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Will Prolonged Low Interest Rates Hurt The Economy?

A key tenet of the study of Economics is the idea that savings is equal to investment. (1)(2)(3)(4) This means that economies will produce goods, which creates wealth. This wealth is stored in the form of savings, and then reinvested in future wealth building which takes place as investments or the building of businesses. Innovation, technology and efficiency are all aspects of this idea of investment. What determines how much money is invested? In Economics, everything has its price. There is a law of supply and demand which strikes a balance between what is produced and what is consumed. This balance is called the market price, which is the present state of whatever the market in question is. In the case of investment funds, the thing being measured is money, and the price of what you can do with your money is the interest rate. The interest rate effectively measures what your options pay in terms of where you can invest your money.

In the past, the interest rate was high enough that wealth creation was turned into savings, and a significant amount of this savings was invested into future wealth creation. Wherever this money was redeployed had to generate enough return to overcome the current interest rate. What this means is that the price of money or capital used to be more expensive, and projects that were slated for investment were more carefully considered because the price of the money was more expensive. The word debt or borrowing could also be interchanged with money.

The assumption being made here is that the interest rate is being determined by all of the players in the free market. What is happening now is that the interest rate is being kept artificially low by the central banks of the world, and therefore the interest rate that we are seeing is not really what the market might have concluded. Presently, we have had very low interest rates for a number of years. What this does is encourage wealth to be spent and borrowed in the present, rather than invested for the future. Since borrowing is so cheap, whatever object the borrowing was intended for is easier to obtain. Investment projects would not need as high a return, so they do not need as much scrutiny. Savers would have to take more risks. Looking at the longer term view, projects with larger returns in the future would be neglected in favour of a smaller return in the present. If more money is spent, there would be less money available for investing in the future. This seems to contradict the idea that the world has a lot of cash and a lot of excess capital, looking for investment. This is also true. The reconciliation of these ideas is that there is a lot more money available, but since the environment is not conducive to making longer term investments, the money is sitting idle.

What happens when a market is artificially influenced for many years? It usually comes back to its equilibrium at some point, and all of the excess or deficiency is usually made up in short span of time. Will the economy be damaged by a lack of investment over many years?

Sources:

1) http://economistsview.typepad.com/economistsview/2005/09/the_economist_g.html

2) http://krugman.blogs.nytimes.com/2009/01/30/saving-investment-keynes-evolution/

3) http://www.revecon.ro/articles/2009-2/2009-2-5.pdf

4) http://www.marxists.org/reference/subject/economics/keynes/general-theory/ch14.htm

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.