Economics for One

Stimulating Interest Rates

Conventional wisdom says that in a recession, the government should lower interest rates to help stimulate the economy.  Unfortunately, this is like saying the cure for a bad hangover is a bottle of whiskey.

Interest Rates Are Just Another Commodity

Like many products, interest rates are subject to market forces.  Banks borrow money from depositors and loan it to borrowers at a higher rate.  In order to induce depositors to give them money, the banks pay interest to the depositors.

If not enough people are saving, and lots of people want to borrow money, then the banks need to pay a higher rate of interest to savers, and are able to charge a lot of interest to the borrowers. This makes savings more attractive, and borrowing less attractive, and over time moves people away from borrowing and into saving.

Conversely, if lots of people are savings, and not many people are borrowing, then the banks don’t need to pay as much interest to savers, but will have to make their loan products more attractive to borrowers by charging less interest. This makes borrowing more attractive and saving less attractive, and over time moves people to borrow and consume rather than save.

So in a free-market interest rates automatically stabilize to an appropriate level based on the amount people are borrowing and saving.

Market Signals

This has a big effect across the marketplace: When interest rates are low, that is a signal to the market that capital is cheap, and that capital intensive projects make sense. When interest rates are high, capital is precious, and should be preserved.

By artificially raising the interest rate, society will under-capitalize projects at the expense of overall economic growth. By artificially lowering the interest rate, society will over-capitalize projects, which will feel like great growth early on, but will wreak havoc when society runs out of capital prematurely.

The Current Recession

So what does it mean when the government lowers the interest rate? Effectively the government is creating an incentive for people to borrow and consume rather than to save. This lowers the savings rate, and increases overall debt.

And that is the core of the recession (depression?) we are seeing right now. Interest rates have been held very low for a long time, causing people to borrow and spend rather than save and invest. This trend is reflected in all of the savings rate data and household debt data of the past 25 years.

So what is the monetary policy we’ve been seeing? A continued reduction in the interest rate to near zero, in an attempt to get people spending. The trouble is, we’ve run out of capital. We hit the wall on what banks could safely lend.

Under a free market, interest rates should have risen a long time ago, and should be relatively high now. After all, banks clearly need more capital, and their loans are clearly risky (thus requiring a higher interest rate to make the entire portfolio profitable).

Instead, rates are remarkably low. The Obama administration, like the Bush administration before it, is telling people to get out there and spend money, including taking on more debt if necessary.  The Obama administration’s Dr. Christina Romer was interviewed by David Gregory on Meet the Press March 15, 2009:

Mr. Gregory:  Final point here.  What is the responsible thing for consumers to do at the height of this global crisis?

Dr. Romer:  That, that’s an excellent question.  I think we know that consumers have lost a lot of wealth and that normally what you’d say is they should be saving more.  I think the truth is consumers have also not done a lot of spending for the last 14 months.  So what I would predict and I think would be a perfectly reasonable thing is you go out and you buy that car that you’ve been thinking about for 14 months and you do some of the spending.  And then over the long haul I’m hoping we’ll come back to probably a higher savings rate, because we know we were at kind of a historic low before this all happened.

But that is exactly the wrong prescription for the long-term health of the economy, or its constituents.  Spending, borrowing, and consuming are not responsible actions in an economy overburdened with debt.  And “hoping” won’t get us a higher savings rate: higher interest rates will.

Though it may seem initially painful, the truly responsible course of action is to allow interest rates to set to their market levels, allow those banks which made remarkably poor business decisions to go out of business (instead of subsidizing them as we have been), and give the market time to readjust back to a healthy level.

Posted in Article | 4 comments

4 Comments so far

  1. Stacey Derbinshire March 15th, 2009 6:01 pm

    Just wanted to say HI. I found your blog a few days ago on Technorati and have been reading it over the past few days.

  2. admin March 15th, 2009 7:16 pm

    Thanks! I hope you enjoy it! I’ll check out your site.

  3. Curt March 18th, 2009 5:00 am

    A short piece I found in the WSJ today
    essentially says that rates need to actually go lower (by 8%) to fight off deflation. What are your thoughts about interest rates relative to deflation?

  4. rick March 18th, 2009 8:43 am

    Great question!

    Inflation is a devaluing of the dollar because more dollars were printed and put in circulation. When the Fed relaxes reserve requirements (allowing the banks to issue more loans against their deposits), that has a similar short-term effect — the same effect you’d get if you went on a spending spree on your credit cards. But eventually the credit card bills come due, and you have to pay them off, so the spending spree comes to a halt, and your budget is reduced even more because now you’re paying off your cards, too. This feels like deflation, because you have less money to spend (since you’re now supporting debt).

    A lower interest rate reduces your interest payments, thus reducing the effect — which is probably where that WSJ article is coming from. Unfortunately, it also encourages continued borrowing and spending. So (for example) if your interest rate were zero you could pile up the debt as high as you like, since there is no penalty whatsoever.

    But there’s only so much money to go around, and as the debt gets higher and higher, the demand for money to borrow gets higher, and the supply of it gets lower, which means the creditors need a higher interest rate to be induced to commit their money to your spending spree. So you have a market force getting stronger and stronger requiring higher rates, balanced against a government policy that is artificially keeping rates low. When that happens, eventually the market forces always win.

    So by lowering rates, in the short-term we can get the illusion of decreased deflation, but we just encourage more borrowing and spending, and more debt. We may put off the day of reckoning for a while, but when it hits, it will be even worse.

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