True economic democracy, one might say, I will be achieved when every American is ripping off every other American. Recent history shows a steady progression toward this ideal. As energy prices tripled and gas lines stretched down the boulevard, for instance, millions of citizens who owned oil stocks secretly chuckled with glee. Oil stock owners formed a formidable bloc of people who not only profited from the energy “crisis” but were in no hurry to see it end.
Today, high interest rates are the greatest plague on the economy. While October brought some encouraging dips in the prime rate, it’s still a long way back to single digits. Since interest rates, like gas lines, affect everyone, it would seem that everyone would be distressed. But far from it. A large, diverse segment of the population actually likes high interest rates.
Financiers, of course, have always favored high interest. But these big wheels, while powerful, have been modest in number. Today the roster of those who root for high interest rates (consciously or not) runs into the millions. It’s composed mainly of middle-class citizens with investments in money market funds, bank certificates of deposit (CDs), and the new All Savers accounts. This emerging category of “interest investments” gives steadily growing numbers of people a stake in keeping rates sky-high.
Consider a 38-year-old engineer who owns his own home. Unless he indulges some illegal habit, chances are he has a fair amount of cash on hand, since the median income of “professional and technical” workers is now $31,000, according to an advance analysis of the 1980 census. If the engineer put his cash in a money market fund in October, it returned 17 percent. Seventeen percent. The railroad robber barons of 1880 would have swallowed their snuff boxes for such a deal! Not long ago, a 10 percent return made Wall Street analysts drool. Yet the engineer can obtain this handsome yield without any special knack for investing (or, for that matter, any knowledge of the market at all). The money is practically guaranteed, and besides he can have it back at any time. This dream deal will continue, however, only as long as interest rates stay high. If they fall, it’s back to five percent and a cloud of dust.
The same applies to CDs and All Savers accounts, which, through tax gimmicks, can be as rewarding as money market funds. Just about anybody who makes a good salary and isn’t looking to buy (or sell) a house can turn the prime-rate “crisis” to his advantage through interest investments. People are doing so in staggering numbers. In October 1979 the money market funds had about 1.5 million members and $35 billion in assets. By October of this year, approximately 8 million people had deposited $160 billion in money funds. Billions more were in CDs and beginning to flow to All Savers.
This shift in financial patterns not only creates a sizable constituency for high interest rates, but diverts money from the risky new enterprises necessary to invigorate the economy. “An investor can now get a 17 percent return in the money markets with almost no risk,” says Stephen Levy, an official of Energenics Systems, a firm that sets up new energy ventures. “What can possibly draw him into a new company that might not succeed? If I propose a venture whose stock price will probably double in five years, most investors now say, ‘So what? My money will double in a money market in four years, and I’m taking no chances.’ ” Ronald Reagan’s economic program is nearly certain to accelerate this trend. It handed more money to the well-off but included no provisions to draw that money toward new or expanded enterprise. A great deal of the cash Reagan cut loose will probably be stuffed into the national mattress of interest investments—where it may eventually find its way to productive uses, but more likely will go to service existing debt.
To understand the full implications of the interest-investing fad, it’s important to remember that the types of people who use money market funds are generally isolated from the realities of borrowing money. Since the mid-1960s the typical pattern of life for a young professional has included only three major loans (“major” being a loan that is large compared to the borrower’s net worth). The first loan is for college. It’s available at a government-subsidized, artificially low rate. The second is for the car that takes a borrower to his first big job; the third is for a house. Car loans can be paid off quickly by someone advancing to professional rank; house loans, if necessary, can be postponed by apartment living. Meanwhile, the modern professional tends to work for a law firm, hospital, government agency, or large corporation. Those institutions may be borrowing money to stay afloat, but few of their professional employees are actively involved in the process. The accountant or banker who handles institutional loans may see huge interest payments, but it’s somebody else’s money. The magnitude of high interest seldom hits home unless it’s your money.
Life didn’t always work this way. Not too long ago, many of the people who are now operatives of large institutions would have been selfemployed, or managers of family businesses. Self-employed or small-business people are intimately involved in the borrowing of money. They understand that large sums are necessary to get something new rolling, and they know from personal experience what a jackhammer job high interest rates can do to even the best-laid foundation. But that’s fading. There is now a large and highly influential class of people who don’t appreciate that high interest rates cripple small business and the poor—and increasingly don’t care, because they see high rates as a sweet deal for themselves.
Leave Me a Loan
Suppose our hypothetical engineer making his median $31,000 lives in a home purchased before 1978. He probably has a fixed conventional mortgage at less than 10 percent. Not only is he hoping for continued high interest rates, he may even be hoping for inflation.
Here’s why. First, his 10 percent mortgage is locked in at 8 percent less than the going rate. That means there’s leverage in the loan itself. Since the bank is losing money on the engineer’s loan, the engineer could, if need be, readily refinance and accept a higher rate in return for upfront cash. Meanwhile, he is basking in the attenuating effects of inflation, because he covers the payments on his house with future “cheap” money. All this time inflation is pushing up the value of his house, making him at least feel like lord of all he surveys (remember, interest rates may prevent him from selling the house and realizing his gain). Inflation may also be pushing up his salary, especially if he’s on the cost-of-living gravy train. Most cost-of-living salary escalators are linked to the Consumer Price Index. CPI’s major component is housing costs, which our engineer has already licked. He may receive, say, an 8 percent cost-of-living increase when his actual incurred expenses have risen at a much slower pace.
Each year the engineer deducts half his mortgage interest from his taxes, so the home loan really sets him back only 5 percent. He puts all his available cash into a money market fund, which pays 17 percent. With inflation now running around 10 percent, that’s 7 percent real growth, at least before taxes. Risk-free, totally liquid. Pour another Chivas and toast the gold medalist of contemporary finance.
According to Census Bureau figures, in January 1978 there were 22 million homes backed by conventional mortgages. Assuming most of the people who owned those homes in 1978 still do, a vast number of people are living by the grace of notes at 9 percent or less, since mortgage rates began their spurt in mid-winter 1978. To get some notion of how many people have the type of salary that provides moderate amounts of cash to invest, I added up Bureau of Labor Statistics figures for professional-type employment— lawyers, doctors, chemists, government managers, journalists, and so on. The total came to 8 million—the same number of people who have money market funds. Surely many of the 22 million home-free homeowners and 8 million well-paid professionals overlap, creating a very large contingent of gold medalists.
All told, since the prime rate hit warp speed in late 1979, interest income for individuals and institutions has increased 42 percent, according to Manufacturers Hanover Trust Co. Interest income now constitutes 13 percent of total personal income—an average that includes tens of millions of people who have no interest income at all. Murray Weidenbaum, chairman of Reagan’s Council of Economic Advisors, recently put it all in perspective for a congressional committee. “These high rates may represent a serious cost to borrowers,” he noted cheerfully, “but they have substantially increased the incomes of millions of Americans.” If you were smart enough to make money before 1979, Weidenbaum seems to be saying, this is the decade for you. If you need to start making money now … excuse me, I’ve got another call coming in.
One Lump Sum Or Two?
Just how do money market funds generate such princely returns, the better to win converts to the cause of high interest rates? What do they know that banks don’t know? Nothing, as it turns out. It’s what money funds are exempt from, as opposed to what they have, that makes them so profitable. But first, let’s backtrack a little.
Until the 1970s, the main alternative for investors who didn’t want to make individual buy-sell judgments about the market was the mutual stock fund. Shareholders would hand their money over to portfolio managers, who would buy a variety of stocks and generate returns from dividends and profit-taking (selling shares that are up). During the last decade, however, several new categories of funds came into being—money market funds, tax-free municipal bond funds, and my personal favorite, the yield-tilted index fund. (For an explanation of what that is, send $25 in subordinated convertible debentures to Easterbrook Investment Services, care of this magazine.) Money markets soon became the star of the new services. They’re outperforming mutual stock funds, and their $160 billion in assets compares to just $4 billion for municipal bond funds.
A money market is the bucket brigade of high finance. It collects lots of little bits of money, consolidates them into a big lump sum, then sells it to those who deal in lumps. Banks, of course, perform essentially the same function on their deposit end—they collect small sums and consolidate. There’s one crucial difference. Banks are regulated. Money market funds are not.
Banks dwell in the land of something called Regulation Q, a Federal Reserve rule that limits the amount of interest they can pay on small accounts. When banks advertise “the highest interest allowable by law,” Reg Q is the “law” they’re referring to. Savings and loan institutions can pay a maximum of 6 percent on passbook accounts; commercial banks are limited to 5 and 3/4 percent.
Money market funds are under no such strictures. They are “securities institutions,” not banks, and hence regulated by the Securities and Exchange Commission instead of the Fed. (Technically a money fund member doesn’t have a deposit, he has a stack of “shares” worth $1 each.) The SEC, unlike the Fed, thinks people ought to be allowed to make money, so it allows “securities institutions” to pay whatever yield they can. Money funds make loans that average out at nearly the prime rate and pass the proceeds right along to their shareholders, minus a small management fee, which is how the funds themselves make money.
At one point in 1980, savers were carting cash to money funds (some of which can be joined for only $1,000) at the rate of $3 billion a week. Pension funds, brokerage houses, and similar institutions also use money funds. Stock-shuffling creates large amounts of cash that has a very short half-life. Brokers don’t want it to sit idle, but also can’t afford to have it tied up. So an instant-out fund fits their needs perfectly.
Since many banks are short of capital, you might think they would be straining against the reins of Reg Q, anxious for a chance to take on the funds head-to-head. But banks are about as anxious to compete, it turns out, as baseball’s first-season playoff teams were anxious to win games after the strike ended. Yet banks now depend on money funds for their existence.
All money funds do with their money is lend it; they never buy stocks. Their loans fall into three categories: loans to government, loans to banks, and loans to business. Slightly more than half the funds’ assets cycle right back to banks as a wide variety of short-term instruments, including “jumbo” CDs, letters of credit, and “repurchase agreements” (see sidebar). The largest single slice of money fund capital, 35 percent, goes to “commercial paper”—short-term loans to corporations. “Paper” lasts for only a month or two. In fact all money fund investments are extremely short-term. Some last no longer than affection in a singles bar.
Liquidite, Equite, Fiduciaire!
Money market funds like short loans—the shorter the better is usually the rule. That’s because money funds are not, as many believe, go-go risk-takers. Far from it. Like most contemporary financial leaders, money fund managers are petrified of anything even the least bit uncertain. Not being insured, they place a premium on liquidity—the ability to jerk their cash back at the first sign of trouble.
Money funds can buy lots of liquid short-term paper because lots of corporations are selling it. With the Dow Jones index sounding like an SAT score, companies have little incentive to issue stock, since it brings a paltry price. Bond sales have nearly stopped, too, blackjacked by interest rates. After stocks and bonds foul out, the only way left for corporations to raise money is generally through paper. To the investor banking on high interest rates, short-term paper offers not only liquidity, but the opportunity to quickly reloan money at an even higher return any time the prime rises. The “average maturity”of a money fund’s loans indicates whether its managers think rates will go up (short average) or down (long average). Five years ago, the industry-wide average maturity for money funds was 108 days. Today it is 29 days.
The short-term loan game has some troubling implications—implications that interest-happy investors ignore at their peril. How can a businessman lay plans for the future when his money supply is guaranteed for only 60 days? How can he make capital investments when he can’t fix the cost of capital more than a month away? The prevalence of short-term financing “further reduces long-term corporate vision, and increases corporate myopia,” says Robert Reich, a former Federal Trade Commission official.
Meanwhile, as the company recoils from longterm investment, the sword of paying 18 percent money-rent hangs daily over its head. Companies have no choice but to cut back capital improvements and use earnings to cover costs. For instance, Weyerhaeuser, a profitable and forward-thinking company, recently announced a 15 percent cut in 1982 investment spending. No time for new products or factories; crank the existing assets up to maximum for as long as they can stand it and when they break, ask for a bailout.
Interest rates take a special toll on small business. Small businesses generally pay one or two percent more for loans than big business to begin with—a combination of the facts that small loans require more bank effort (there’s an advantage to buying anything in bulk, even money) and that small businesses are more likely to fail. High rates hit troubled or new businesses doubly hard because of the tax system, which favors established firms. Tax deductions for interest payments—a key element of the prime-rate absorption system—are useful only to firms with something to deduct from. Unless a company is safely in the black, tax deductions for interest don’t help.
Perhaps most ominous, fat, risk-free interest investments have become an impenetrable force field against new enterprise—the fountain of job creation and economic innovation. According to Levy of Energenics Systems, the “investment hurdle rate”—the return a venture must offer in order to lure investors—has gone off the scale. At the moment, Levy says, investors won’t start talking until they are promised a new enterprise with a 40 percent pre-tax return—hard to imagine for anything short of a diamond mine.
Could any of today’s most innovative industries—semiconductors, photo offset typesetting, composite structural materials—have gotten off the ground under these conditions? Entirely new ideas like semiconductors, Levy says, would scarcely merit a second thought if they had to compete with the high yield of today’s short-term interest investments. “Nobody’s looking for longterm projects,” he notes. “The question they all ask is, ‘Does it work right now?'”
Clean, Carefully Washed Hands
Consider how these factors unify in the minds of well-paid young professionals. Why invest in companies when you can invest in interest? Many young professionals are unmoved by the country’s lagging productivity, since they themselves are sequestered far from actual productive enterprise. They occupy “clean hands” positions in law offices and newsrooms, where they analyze and comment on what other people do, but never do (in the productive sense) anything themselves. Those with business schooling have been elaborately trained to emphasize short-term results. Meanwhile most young professionals seldom borrow amounts of money that are large compared to their own worth, so they don’t know what a crust-breaking impact 18 percent has on anyone skating on thin ice. One thing they understand very well, however: money market funds, CDs, and All Savers guarantee them fabulous returns but only as long as interest rates stay high.
Is it any surprise that this large and influential group is not shaking its fist at the prime rate? In fact interest investors, consciously or not, are using their influence in exactly the opposite direction. Two years ago, when S&Ls and commercial banks began lobbying state legislatures to cripple the money funds (see “High Noon at Wall and Main,” page 38), fund proponents beat the banks with ease—blew them out of the water, in fact. Banks, bear in mind, have traditionally been the two-ton gorillas of lobbying, using campaign contributions and well-developed local influence to get their wish lists approved on a regular basis. That the money funds broke the banks may be a good thing—but it also shows how powerful the funds have become, in a very short time.
Neoconservative commentators like to speak of a “new class” of young professionals who seek tenured, important-sounding but unproductive jobs, living off society’s past successes while adding nothing to its future. These new-classers are supposed to congregate in government agencies. But interest investing, which sounds alarmingly like a new-class attribute, has swept up lawyers, accountants, management consultants, and others generally associated with the business world, as well as Great Society types. Today people on all sides of the fence seem to long mainly for no risk and for instant gratification.
One other feature seems to define the new-class investor. To buy stocks, you must pay a fair degree of attention to the market. You must root for the business climate to improve, and study the relative merits of companies to determine which ones are likely to prevail. These things, besides being difficult, have a distasteful connotation to many young professionals. Stocks are used to, well, profiteer—to make dramatic gains from companies that fleece the poor and spoil the land. Money funds, on the other hand, cannot make you filthy rich. They just. provide a nice, predictable return. That seems, somehow, so much more respectable.
The buyer of stocks or bonds also takes on a measure of responsibility for corporate behavior. He might hear that Raytheon was. using his equity capital to make antipersonnel fragmentation grenades. Some people don’t lose sleep over such things, but many young professionals— especially journalists and college teachers, who have influence disproportionate to their numbers—do. In fact, losing sleep over corporate behavior has advanced to such a degree that many new-class members toss and turn even over socially responsible companies that make lumber, gearshifts, or toothpaste.
Passing your cash on to a money-market intermediary absolves you from all that. Your money’s thrown into a big pool and how do you know where it ends up? Maybe it’s at Raytheon, or maybe it’s funding a free macrobiotic food program for senior citizens. Mutual stock funds served this purpose up to a point, but they still had a prospectus—you could see which stocks your fund was buying. Not so with interest investments. All you see is a printout of returns, no indication of where the money really went. You’re off the hook.
None of this, of course, is to say that interest investments are, of themselves, unwelcome developments. They bring flexibility to capital markets and high returns to average people, encouraging savings and spreading a benefit that until now has been reserved for the wealthy. But as long as high prime rates persist, the interest-investing sector will continue to serve the entrenched at the expense of the struggling, and encourage short-term thinking when what’s needed is long-term revitalization so that all can prosper. It’s an unsettling sign that many pension funds have made large money-market deposits. Pension funds are supposed to foster long-haul economic expansion, creating wealth that will serve their members when they retire many years hence. Now even pension funds want profits today and tomorrow be damned. Interest investors are strip mining the landscape of American finance, blithely assuming that someone else will clean up the debris.
