Never Mind Negative Interest Rates: All Interest Rate Adjustments Are Fundamentally Flawed.

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Includes: RINF
by: Ralph Musgrave

There are fundamental flaws in the whole notion that demand should be regulated by adjusting interest rates. They are not mentioned often enough and they are as follows.

First, the basic purpose of economic activity is to produce what people want: both privately and publicly produced goods and services (roads, education, etc). As to what proportion of GDP should be allocated to those two types of spending, that's a purely political question: it's one of the main issues that differentiates the political left from the political right. But certainly it's true that the basic purpose of economic activity is to produce what people want.

That being the case, if there is inadequate demand, the solution is (gasps of amazement) to up the production of the goods and services that people want, and that can be done first by giving people more of the stuff that enables them to purchase goods and services and that stuff is called "money." For example, money can be channeled into household pockets via tax cuts. Second and as regards publicly produced goods, output of those goods can be increased by having government print or borrow money and spend that money on those goods.

Interest rates

An alternative method of adjusting demand is to adjust interest rates. But all that does (allegedly) is to adjust investment spending. Or to be more exact, it adjusts investment spending primarily by firms and households, which are dependent on borrowed money when it comes to investing: i.e. some firms and households have plenty of cash and do not need to borrow in order to invest. (Incidentally, "investment goods" includes stuff like fridges, cars etc).

Now if households and government are given the freedom to buy more, they're guaranteed to want a wide variety of different goods and services, thus it does not make sense to adjust just one type of spending, namely investment spending by entities that are short of cash.

Of course, when investment spending changes, there is a trickle-down effect: e.g. increased spending on roads increases the incomes of contractors and their employees. Nevertheless, trying to adjust only investment spending (and at that, only for entities that are short of cash) when the object of the exercise is to adjust almost all types of spending is nonsense. We might as well increase aggregate demand by boosting sales of just cars, computers and ice creams. That too would have a trickle-down effect.

That's one basic flaw in interest rate adjustments.

Skilled labor

A second basic flaw is that it's not easy to suddenly expand just one relatively narrow sector of the economy, whether it's the investment goods sector, agriculture or any other sector. Each sector needs specific types of skilled labor. Those types of skilled labor may not be available even if unemployment is higher than normal. That is, all else equal, it's much better to expand all sectors rather than just one.

The evidence

In addition to the above theoretical weaknesses in interest rate adjustment, THE EVIDENCE is that interest rate adjustments are not all that effective. See here and here.

As Jamie Galbraith put it, "Business firms borrow when they can make money, not because interest rates are low."

Having criticised interest rate adjustments, there are SOME possible arguments for the alternative to interest rate adjustments, namely fiscal policy. But the arguments are not brilliant. Let's run through them.

Lags

A possible excuse for concentrating on interest rate adjustments is that the reaction of the real economy to such adjustments might be QUICKER than in the case of tax cuts or extra public spending. However, reaction times or "lags" actually seem to be similar.

Central bank independence

Another excuse for interest rate adjustments is that if central banks have their very own method of adjusting demand - quite independent of anything that politicians do - that effectively keeps politicians away from the printing press, because central banks can overrule anything the politicians do.

One answer to that is that the evidence seems to be that there is no relationship between the degree of central bank independence and inflation. Put another way, and surprising as this might seem, when politicians DO HAVE access to the printing press, they don't normally act in an irresponsible manner, though Robert Mugabe is an obvious exception. (See chart here.)

Indeed, since the 2007/8 crisis, it's the Fed that has done most of the printing (in the form of QE), while politicians have been far too timid: they've been in a state of near nervous breakdown over the size of the national debt. That is, it's the Fed that has in a sense been "irresponsible" and politicians who have been responsible.

A second answer to the above claim that central banks must have their own method of adjusting demand is that assuming it is desirable to keep politicians away from the printing press, there are ways of doing that other than giving the central bank its own method of adjusting demand. To illustrate, it would be perfectly possible to have some independent committee of economists (possibly even based at the central bank) decide how much stimulus was suitable in the next six months or so, while purely political questions, like what proportion of extra spending goes to the public and private sectors are left with politicians.

That is, the latter committee could decide that $Xbn of extra spending is suitable in the next six months, while politicians decided how to allocate that extra spending. Indeed, a system just like that is advocated in this work (p.10-12).

Should interest rate adjustments be banned?

Given the above litany of problems with interest rate adjustments, it's tempting to suggest we abolish them altogether. Indeed, the work mentioned just above advocates just that. Personally, I wouldn't go quite that far.

Fiscal policy does have a potential problem, which is that a large scale reversal of fiscal stimulus can be politically difficult. That is, it's easy enough to slash taxes while leaving government spending untouched (i.e. in effect print money and hand it out to everyone). But a sudden and drastic reversal of that, should it prove necessary, may be politically difficult. Households' take home pay would be slashed which might lead to riots.

Thus, I suggest interest rate hikes should always be there as a backup tool to be used in emergencies. But apart from that "emergency" point, the case for interest rate adjustments is very weak.