Economic Myths: High Interest Rates Encourage Saving; Low Interest Rates Boost Consumption

These platitudes are trotted out over and over again, and are repeated at Wiki There must be something in it, but Excel tells us otherwise.  The most important form of saving (apart from paying off your mortgage) is of course saving for your old age, i.e. a pension. Let's ignore tax subsidies/distortions and pension company charges (the two largely cancel out) and assume low and predictable inflation so all we need to consider is real interest rates.  Our idealised pension savers would like to have an annuity of £10,000 (the annuity company works on a remaining life expectancy of, say, 25 years) when they retire and start saving the same annual amount each year 25 years before they retire.  If real interest rates are 1%, they have to save up a final pot of £220,000, which requires savings of £7,798 each year. If real interest rates are 2%, they only have to save £6,095 a year to end up with £195,000. And if real interest rates are 3%, they only have to save £4,776 a year to end up with £174,000.  So if you are confident that real interest rates will be quite high, you can get away with saving £3,000 less every year than if real interest rates are going to be very low (they are currently negative, of course).  Of course, mortgages work the other way round.  Again, assuming a minimum spread for the banks of 1%, in a low real interest rate scenario, real mortgage rates are 2% and paying off a £160,000 mortgage over 25 years costs £8,200 a year. If interest rates are 4%, it costs £10,200 (£2,000 more).  So in a high real interest rate scenario, our typical saver couple is 2 x £3,000 better off for the 25 years they are saving for their old age and £2,000 worse off for the 25 years they are paying off their mortgage (there will be ten or twenty years in the middle where the two overlap).  All things considered, they are on average £4,000 a year better off with high real interest rates - they can spend £4,000 more each year - and that's ignoring the fact that they could optimise the position further by paying off the mortgage a bit more quickly and then saving more towards their pensions over a shorter period.  The real beneficiaries of low interest rates are of course banks and bankers, but as they are not producing anything, merely consuming other people's output (or do not produce anything extra, merely because interest rates are lower), total production is not increased whether real interest rates are high or low.  And if production is unchanged, then consumption is also unchanged, it is just that with higher real interest rates, the relative share of total output consumed by banks and bankers drops quite considerably and our hard-working hard-pressed etc. couple gets to consume more (of their own output).  Just sayin', is all.