John FitzGerald: Low interest rates are a double-edged sword

One the most damaging legacies of the financial crisis in Ireland is the high level of indebtedness left in its wake. While down from its peak, government debt remains at 110 per cent of GNP. Although mortgages in arrears have shown an encouraging decline, nevertheless household indebtedness in Ireland remains high, well above a European norm.

The very low rate of interest that currently prevails makes the burden of debt more tolerable both for the public finances and for indebted households. However, as we know, a substantial number of households still find it hard to service their debt even at low interest rates. Also, with a very low rate of inflation, real interest rates – the nominal interest rate minus the rate of inflation – are still positive. These can't match the stimulus to investment that came from the negative real interest rates experienced on occasion in the past.

Though the household sector, on average, has a high level of debt, what is not widely understood is that households on aggregate also have substantial financial assets that greatly exceed their aggregate debt.

Figure 1 shows households’ net asset position, after deducting their debts. Net financial assets of Irish households in 2001 had amounted to 120 per cent of GNP, but declined to just 40 per cent by 2008 as a result of the borrowing spree that fuelled the property bubble.

Since then, there has been a climb back to reach 110 per cent of GNP in 2013. This recovery has two elements, a fall in mortgage indebtedness, and a rise in financial assets. Household debts, primarily mortgages, have fallen steadily since they peaked after the crash, and there has been little by way of new mortgage borrowing to top up aggregate indebtedness. By 2013, household debt was 17 per cent below its peak value, and it has continued to fall since then.

On the asset side, financial assets of households have grown to 22 per cent above their 2008 level by 2013. These assets mainly consist of bank deposits, pension funds and life assurance assets. Of these, the total value of pension and insurance assets is up 42 per cent since 2008, helped by rising equity values.

While there is a general welcome in Ireland for low interest rates, as that eases the burden of debt and encourages investment, the focus of attention in low-debt countries like Germany is on the poor return on householders’ savings.

In Ireland, we have had very little public discussion on the “cost” of low interest rates, although it brings losses as well as gains.

Firstly, it is affecting many retired people and those approaching retirement age. In funded pension schemes, there is a substantial lump sum available at the point of retirement to provide for a pension. Much of this sum is invested, by the pension scheme or the individual, to provide a continuing pension over the expected life time.

Impact

Of necessity the investment is confined to “safe” assets. However, safe assets, such as government bonds, now offer a very low interest rate, so the lump sum buys a smaller pension than might have been originally expected.

A second impact of low interest rates is through the effect on the finances of insurance companies.

Typically the costs that insurance companies face in meeting their claims arise some time after they receive the premium income that covers those claims. You pay your car insurance in January, you may have an accident in June, and may wait until September to get the claim paid. If it is a personal injury claim, the delay is much longer, maybe years, and such claims account for the biggest share of pay-outs. So the revenue companies earn from investing premium income until the date of pay-out is a core part of the economics of insurance. Good returns on these investments can help keep premiums low in a competitive market.

However, on top of escalating claims costs, insurance companies are also experiencing minimal returns on their investment income. These factors are combining to put up substantially the cost of insurance to consumers.

So the same low-interest force that has pushed mortgage repayments down is serving to put up the price of insurance premiums. Of course, looking at household assets and household debts in the aggregate masks the fact that debts and assets may be held by very different households.

Older age groups who have paid off their mortgages tend to have few debts and substantial assets, while families in the 35-45 age bracket typically have high debts and very limited financial assets.

Thus low interest rates, especially for tracker mortgages, are providing a very important support for indebted households with young families. While in many ways the older generation have been less hard hit by the post 2008 recession, those dependent on investment income to support their old age are rendered worse off by the low interest rates, something that affects private sector pensioners on funded schemes but not most public sector pensioners.

If the expectations of the financial markets are correct, the current low interest rate regime will persist for some time to come. However, we all know about the fallibility of financial markets!

If interest rates were to rise rapidly in 2017 and subsequent years, for example as a result of a strong European recovery, this could put renewed pressure on the households who will still be heavily indebted. Low interest rates probably continue to be in Ireland’s interest for the foreseeable future.