than people and businesses.

It's clear that savers are being brutalized by the Federal Reserve keeping short term interest rates substantially below the inflation rate. The discount rate is at 2% right now and inflation is at 4% or more (depending on who is calculating it). That means the savings you can earn at your local bank causes you to lose purchasing power every year.

Contrast that to last year, before Ben Bernake started drastically cutting interest rates, when you could easily earn 4% or more in a money market account. At least last year you could keep up with inflation, not so this year.

But look at the banks. Because of these artifically low interest rates (that can only happen because the Federal Reserve manipulates interest rates to serve their members) one of their biggest expenses has been lowered. The interest rates they pay their depositers is substantially reduced.

This is very important when banks are as capital impaired as they are right now. They are capital impaired because they made reckless loans to people who couldn't afford them and now they need to be bailed out of their own bad decisions!

Keeping short term interest rates artifically low also spurs inflation. Remember, low interest rates means there is more money chasing the same amount of goods - that causes inflation. In response to inflation, bond investors start demanding higher interest rates for longer term bonds.

This causes the spread between short term interest rates and long term interest rates to widen. That is very profitable, especially when you borrow money with low short term interest rates and lend it out at higher interest rates like banks do. When spreads narrow, it becomes very difficult to make money.

So, the banks benefit from lower short term rates because it lowers their expenses. They also benefit as longer term rates rise because they can make more on the money they lend out.

That's Win-Win for the banks. Unfortunately savers get screwed in the process and debtors only end up getting a little relief.

It's quite ingenious how the debate around interest rates revolves around should the Fed cut interest rates or raise interest rates? Unfortunately, nobody ever asks why the market isn't allowed to set short term interest rates. After all, if the market can set long term interest rates fairly and efficiently, why would it be any different with short term rates?

Just something to think about the next time you get your bank statement and they've paid you $0.10 on your $100 deposit.