How Long Will Interest Rates Stay Low?

A very good question. Back story here. These are the words.

How Long (Will Interest Rates Stay Low)?
by Merle Hazard
(c) 2016

Chorus 1
How long (how long) will interest rates stay low?
That’s the question, the whole world wants to know
How long (how long) will interest rates stay low?
It seems like if they’re going up, they’re going pretty slow

Verse 1
Our country’s central bank is really scared, that’s plain to see
When everything is leveraged, raising rates is misery
But keeping rates too low, too long, would cause us pain and sorrow
There is no easy option in a land of constant borrow

Chorus 2
How long (how long) will interest rates stay low?
That’s the question, the whole world wants to know
How long (how long) will borrowing be free?
How long will we be subsidized by savers and retirees?

Verse 2
Central banks around the world, not only in the States
Are each at work on lengthy slumps, their countries’ tragic fates
Legislatures will not spend to give sufficient boost
Lower interest rates are all that’s left to get their countries juiced

Chorus 3
How long (how long) will interest rates stay low?
If you could predict it, you could make a lot of dough
How long (how long) will interest rates stay depressed?
The answer…is anybody’s guess

Verse 3
Some say low rates are symptomatic, rather than the cure
I have a hunch they’re right. I can’t say I am sure.
But recovery has been long and slow, the crisis wounds are deep
So until we see inflation, money’s likely to be cheap

Chorus 4
Instrumental solos

Verse 4
Capital’s abundant, money’s not in short supply
China holds our Treas’ry bonds, although I wonder why
Start-ups happen in the cloud, few people are employed
If something could push rates back up, I’d be overjoyed

Chorus 5
How long (how long) will interest rates stay low?
That’s the question, the whole world wants to know
How long (how long) ‘til we really start to grow?
Interest rates are goin’ up, but they’re go-in’…pret-ty…slow….

And here he meets Arthur Laffer! Leads to another song about bond traders and even Milton Friedman.

More economic incompetence coming our way

Modern economics is so incompetent to deal with the problems of our economy that it is simply breathtaking. This is the headline at The Oz: “Reserve Bank paves way for further cuts in official interest rates”.

His comments come against a backdrop of deteriorating economic data: house prices and building approvals are falling, while the national economic growth rate dropped from 3.4 per cent to 2.8 per cent, it emerged this week, surprising economists.

Speaking at the Australian Business Economists annual dinner, Dr Debelle said the federal government had room borrow and spend to stimulate the economy, if needed.

These people do not, of course, have any idea why the economy is floundering. They have kept rates low since the GFC and public spending has never been higher. Of course, a major part of the problem is that rates have been too low and public spending has been too high, but they would be the last people to know. Look at what he even said:

“Fiscal space is really important; we still have that in Australia,” he said, backing former Treasurer Wayne Swan’s controversial $52bn fiscal stimulus of late 2008 and early 2009, which saw $900 payments to households, help for first home buyers, discount roof insulation and a school hall building boom.

“Fiscal stimulus in Australia in my view was absolutely necessary and was a critical factor behind Australia’s good economic outcomes,” he said.

Unbelievable. No idea how an economy works but they will bludgeon it again until it finally responds to treatment. And there is not much doubt we are heading into an economic sinkhole that Treasury and the RBA have between them created.

The GFC is now a decade past and we, along with pretty much everyone else, have never had even an inkling of a robust recovery. Amazing.

A dark age coming

The headline story in The AFR today begins:

The federal government has slammed plans by business to go it alone on climate and energy policy but industry leaders are holding their ground and have the backing of Labor and the Greens.

It’s a new world out there.

Meanwhile, in the US: Is The Fed Trying To Tank The Trump Economy Before The Midterms? Want to breed uncertainty? Try this on for size:

Dallas Fed President Robert Kaplan said he still favors the central bank raising short-term interest rates three more times before deciding whether more increases will be necessary to keep the economy on an even keel.

This suggests the Federal Reserve should lift rates at its December, March and June policy meetings “unless something changes,” Mr. Kaplan said Tuesday in a Wall Street Journal interview.

Fed Chairman Jerome Powell said then that rates remain low enough to continue stimulating economic growth. But according to the Wall Street Journal other officials have expressed a range of views, and some uncertainty, about how high rates would have to go to reach a so-called neutral level that neither spurs nor slows growth.

A COMMENT ON RISING RATES: I have been asked about rising rates in the comments. And as I have said in the past, rates have been too low for too long which has lowered the productivity of our array of investments. The issue is not whether rates should rise – they should – but whether they should rise now immediately before an election. The effect on share markets was obvious enough. Front-page treatment of a falling market can move voter sentiment, specially the way it can be played on by the media. The Fed kept rates down throughout the Obama presidency and there was never any doubt it would push them up once PDT was elected. Optics is all, and even if the adjustments brought on by higher rates are positive for the economy, it may not look that way to anyone who is paying out more on their mortgages or small-business loans.

Do NOT raise taxes and do NOT lower rates

If the Government’s suicidal tendencies continue, there will be no saving them from their own idiocies. It’s not even that raising taxes is politically popular. It is absolute voter poison. Raising taxes is guaranteed to lose you the next election.

But what makes it worse, is that raising taxes is also economic poison. The Treasurer has his eyes firmly fixed on 2055, forty years from now. I wish he would occasionally also glance at 2016 and 2017, which also happens to be when they will be trying to get re-elected.

It is bad economic management to raise taxes in a recession. Let me say this again with emphasis: It is bad economic management to raise taxes in a recession.

You have to stop looking at things from the perspective of those dunces in Treasury. All they can think of is how are they going to find the money for all of those programs you and Labor have committed us to?

If you really do think that recovery is in any way promoted by government spending, other than in a very very narrow and select range of areas, then you have not even got to first base in understanding how an economy works. Stop listening to these people and start thinking about who you really want to put purchasing power in the hands of.

It is business and the private sector that will give you growth and lower unemployment. It cannot come from any other source. And if you think that business will be encouraged by hearing that the budget deficit is fractionally lower, then you are so far off the beam that I don’t know where you think you are. Business is encouraged by making money. The economy grows through productive investment. Jobs and real increases in income are based on faster rates of private sector growth. If you think private sector growth driven by some form of government-financed activity is the same, then your whole basis of thinking about these issues is a FAIL.

And then there are the supposedly popular cuts to interest rates. Here’s a small test. Suppose interest rates went up by a quarter of a percent (which is what they should do, but won’t). You tell me: what would happen to the housing market? It would stall and possibly crash. Housing is already unaffordable. Why would you want to continue to finance a bubble that has now trapped every government so deeply, that it seems almost impossible to imagine rates going up any time soon. Although given past history, they will, in the month before the next election.

The Australian School of Economics

There really is a different way of looking at economic issues in Australia, which is why we are still one of the most successful economies in the world. Two items from the news today, both of which go entirely against the world consensus on economic management. First, from The Australian, Rate cuts failing to bite: RBA. The opening paras:

INTEREST rate cuts are losing the ability to stimulate the economy, with the Reserve Bank warning that it is up to the government to take measures to help revitalise growth.

In a frank admission of the limits to the influence of central banks, Reserve Bank deputy governor Philip Lowe said consumers, businesses and governments were not responding to the extraord­inarily low interest rates that would once have sparked an inflationary debt boom.

The notion that interest rates can be too low is something almost no one can follow if you start with a standard macro model. Arbitrarily lowering interest rates will, in fact, make things worse but who any longer understands even why that might be the case. And if you are looking for what is truly unique about how we go about things, think about this, from the new Secretary of the Treasury, John Fraser:

[Fraser] declared to the Senate Economics legislation committee: “I do not resile from the point that I do not think spending our way out of lower economic activity is the way to go.”

Once, such a view was uncontroversial. Today, practically every international economics organisation preaches the opposite.

How against the consensus grain is all of this. If you want to find your way out of recession, keep interest rates up and lower public spending. And if you are looking for a theoretical explanation of why this is so, there is nowhere else to go other than the second edition of my Free Market Economics. And if you would like some idea of just how unique this book is, this is from an article I am in the midst of writing on the role of the entrepreneur in economic theory:

I have examined each of the following introductory texts because they happened to be on the shelf in our library, and there is either no reference to the entrepreneur found in the index, or the text contains only a perfunctory mention, never continuing for more than a page: Abel and Bernanke (2005); Blanchard (2006); Lipsey and Chrystal (2007); Mankiw (2007); McConnell and Brue (2008); McTaggart, Findlay and Parkin (2006); Parkin (2008); Samuelson and Nordhaus (1995); Sloman and Norris (2010); Stiglitz and Walsh (2006). It is clearly possible to discuss the operation of a modern market economy without mentioning the single most important function in allowing the economic system to work. There is not the slightest doubt that even if the most recent editions had been to hand, nothing would have been in any way different.

The Australian School of Economics can explain the role of higher interest rates, balanced budgets and the entrepreneur and with these concepts in hand explain how an economy works and what needs to be done to get recovery firmly in place.

Cochrane may think he’s anti-Keynes but he doesn’t go far enough

I am happy to find that others see me in the way I see myself, as a centre for anti-Keynesian thought. The article by John H. Cochrane in the Wall Street Journal with the title, An Autopsy for the Keynesians, made its way to me from a number of directions. I am, of course, content to see Keynesian economics being hammered. But the fact remains that so far as I am concerned, Cochrane makes only an averagey sort of anti-Keynesian. I shouldn’t quibble since slagging Keynes is all to the good, but he needs to go farther.

The essence of classical economics, and the core point made by Say’s Law, was that the economy NEVER receives momentum from the demand side. You cannot make an economy grow by buying more, only by producing more. And even that’s not enough. The “more” that is produced will make an economy grow if, and only if, the value of what is produced is greater than the value of what had been used up during production. Demand is created by value-adding supply. Here is the excerpt from Cochrane’s article that leaves me unsatisfied; I don’t think he quite understands it himself.

Keynesians told us that once interest rates got stuck at or near zero, economies would fall into a deflationary spiral. Deflation would lower demand, causing more deflation, and so on.

It never happened. Zero interest rates and low inflation turn out to be quite a stable state, even in Japan. Yes, Japan is growing more slowly than one might wish, but with 3.5% unemployment and no deflationary spiral, it’s hard to blame slow growth on lack of “demand.”

Keynesian policy has now mutated into a policy of low interest rates, again with the intent of trying to make the economy grow from the demand side. You need to go to the final two chapters of the second edition of my Free Market Economics, where the problems of low interest rates are discussed, to understand the problem. As he says at the end of the article:

Yes, there is plenty wrong and plenty to worry about. Growth is too slow, and not enough people are working.

He doesn’t see that low interest rates are the very essence of the problem, even after all the spending has slowed down. I will think he has finally got it when he starts worrying about quantitative easing, and recognises that rising interest rates are what is needed if recovery is every to take hold.

Central bank policy

Central banking has as many different approaches as there are central bankers. The aim of central banks is to provide oversight and stability to the financial system which gathers in national savings and disperses those savings to those who can make the most productive (that is, profitable) uses of them. Saving is undertaken individually by putting money aside for future use. But from a national economic perspective, saving is precisely the use of resources to strengthen the economy through productive investment. Watching the two separate streams – the money stream and the real resources stream – and keeping them separate while at the same time being aware of how they interact, is crucial if one is even to have the most basic understanding of the processes involved.

There are real resources (bricks and mortar, labour and machines) that can be used in a variety of productive (and non-productive) enterprises. But the only way for a business to get their hands on these resources is first to get the money that will allow it either to buy, hire or rent the inputs it needs. Thus, what the financial system does is lend money as the intermediary to securing the various resources needed.

There are no end of various financial intermediaries who receive money with the promise to return an even greater amount of money at a later date. Banks, insurance companies, superannuation funds, building societies, share markets and the list goes on. Money comes in because there is an expectation that an even greater amount of money will come out later.

Lots of people want to take your money, and will do that with the promise that they will give it back with interest. The only way they can do that is to lend the money to others who use that money in a value adding productive profitable way. They then repay the financial institution from their receipts which then repays the people from whom they had initially received the funds. The economy grows so long as the people who took the money have used those funds to build productive profit-making assets.

Financial institutions that do not lend to businesses which make a positive return, find they have lent to businesses who cannot repay their loans. The businesses go bankrupt, and for financial institutions, if enough of their borrowers fail to repay their debts, the financial institution will also go bankrupt.

Central banks keep an eye on the entire process, but their two major roles in every economy have always been (1) to keep solvent those financial institutions that run into temporary difficulty and (2) ensure that the financial system itself does not collapse because of a failure of enough liquidity to allow commercial transactions to take place. The role of central banks during the GFC was exemplary. Just what was needed.

Central banks have now taken on an additional role which is to adjust interest rates to affect economic activity. Interest rates will, of course, be generated without a central bank so its role is totally superfluous so far as interest rates are concerned. But many like this role since it seems to provide a form of stability. For myself, the stability is illusionary. They only provide a talking point but can never really do what is needed since they cannot know with sufficient detail about the future state of economic activity. No one else does either, which is why it should be left to the market to sort out all of the contrasting sentiments found across the economy.

But now central banks also adjust rates with the intention of stimulating economic activity and sometimes even slowing it down to slow inflation. Low interest rates are seen as a positively good thing since supposedly it will stimulate investment. But it is noxiously misguided because low interests have all of the following effects:

  • reduces the supply of saving
  • reduces the flow of real resources into the economy
  • misdirects investment since low interest rates allow borrowers with low productivity investments to secure funds ahead of others with riskier but more productive investments
  • lenders are able to choose their friends to lend to since there is an excess supply of funds relative to the period when rates were kept higher
  • money goes into the purchase of readily available forms of assets such as housing or shares
  • governments, who are almost invariably low productivity borrowers, find it easier and cheaper to borrow.

The result of such low interest rates:

  • price bubbles in share markets, housing or other types of value-holding fixed assets
  • higher inflation which may come in the form of higher prices, or if prices are unable to rise, a crumbling asset base across the economy leading to an ageing and decaying capital base
  • slower growth
  • higher unemployment
  • a fall in living standards.

Unnaturally lower rates of interest lead to prolonged periods of depressed economic activity which, given the useless way we teach economics nowadays, hardly anyone understands, while at the same time there is no political constituency for a rise in rates since those who borrow become infuriated at any government that happens to be there when interest rates begin to rise.

For a more detailed discussion, see Chapters 16 and 17 of my Free Market Economics. The 2nd ed will be even clearer on this than the first.

The menace of low rates of interest

Here is the text:

The Reserve Bank of Australia recently lowered its economic growth estimate for the upcoming calendar year to 2 per cent to 3 per cent from an August forecast of 2.5 per cent to 3.5 per cent.

It has cut interest rates eight times over the past two years in an attempt to boost spending to help ease the country’s transition to a less mining-dependent economy as a long resources boom cools.

As they tell it, the fall in growth rates is in spite of the fall in interest rates. As I tell it, the fall in growth rates is because of the fall in interest rates.

Low interest rates are not a good thing as I explain to my classes. Pull them down at the height of a panic but the rest of the time they should be kept relatively tight to ensure our savings are directed to their most productive users. You can’t get a recovery based on lowering rates. It’s from the same Keynesian stable that believes that economies are made to grow from the demand side.