Low interest rates are great, right? As a consumer, you pay less for the money you are borrowing; as a government, you can issue far more debt; as a company, money is easily available.
So what's not to like?
Read this to understand the dangers of low interest rates.
First and foremost: misallocation of capital.
This is the first and foremost cardinal sin of economics: money poorly spent, money frittered away on non-essentials, money invested in projects that fail to perform, all of it is wasted.
Economics, after all, is primarily about limited resources and unlimited demand, reconciling the two.
Misallocation of capital is, I repeat, a cardinal sin in economics.
What does this have to do with low interest rates?
Simple: lowering the price of money increases the possible universe of projects that can be financed. Not all projects should be financed; not all projects will be financed; not all projects deserve to be financed. By putting a price on money, you can judge which projects are those that should be financed, that deserve to be financed, and finally those that will be financed because they bring a proper return in income.
Drop the price of money and you strongly expand the "proper" return on income, that which is enough to pay for the project and remain profitable. The more expensive money is, the more difficult it is to find projects worthy of investment: when interest rates are 10%, the universe of viable projects is much, much smaller (and generally involved considerably more work) than when interest rates are at 3%.
A fundamental truth, despite low interest rates remains: that capital is and always will be a limited resource, despite the activities of the government printing presses. Once invested, it is no longer fungible and easily moved from one project to the next; once invested, it is no longer available for other uses.
Hence low interest rates can be extraordinarily destructive: it leads to investments that fail to perform when interest rates are no longer low and when it comes time to refinance the investment, the business case evaporates and someone is left with a white elephant that cannot be sold for love or money. Case in point: Xanadu.
Now, why then the insistence of low interest rates by the Fed?
Well, there was this recession...
Seriously: low interest rates by the Fed saved the financial system from gridlock and collapse as the subprime crisis and its follow-on effects worked it way out. It allowed the banks to avoid liquidity traps and survive.
It also allows the government to take on very large debt levels, as the cost of financing that debt remains well within the ability of the US government to pay via its cash flow.
The downside, of course, is that while the banks survived, they also stopped lending in order to eliminate any new debt turning into a problem, as well as to return to profitability, since the liquidity was invested in US government debt, with the banks making a handy, risk-free return on the money that they had borrowed from the Fed in the first place. After being burned so badly, a risk-free return of 100 basis points sounds awfully good to a lot of bankers; why loan money with risks of default at relatively high levels when you can earn it for free elsewhere?
Another downside is that interest rates won't remain low forever, but that is exactly the only way that the US government can afford a debt crisis without having to either cut spending drastically and/or raise taxes significantly. If interest rates for US government bonds were to climb to, say, 5% for a 90 day bond (which is where a significant portion of US government bonds are issued), the government would have to spend quite a bit more for interest servicing. Back in the good old days (pre-Clinton, to be exact), the US government largely financed spending via long-term bonds; this was explicitly changed by the Clinton Administration to short-term bonds, increasing the inherent instability of the US government's ability to service those bonds.
Because short-term bonds are always more volatile than long-term bonds. Bonds have an interest rate and a price; the combination of the two determines the performance of the bond. The interest rate is determined when the bond is issued; the price fluctuates, approaching 100% of the nominal price of the bond when the bond reaches maturity and is paid out at the face value. If demand for a bond suddenly tanks - no one wants to buy it, everyone wants to sell it - then the effective interest rate skyrockets upwards; long-term bonds are usually fairly free of these fluctuations, as they can first be redeemed in years, not in months or days.
Hence if the Fed were to raise interest rates, the ability of the US government to finance its debt could be called into question, as the sum of the debt is huge and even small changes here make mockery of any budgetary planning.
This is perhaps the greatest danger of low interest rates coupled with heavy debt: once that debt is accumulated, it has to be serviced and, invariably, re-financed as short-term bonds mature and have to be repaid (financed by new bonds). The fact that interest rates are low has enabled the US government to take on massive debt; the flip side is that this debt is largely short-term and must be refinanced. Raising interest rates here would effectively cripple the ability of the US to refinance its debt.
If that happens: watch out, what we saw in the last few years is nothing in comparison to a US sovereign debt default.
So now we have the conundrum of low interest rates: great to have as a consumer, but a catastrophe for the economy. The Fed cannot afford to raise interest rates because if it does so, the ability of the federal government to raise capital is badly damaged; if it does not, in the face of inflation, it will damage the rest of the economy. Companies have taken on projects that can only show a return on profit when interest rates are low (because when interest rates rise, they turn the project unprofitable) because it was simpler and easier to do so, rather than finding the projects that were more resilient and rewarding, but harder to do and harder to make work well.
Low interest rates are a trap for the unwary. If companies and the US government had maintained their standards, low interest rates wouldn't be a problem: however, low interest rates drive both companies and the US government to misallocate capital, the cardinal sin of economics.
The conundrum remains: there is no simple solution. The only real solution would have been to not go so heavily into debt (US government) or to maintain high standards of due diligence for corporate investments and spending (companies).
Returning to economically sensible behavior after such a period of debauchery will be both expensive and tedious, marked by much stronger savings rates and the accompanying postponement or abandonment of consumption in order to regenerate savings and hence capital.
We'll all be paying for the low interest rates for decades to come, until companies have written off their losses and government debt comes down significantly.
Now that's a legacy.
There is no easy answer