The Law of Unintended Consequences

The Law of Unintended Consequences

Risk. It’s everywhere.

When central banks and governments around the world hold interest rates to artificially low levels, the world’s financial marketplace is being distorted. This distortion should bring benefits, primarily by making it easy for businesses to borrow funds for purposes of investment, and business investment stimulates national economies. A low interest rate environment also encourages consumers to borrow, again tending to stimulate business activity. One may argue about how effective this low interest rate strategy has been, but it’s there and we are living with it.

While one can appreciate the anticipated benefits of a low interest rate policy, especially for building business and investor confidence after the financial crisis of 2008/2009, as with any type of distortion, there are also negative aspects to this policy. In Canada, one widely discussed aspect is that very low mortgage rates have stimulated the housing market, which can be good, but there are many indications that Canadians are in fact “over-borrowing”, i.e. borrowing as much as possible to get a stake in the housing market, driving up home prices but perhaps more significantly, placing themselves in a position of considerable risk when interest rates begin to move up. Will they be able to afford the payments on the large mortgage loans they have been able to afford when rates were very low?

Another distortion that may have considerable significance over time, is the impact of unexpectedly low interest rates on long term financial entities such as life insurers and pension funds. Actuaries have determined the amounts that policyholders and employees, respectively, will have to contribute in order for their financial contracts to be able to be honoured in the future. In making their calculations the actuaries have made assumptions about future interest rates because in addition to actual contributions from the participants in the financial programs, it is the future income generated by invested funds that will make it possible for the programs to make good on their promises to consumers. However, no one, including professional actuaries, anticipated that interest rates on government bonds, for example, would drop to near zero over a significant period of time. Therefore if you consider, say, a particular life insurance policy that was purchased by a 30 year old male in 2007, the annual premium payable over the life of the policy would have been determined largely on the basis of an anticipated future interest rate yield generated on the invested premiums over the expected life of the policy, which might be 40 or 50 years. The longer rates remain unusually low, i.e. the longer the underlying assumptions of the actuary are not being realized, the greater will be the “deficit” in the accumulated value of the funds available to discharge the life insurer’s obligation under the terms of the life insurance contract.
If the annual premium for our hypothetical policyholder is $2,000, when the policy was sold the insurer may have been confident that by 2016 the policyholder’s “fund” (i.e. the amount of the invested premiums) would be about $20,500. That’s the accumulated value of $2,000 per year if it is invested at 5% per annum. Five percent would have been quite a conservative interest rate assumption in 2007, when according to the Bank of Canada, at the start of 2007 the bank rate was 4.5%. But with the extremely low interest rates that have been imposed by Canada (and similarly with other developed countries), the accumulated value of the premiums will not be very much more than the $14,000 that has been paid by the policyholder. Even if investment returns were to suddenly move back to more normally expected levels of 5% or so (and there is no indication that that will happen any time soon), the $14,000 invested amount will not be able to grow “to make up the difference”. There is no simple way to close the gap once the accumulated value of the funds being put aside for this policyholder, become significantly less than the expected value at a point in time. Hopefully the life insurer will have sufficient capital funds to ensure that the amount that ultimately becomes payable under the contract, will in fact be able to be paid out.

The point is that distortions in the financial system, while they may be addressing particular financial issues, will inevitably have unintended consequences. The unintended consequences are reasonably clear when we talk about life insurance and pension funds, which will find themselves in an underfunded position because of low interest rates. But the financial world is an incredibly complex system; perhaps the most complex system that humankind has yet created. In 2007, no one saw or understood how various interactions between seemingly disparate financial pools could create a vast tsunami that would churn through the financial system as a cataclysmic event that is still being dealt with.

My biggest worry is that once again, risk has been pushed into various dark places within the system – where exactly, no one can say. But when economic forces are being artificially constrained, a single spark, or a combination of what might even seem like unlikely sparks, may release the pressure that has been building up in those dark places and we could once again experience a financial meltdown of similar proportions to our experience of eight or so years ago. I hope not.