Thursday, 25 June 2015

Interest Rates – low but not low enough

Interest rates may not be low enough to get us on the road to recovery but falling prices should help

Something strange is afoot in the economy.  With interest rates at record lows in many countries, borrowing should be booming and saving on the decline but the opposite is true.  This suggests that the economy remains out of kilter without interest rates being able to set the right balance between savings and investment.  Instead, the shortfall in demand due to limited investment and weak spending may be dragging down prices as a means to put the economy back to health.  

Not so free market

The self-healing ability of any economy is one of the central tenants of economic theory.  Prices adjust as a means for the economy adapting to any changes.  For example, an increase in the supply of bananas will trigger a fall in prices and more people eating bananas.  A rise in companies looking for software experts would drive up their wages (the price for labour) and the number of people wanting to learn more about computers.  Through changes in these prices, the economy moves toward an equilibrium where everything is at appropriate levels.

Interest rates act in the same way acting as the “price of money” to make sure that there is neither too much nor too little savings or investment.  Lower interest rates are used to make borrowing cheaper and savings less worthwhile.  This was the course of action taken by central banks in order to stimulate the economy by attempting to boost investment (funded by lending) and spur on more consumption (due to lower savings).  Quantitative easing adds to this by giving banks more money to lend and less need to entice people to leave money in the bank.

Still waiting

The continued wait for a robust recovery suggests that something remains amiss.  The lack of appetite among companies to expand their operations by borrowing is both a cause of and caused by weak demand in the overall economy.  Spending by consumers is also faltering with people happy to let money mount up in the bank despite the low returns on savings.  The high levels of household debt that still persist are another reason for consumers to hold back from spending.

The persistence of the state of low investment and high savings suggests that monetary policy has not been enough to get the economy back on the right track (although it has helped to prevent a financial collapse).  A further loosening of monetary policy is not on the books for most central banks.  Interest rates cannot be lowered much further considering that negative interest rates are difficult to implement.  Quantitative easing also seems to have run its course while increasing creating negative side effects

Where to next?

The inability of interest rates to adjust is hampering a return to economic growth.  With interest rates not able to go any lower, it may be the case that it is prices which are instead moving to get the economy back to equilibrium.  That is, rather than interest rates falling to balance out weak lending and growing savings, prices are being depressed by the lacklustre economy.  The hopes for economic recovery rely on cheaper prices spurring on more spending thanks to consumers felling richer.  Further impetus would result from the extra spending helping to push up investment and lift the economy to better match the current level of interest rates.

This route back to recovery may take time considering that any decline in prices will be limited and wage gains have yet to take off.  There are ways to push this along of which easiest way would be for governments to temporarily increase spending.  Money used for investments in infrastructure or training and R&D in new technologies would be worthwhile at a time of low interest rates.  Another alternative would be for central banks to use their money-printing capabilities to transfer cash to consumers.  This more radical option would provide a short-term boost to spending.  Sometimes we all need a little bit extra to get us back on track and the economy is no different.


  1. You seem to subscribe to the Krugmann IS/LM nonsense. Even the creators of that idea have admitted it was never meant to represent reality. Krugmann with his massive ego will never admit his model is wrong. He just finds an excuse such as the strange, "liquidity trap" idea, which even he said, renders his model unusable in that situation.

    The "self-healing" of an economy is another piece of idiocy which igmores real life and the action of capitalists, policy makers, central bankers and global competition all acting in different directions.

    I cannot see that there is any one "equilibrium" that an economy moves towards. It is one humongous mulitvariable system with myriads of random events.

    What is amiss is that the economic theories bandied about are simply not up to the job.

    Your statement, "Quantitative easing adds to this by giving banks more money to lend" is way way way off the mark, and displays the current ignorance amongst economists and politicians of how the banking system functions. Banks DO NOT lend out of reserves and banks DO NOT lend out depositors' cash. They are NOT intermediaries between depositors and borrowers.

    Banks simply create out of nothing the debts and simultaneously the deposit to fund the debt.

    Without this basic and fundamental precept of how the money creation works in the finance system, and integrating it into economic models, all economic models are doomed to failure. Which they are anyway, because we are dealing with fickle humans, who have a herd mentality, and governed by a bunch of decision makers with their own interests constantly in mind.

    A recent article in the Telegraph stating that the UK hardly works at all, it is difficult to see why they should receive any salary increase until they put in a full day's work. Fully 10% of UK workers state that they work 30 minutes each day!

    And pop this paper into your theory about interest rates and prices.

    Huge productivity increases in food production, and moves towards stopping the incredible waste of food we decadent Westerners chuck away every day.

    And check out how many gadgets are being shrunk into one smart phone. Instead of ten different bits of stuff, it is all integrated into one device.

    Pissing about with IS/LM and interest rates is just a totally blinkered approach. Might be nice for the stupid politicians, "Oh, we only have to tweak the interest rate and all will be hunky dory".

    But it won't work.

    What might improve things is more focus on differential interest rates across the economy and government policies to determine where the banks should be lending money. Currently most lending is going into pumping up house prices, a non-productive asset, and the main reason why people have little discretionary spending. It is all going on rent or mortgage repayments.

    1. Thanks again for your comments.

      I studied economics at university after finding it useful to understand the world around me. So you will have to excuse me if I remain somewhat wedded to the ideas that I learnt and wanting to use the bits of economic theory that I still find useful.

      The ideas for this blog posting do not rely on the IS/LM model but more basic ideas on the role of interest rates in the economy. Economic theory struggles to explain why you would have surplus saving and little investment so the blog posting was an attempt to find an explanation.

      I agree with your comments on the inability of "financial tweaks" to fix the economy. In this blog, I have argued for more expansionary fiscal policy and monetary policy which puts cash in the hands of consumers rather than banks.

      I also agree with your comments on where bank lending comes from. Banks have the ability to create cash from nothing but that does not mean that quantitative easing has not provided extra liquidity for the banking sector at a time of heightened concerns about cash reserves.

      However, as you may imagine, I do not share your skepticism about the usefulness of economics. It is true that much of economic theory has proven to not only to be irrelevant but also misleading. But I still hope that lessons can be learnt and something can be salvaged. Ideas like a "self-healing" economy and an economy moving to "equilibrium" may seem antiquated but still have some relevance. Capitalism would not have made it this far if economics did not provide policymakers with some useful insights.

      This has just been a general reply but please let me know if there is anything in particular that you think might require further explanation.