Devin Helton

Interest rates have been a hot topic in the econo-blogosphere. Rookie blogger Ben Bernanke has written a series of posts on why rates are so low. Now Professor Scott Summer writes:

Let’s start with the term ‘artificially’—what does that actually mean? OK, but how would we establish whether the equilibrium interest rate is “artificially” low or high? There’s really only one set of criteria, which (AFAIK) were first modeled by the economist Knut Wicksell. He referred to the natural interest rate as the rate that would lead to macroeconomic equilibrium.

To us heterodox, non-state sponsored econophiles, the natural price of anything is the price based on the supply and demand of a free market. The interest rate is simply the price of future money. The natural interest rate is the rate that equalizes supply and demand between those who wish to consume or spend on capital goods now and those who are willing to forgo the current use of money for greater consumption later.

Saying that interest rates are “artificially low” is not to say anything particularly novel or interesting. Interest rates are massively influenced by both the actions of the Fed and Byzantine set of subsidies from the rest of the government, (such as the state sponsored agencies that sop up mortgages and student loans, government mandates that require pension funds to own bonds, etc.). Thus all interest rates in the modern financial system are “artificial.” Particularly low interest rates are thus “artificially” low.

Semantics aside, let me address the Scott’s other points:

If rates were artificially low in the UK, then we ought to see either high inflation or high productivity growth. But both of these variables are growing very slowly.

There is no fundamental reason that this needs to be true. The existing financial system is massively complex. So to understand the mechanics, let us use a simplified model:

Imagine an economy where the government prints money to increase the money supply by 2% a each year. The government issues the newly minted money in the form of tax rebate checks. There is no Fed nor any other government intervention in lending. This is a very simple free market economy. Interest rates sit at 5% due to the intersection of supply and demand for future money.

Now the government changes policy. It still prints out 2% in new currency each year. But it now distributes the new currency by lending it out, by auctioning off loans. If the government injects massive amounts of money on the supply side of a market, it will drive the price down. By injecting massive amounts of cash into supplying new loans, the government drives down the price of loans, drives down the price of present money. Interest rates will fall, interest rates will be “artificially low.” Yet, the same total quantity of new money is injected into the economy. In this model, the new money being loaned out comes at the expense of money that would have been refunded to tax payers. After this intervention, average tax payers no longer get nice tax refunds with which to remodel their kitchen. Instead, they will borrow money at these super low rates to remodel their kitchen.¹ So the same amount of money chases the same total production. Neither productivity nor inflation rises. All in all, interest rates are much lower, interest rates are artificially low, but the overall measures of the economy remain the same.

Wicksell’s theory is hogwash. There is not one rate of interest that maximizes employment. In reality, the economy can adjust to many different interest rates. What causes disequilibrium, unemployment, and recessions, are the particular bugs and poor designs of the banking system, which create cycles of debt inflation and then debt deflation. To help counteract these cycles, the Fed tries to intervene in interest rates. But these interventions are not necessary due to some fundamental laws of economics, they are triggered by particular bugs in our particular system.

If rates were artificially low, then attempts to raise them should be successful. But recent attempts by central banks to raise rates have all gone poorly.

The Fed cannot raise nominal interest rates, because the rates have been too low, for too long. It is as simple as that – existing firms and people are addicted to the current rates. Raising the rates will be like quitting heroin.

My general theory of the business cycle is that depressions are caused by a collapse in paper net wealth, a collapse in balance sheets. People see their home equity fall, their stock prices going down, etc, and realize they are not as rich as they thought they were. The immediate reaction is to delay spending on durables, construction, luxuries, anything that can be delayed. This causes unemployment as those industries lay people off, due to lack of need. The layoffs and falling stock prices causes more panic, often feeding upon itself.

During each economic cycle, the Fed has responded with lowering interest rates, each time making the economy more dependent on debt. For instance, a new and very unhealthy phenomena in the past few years is for companies to issue debt to buy back shares. If interest rates rise, companies will have to stop the practice and pay the debt down. This will be very painful for stock prices.

So, in 2015, if interest rates were raised:

• Construction projects financed by low interest rates would be deferred or aborted
• Debt payments would increase, companies profit margins would get squeezed, companies would have to tighten their spending a bit
• Housing prices would decline
• Share buy-backs financed by borrowing would come to a stop. And remember, simply the withdrawal of existing buyers causes stock prices to fall.
• Bonds become more attractive relative to stocks, causing people to shift money into bonds, and stock prices to fall

The net result will be a fall in stock and home prices making people feel poorer. You will have a stoppage in construction projects causing unemployment. When people feel poorer, they cut spending, especially in durables and luxuries. Producers of those items cut jobs, since they are producing and selling less.

So in all, the existing production structure is dependent on the current low interest rates. If interest rates were raised, you would get a nasty recession. Hence the Fed is scared to raise interest rates.

This dependency on low interest rates have nothing to do with any “real” economic factor such as the limits of growth or Baumol disease or anything else. It is purely based on the structure of paper wealth, the structure of existing debt contracts.

The hard libertarian view is that we should suck it up, allow interest to rise to their natural rate based purely on time preference, sans intervention by the Fed, and endure the pain of the heroin withdrawal.

In my view, there is a methadone option. The government could raise interest rates, but at the same time prop up paper wealth. It could buy up stocks (and retire the shares) to keep stock prices up, issue more home buying tax credits, allow corporations to replace short term debt with long term debt at the current low rates, etc. If done carefully over a couple years, there could be a transition to higher rates without too many ill-effects.

In reality, the government has neither the talent, will, political cover, nor asabiya to pull off the methadone option, and so we are stuck.