Economics: The Greenspan Equation ... There are Also Losers
The Las Vegas gamblers are purposely seeking out risks, as their games by their very nature must have winners and losers. The quest for risks generates flows of adrenalin producing an excitement that is accepted (or craved) as an offsetting reward for likely financial losses. The experience is entertainment. In the investment world, however, most players calculate, to one degree or another, how they may avoid risks, as they wish not to play in a Las Vegas style win-lose game.
Wall Street is different in that all the investors can be winners. This situation was almost experienced as the vast portion of stock investors in the late 1990s did see the values of their equities rise. They played a win-win game. However, unlike Las Vegas where players win and lose and the casino always wins, on Wall Street, there are also moments when everyone can lose. Over the past year and a half, it has seemed that many Wall Street games were lose-lose games. The weak economy and then the events of September 11 have brought the collective value of investments downward.
As recourse to the weak economy, Federal Reserve Chairman Alan Greenspan has come to the rescue. The Federal Reserve Board has reduced it rates ten times over the past year and a half from 6.5% down to 2%. It has been four decades since interest rates have been this low.
Forty years ago there was no global economy with fierce competition from cheap overseas labor, no Internet, and only a few people with very strong credit ratings had credit cards. This was a time when American manufacturing dominated the world economy with General Motors reigning as the world’s largest producer of automobiles. In the early 1960s very few families owned stocks, the mutual funds industry was in its infancy, there were no IRAs or 401Ks. Cars were purchased rather than leased, groceries were bought with cash not put on a credit card, as was true for most purchases. The economy of America and the finances of the American family forty years ago were quite different from today’s America. To suggest that the current 2% interest rate would have the same effect on today’s economy as it did forty years ago would be folly. There are too many differences in the economies of 1961 and that of today to draw parallels between the two.
With no real historical precedent, many see today’s 2% interest rate as a win-win situation for the economy. The reductions in interest rates are considered policies that will allow businesses to borrow more money for expansion (supply-side generated prosperity). Persons wishing to purchase large items--cars and houses--will be encouraged to let their eyes become larger than their pocketbooks (demand-side generated prosperity). A win-win game.
But alas, that is not the reality for all. The actions of Mr. Greenspan also produce losers.
It has often been said that on Wall Street sometimes the bulls are winners, and sometimes the bears are winners, but at all times the pigs are losers. Well there are losers under the Greenspan equation, and by no stretch of the imagination are they the greed driven"pigs" found in that cute remark. No! They are average Americans seeking an average retirement security without having to incur adrenalin-generating risks. The losers are neither bulls, bears, nor pigs, but rather people who simply want to survive in an economic sense. They have saved and seen their children through educations that hopefully will allow them to go into the world and make it on their own. They also want to support themselves through their retirement years burdening neither their children nor society. For these Americans gambling is totally out of the picture as a strategy for economic life. Let's consider some examples.
Actual figures from the most recent University of Michigan Institute for Social Research study found that the median household worth of persons 65 and above is $158,500 (including house equity) Of this, only $35,500 is liquid, or considered household financial wealth.
Using $35,500 as a base for discussion, professional financial advisors suggest that an individual's fixed income investments (bonds, C.D., etc.) should be equal to his/her age, while the rest should be invested in stocks, hopefully to grow the portfolio to keep pace with inflation. At age 65, there would be $23,075 in fixed income investments (65% of $35,500) and $12,425 in stocks (35% of $35,500). Regarding the return on these investments, professionals advise that 62.5% can be spent, but that 37.5% should be reinvested for future growth and as a further hedge against inflation. With people now living into their eighties, this is wise advice. To do otherwise may mean that the person will outlive his/her money.
With $23,075 to invest in bonds or a certificate of deposit (C.D.) yielding 6% interest, the person can generate $1385 per year, or $115 a month. Despite the current decline in the stock market, on average stocks return about 11% a year. Since the equity portion will be invested to grow the portfolio over several years, stocks will be ignored and we will concentrate on fixed income investments.
Until recently a 5 year C.D. could be bought that would yield 6%. This is no longer the case. Now one is lucky to find a yield of 4%. Money market accounts give 2%. If the individual staggers investments--makes investments of 20% of the portfolio over several years, for example, then $4615 (20% of $23,075) will now need to be invested at 4%. The remaining part of the portfolio--$18,460 (80% of $23,075)--will yield $1180 next year, while the new investment yields $185. The total return is $1293 or $92 less than the previous year ($1385-$1293). If the person did not stagger investments and the full $23,075 came due at one time to be reinvested at 4%, the yield would now be $923, or $462 less than the previous year ($1385-$929). So it goes with lower interest rates and financial planning.
What should the individual do? Most options are painful. It is likely that the individual will reduce spending with expected negative consequences for both the individual and the full society. Perhaps the person can get a job, but then the economy is in recession, there are not many jobs, and the person is older. The individual may also dip into his/her principal, jeopardizing future retirement security.
There is social security, but even those making the maximum contribution receive an annual benefit of only about $15,000. This should keep the poverty wolf at bay, but here you can see that the $1385 investment income represents fully 9% of annual income above social security.
Others are hurt also, even young people. Folks don't simply sign up for a house mortgage or car loan. They must have down payments. The lower interest rate means it will take longer to accumulate the down payments for houses and cars.
Consider this real life example, one woman as she approached her senior years. When her husband died in 1975 she was left fairly well off by 1975 standards. She did not like risks as her husband had made some poor investments in the stock market, so she was attracted to CDs and bonds. Her first investments paid high rates of interest as they were driven by the high inflation at the time. She bought five year CDs. When they came due in the early 1980s, interest rates had fallen. She reinvested at 10%, then in the next round 8%, then 7%, and so it goes. She was now too old to work to make up the difference, so she cut spending, and in order to get cash, she sold her house. When interest rates sunk below 7% she began to dip into her principal. At the time of her death, only 10% of her principal was left.
Of course she could have gone to the stock market, but she was risk adverse. She never once thought about seeking out the games of Las Vegas. By taking the safe road of fixed investments instead of the riskier road less traveled, she lost buying power, she lost her house, and she saw her fortune dwindle almost to nothing when she died at age 83. Many live much longer.
The interest rate cuts may yet rescue our economy, and for most of us that will be a good thing. However, we should be very wary about accepting interest rates as some sort of blessing without costs. For persons approaching retirement we suggest they hedge their bets by diversifying portfolios with some equities and staggering their CDs and bond investments, while investing for the long run. We cannot expect the Federal Reserve to make its policy decisions for just one sector of the population, as many benefit from lower interest rates. Nonetheless we have to be aware that the game being played by Mr. Greenspan is not invariably a win-win game for all, there are losers.
comments powered by Disqus
- Colorado Students Strip Naked in Protest of ‘Censorship’ of AP History Classes
- They should give this definition of History to all first year undergrads on their first day
- Field Report: What I learned by attending a workshop on Korean history
- Historians suggest ways California can integrate gay history into the school curriculum
- Now it’s Andrew Bacevich’s turn to do a MOOC