Why we need to raise interest rates - the Ogden Rate

That interest rates were lowered to avoid economic collapse is just fine. We're really rather glad we didn't get a replay of the Great Depression, one which Ben Bernanke follows Milton Friedman in blaming upon the tight money policies of that era. However, there does come a time when we've got to unravel that, the Ogden Rate being an example of the sort of trouble we're going to get into if we don't:

Britain’s car insurers suffered combined losses of £3.5bn last year due to controversial new compensation rules for serious injuries, according to a report which predicts further sharp rises in insurance premiums, especially for young drivers.

Consultancy EY said the new Ogden formula led to significant underwriting losses for the motor insurance market in 2016. The unexpectedly deep cut in the Ogden rate, from 2.5% to -0.75%, prompted a furious backlash from insurers who claim that it will “overcompensate” victims of car crashes or medical errors in hospitals.

Although the change to the discount rate was announced in February, most insurers reflected the impact on outstanding claims in their 2016 figures.

No, we're not weeping for the insurers and their profits. This is an example of a much larger problem. Low interest rates mean that, obviously, risk free investment produces a smaller return. Insurance company profits are made up of both the investment returns upon the float and the performance of the underwriting. This is the mirror image of the size of payouts, in order top produce an income in the future a higher capital sum must be paid out now.

The important part of the economy this affects though is pensions. You'll have noted that near all funded pensions schemes have vast deficits - that's because more capital is needed now to produce a future income with low interest rates.

It gets worse than this too. Friedman again, the permanent income hypothesis, the idea being that we'll smooth our lifetime income over our lifetimes. If, after starting work, we're likely to live another 50 years but only work for 40 of them then we'll try at least to save enough in the 40 years to have an income in the last 10. Those savings are boosted by the investment returns from them over the years. If those returns are lower then we must save more now in order to so smooth incomes. 

This does in fact happen too. Generally, deposit rates in Chinese banks have been negative after inflation. That's why the gross savings rate is up at 40 and 50% of GDP. If you're losing money on your savings every year you've got to have a lot of savings to finance old age. We have also seen this in certain reports from the eurozone recently.

Yes, it's perverse, we would think that lower returns to savings will produce fewer savings. But that's not necessarily how it works, lower returns on savings can, by removing the investment gain on them, mean people saving more for their retirement. And at some point in this process low interest rates stop being expansionary, they become contractionary, entirely opposed to the reason we've got the low rates in the first place. 

Odd but true, the reason we need to raise interest rates is to stop people saving too much.