09 Jan 2010

How (Falsely) Low Interest Rates Screw Up the Economy

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I just made a fairly long and technical post, which I’m sure half of my readers will skip. Let me say it in plainer English:

Loosely speaking, the market interest rate allocates the available financial capital among various possible investment projects. The equilibrium interest rate is j-u-u-s-t right so that people save exactly the amount of money that other people want to borrow.

Although we think of it in terms of money, there is a corresponding physical reality to all this, too. If entrepreneurs see hot new investment projects and want to start hiring workers and buying raw materials to get started, those workers and resources have to be redirected away from other things.

Ideally, if everyone in the community wanted to cut back on eating out once a month, in order to save up for a summer cruise in 3 years, what would happen is that their spending and saving decisions would (a) cause layoffs in the restaurant industry, and (b) lower interest rates enough to make it profitable for the people in the cruise industry to borrow money to start building more ships and training more crew members. Obviously in the real world things would be messier, but the point is that market prices–especially interest rates of various maturities–would help with this transition.

Now what happens if the government comes in, prints up a bunch of $100 bills, and starts lending them out to borrowers at lower rates than what the original market interest rate was? Obviously that will totally screw things up.

Even if people are fully aware that there’s a guy throwing funny money into the works, they can’t not borrow at the lower rates. That would only work if they could trust every single person in the whole economy to not take the crisp new $100 bills from the Fed official, even though he was offering to lend them at lower terms than the other people offering equally-legal $100 bills.

The point is that it can’t be the case that this handing out of new money is benign. People end up borrowing more money than they otherwise would have been able to get. Even a particular entrepreneur who knows there is a bubble, and knows interest rates will eventually shoot up, and who gets out in time, has still screwed things up. In other words the damage caused by the Fed guy handing out $100 bills is not simply the borrowers who get caught with their pants down when rates shoot up earlier than they thought.

No, from DAY ONE, when people borrow more money at the artificially low interest rate than they should have been able to borrow, the structure of the market starts diverging from what it should have been. If you think “rational expectations” should allow people to offset everything, then you are really saying the market interest rate serves no function.

If you admit the market interest rate means something–that a businessperson needs to know, for example, whether the one-year rate is 3 percent versus 2 percent–then you have to admit that it screws things up if the government pushes down the original 3 percent rate to 2 percent.

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