Challenging the Low Interest Rate Religion

In The Unintended Effects of Bad Policy (May 18th), I wrote that:

[L]ow interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like "pushing on a string." There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world's carry trade currency of choice. Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical.

The test of such a statement would be a country which is raising interest rates, while the rest of the world keeps them low. This week, Australia has provided us with such a test. Their central bank has raised interest rates, and so far, Australian equity markets have moved higher

I would argue that their central bank's decision to raise rates will incentivize capital to move from countries with anemic interest rates to Australia, which will (everything else being equal) benefit their economy and equity markets. Currently, central banks around the world operate under the erroneous assumption that anemic interest rates are stimulative. I have argued that ultra low interest rates increase asset prices rather than stimulate the real economy. Australia should benefit from its rate increase. Of course, only time will prove the point.

Hopefully, the world's central bankers and economists are taking note.

Disclosure: Long EFA. Positions may change at any time.

Comments

[chap08:]

Wrong on several counts.

Australia is not a test of your theory. Australia is a strong economy that is directly exposed to growth in emerging Asia. They feed China et al with natural resources. This will keep Australia's economy and stock market strong. They can afford to raise rates.

Quoting from the RBA statement:

"Growth in China has been very strong, which is having a significant impact on other economies in the region and on commodity markets"
"Economic conditions in Australia have been stronger than expected"
"Unemployment has not risen as far as had been expected"
"Housing credit growth has been solid and dwelling prices have risen appreciably over the past six months"

Does this sound like the US today? Does it sound like Japan over the last 20 years? Japan was no proof of your theory. They had no effective monetary policy until 2001, and even then they weren't strong enough. Liquidity was not sucked out of the country. The problem was that there were no good investment opportunities internally due to a declining economy and ineffective action by the government and BOJ.

If you want to see the effect of raising rates on a weak economy, look at the US in the early 30s. It was a disastrous policy. The same would be true for weak economies, such as the US, today.

Oct 07 06:37 AM

[Harry Long:]

Where do I begin?

No investment opportunities in Japan? Oh, I forgot, Toyota and Honda aren't real companies like GM, Ford, or Chrysler.

Ineffective action by the gov and BOJ? It was very effective, if keeping zombie banks alive and not forcing them to write down loans is the goal (hence, my point).

To your point about the 30's, low interest rates do not stimulate the real economy, they affect prices. Half of the U.S. monetary base was wiped out when banks failed. You blame the weak economy on interest rates against that backdrop? Wow. It's time to embrace evidence-based thinking.

Oct 07 09:26 AM

[Harry Long:]

You whole assumption the low interest rates stimulate the real economy (as opposed to increasing prices) is common. However, this seeming "logic" is as widespread as it is wrong.

For example:

A main condition for stable and profitable growth is low inflation.

Inflation kills demand in terms of the aggregate quantity of goods citizens can afford. It doesn't spur it.

For instance, for families with fixed budged constraints (a fancy term for incomes), if the price of Tide goes up by 20%, the family either buys 20% less quantity of Tide, or less of something else in order to still afford it. But their income is unchanged. They can afford less of everything. The economy is hurt, not helped. When citizens can afford less goods, businesses lay off even more workers. Less quantity of goods can be afforded, businesses earn less or go broke, more workers are laid off. It' a simple and vicious cycle.

But, the socialists will proclaim, incomes will rise as well, negating this effect. Go to your boss and ask for a raise. See what happens. Inflation kills economies.

As Milton Friedman recollected of du Pont's famous adage "we do not have to be gracious at all to inconsistent logic or absurd reasoning. Bad logicians have committed more involuntary crimes than bad men have done intentionally." No society has ever prospered from inflation.


On Oct 07 06:37 AM chap08 wrote:

> Wrong on several counts.
>
> Australia is not a test of your theory. Australia is a strong economy
> that is directly exposed to growth in emerging Asia. They feed China
> et al with natural resources. This will keep Australia's economy
> and stock market strong. They can afford to raise rates.
>
> Quoting from the RBA statement:
>
> "Growth in China has been very strong, which is having a significant
> impact on other economies in the region and on commodity markets"
>
> "Economic conditions in Australia have been stronger than expected"
>
> "Unemployment has not risen as far as had been expected"
> "Housing credit growth has been solid and dwelling prices have risen
> appreciably over the past six months"
>
> Does this sound like the US today? Does it sound like Japan over
> the last 20 years? Japan was no proof of your theory. They had no
> effective monetary policy until 2001, and even then they weren't
> strong enough. Liquidity was not sucked out of the country. The problem
> was that there were no good investment opportunities internally due
> to a declining economy and ineffective action by the government and
> BOJ.
>
> If you want to see the effect of raising rates on a weak economy,
> look at the US in the early 30s. It was a disastrous policy. The
> same would be true for weak economies, such as the US, today.

Oct 07 09:43 AM

[a. palmer jr.:]

I'm one who agrees that interest rates shouldn't be so low in the U.S. As far as stimulation; If one is starting a business or expanding, shouldn't one expect to pay at least a modicum of interest on their loan? 40 years or so ago when I was buying a house the interest rates were around 7% but it didn't stop me from buying. The economy didn't seem to hurt back then and the stock market wasn't nearly as volatile as it is today. It seems that higher interest rates for loans and savings adds a little stability to the market. Oh, by the way, I didn't default on the loan, I paid it off.

Oct 07 10:36 AM

[Harry Long:]

Palmer, thank you for the reality check. More people need to hear it.

Sometimes, it feels like I am out in the wilderness with the theorists who refuse to wed their thoughts to inconvenient things like facts and evidence.


On Oct 07 10:36 AM a. palmer jr. wrote:

> I'm one who agrees that interest rates shouldn't be so low in the
> U.S. As far as stimulation; If one is starting a business or expanding,
> shouldn't one expect to pay at least a modicum of interest on their
> loan? 40 years or so ago when I was buying a house the interest rates
> were around 7% but it didn't stop me from buying. The economy didn't
> seem to hurt back then and the stock market wasn't nearly as volatile
> as it is today. It seems that higher interest rates for loans and
> savings adds a little stability to the market. Oh, by the way, I
> didn't default on the loan, I paid it off.

Oct 07 11:00 AM