|Guest Post: How low interest rates screw up the economy|
Dec 14, 2010 Ben Rabidoux financialinsights.wordpress.comHat tip to Caleb over at TANSTAAFL CANADA! for this excellent post explaining how low interest rates screw up the economy, a common theme on this site. Caleb has given his permission for this re-post.
My favourite thing about getting news online are the comments. No longer do letters to the editor need be to thought-out and expressed coherently. No longer are the opinions of the readers filtered through the editor’s pick-and-publish criteria of newspaper letters. On the internet, one can read a story and immediately comment on it. Then other people can disagree and before you know it, the comment section has become an online debate.
This post is a brief overview of what interest rates actually are, and why keeping them artificially low destroys the economy.
Note – this is the simplistic version. Things are more complex in reality, but this brief overview should give you some understanding behind interest rate numbers. For more information you could go get a PhD in Economics, use Google or watch this: http://www.youtube.com/watch?v=jFqtTj7TeO0
In a free market economy interest rates represent the amount people are saving and investing for future consumption. The more people save, the more money there is in the bank. When banks finds themselves with an overwhelming supply of money they offers less interest on personal savings. When the supply of money is limited, then banks offer higher interests on personal savings (this is simply supply and demand).
These long-term projects eventually bear fruition when people start withdrawing money from the bank to spend. As savings are reduced, the interest banks offer on money rise. This, again, indicates to entrepreneurs that people are consuming in the present. Businesses can still plan for long-term projects, but the interest on loans is higher.
That’s a very basic overview of how the system is supposed to work. Now let’s examine what happens when central banks or governments decide to play around with interest rates.
Let’s say the interest rate is at 15%. Without any involvement from the central bank, the 15% shows that people are spending in the here and now. It’s expensive for people to take out loans, particularly for entrepreneurs wanting to expand their business.
Lo and behold, for whatever reason the central bank slashes interest rates down to 5% (right now Carney’s got it at 1%). You’d think the mass of people would realize their savings haven’t increased, it’s just an arbitrary policy enacted by our central planning authorities. But, for whatever reason the market behaves as if real interest rates really were 5%.
Remember that lower rates also indicate to businesses that people are saving their money and that investment in long-term projects is a viable goal. But since these interest rates are artificially low, the fact is is that nobody is saving their money for future consumption. People continue to consume as businesses embark on long-term projects.
The best, and most recent, example of this is housing. People are piling on debt, consuming everything in sight. First things first, they want a house. The housing sector has to keep up with consumption in order to maintain profitability, so they want to build more houses. The longer interest rates remain low, the more houses are going to be built and the more people are going to buy them via credit.
Left too low for too long, bubbles begin to form. The way to burst a bubble is to raise interest rates. When this happens it becomes apparent how messed up the economy actually is.
The problem isn’t that consumers were spending too much or that businesses were overproducing – the problem is that these resources were misallocated. Normally, interest rates would indicate consumer preference and businesses would allocate resources accordingly. When the central bank messes up the fundamentals, malinvestments are made. Entrepreneurs are still allocating resources for profit, as they always do, but the profit is from phony wealth via low interest rates.
A rise in interest rates makes it apparent that it is unprofitable to continue misallocating these resources. Consumption, too, slows down as it becomes harder to finance debt. This is the bust, the part in the business cycle that people call a recession. As one can see, the recession is actually the cure to the “boom” period prior to. As the economy liquidates all the bad debts, prices (and wages) fall to correct market levels where people begin saving again.
Unfortunately instead of returning to sound free market principles, central bankers usually begin lowering interest rates again, as soon as the economy recovers. In a recession further lowering of interest rates causes all kinds of havoc. The economy can’t restructure itself as more malinvestments are made.
Bank of Canada Governor Mark Carney’s modest interest rate rises last year weren’t enough to ward off Canadian malinvestments. Not that he could, once you get this beast going there is no “soft landing”. The longer Carney waits to burst the bubble, the more misallocations businesses are going to make and the worst the bust is going to be.
That’s my brief interest rate overview. Be sure to scroll back up and watch that video I linked to before. It’ll give a more in-depth explanation of how central banking, instead of smoothing out “free-market volatility” actually f*** up the economy.
And they f*** it up big time.
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