Saturday, January 9, 2010
How (Falsely) Low Interest Rates Screw Up the Economy
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.
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.
Comments:
"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."
Isn't this the prisoner's dilemma explanation? Do you agree with this?
Isn't this the prisoner's dilemma explanation? Do you agree with this?
# posted by 
: January 9, 2010 at 2:08 PM
: January 9, 2010 at 2:08 PM
"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."
I feel like this "depends".
For example, if, as a good Austrian economist, I know that the thing I'm being loaned money for is going to come crashing down in a reasonably short - but unpredictable - time, then I may be better off sitting out, even if everyone else joins in. Despite rock-bottom interest rates in the mid-zeros, Peter Schiff DID decide to rent rather than buy a home, and is better off because of it - despite the fact that real estate was running rampant at the time.
On the other hand, if we expect the new money to cause very high price inflation, then it may make sense to borrow the money and spend it on durable consumer goods as fast as possible, and that DOES depend on what everyone else is doing.
Of course, with money being fungible, it might be that the cases aren't actually that dissimilar... But, I'm not sure that behaviorists would let us claim that loaned money is actually perceived as fungible...
I feel like this "depends".
For example, if, as a good Austrian economist, I know that the thing I'm being loaned money for is going to come crashing down in a reasonably short - but unpredictable - time, then I may be better off sitting out, even if everyone else joins in. Despite rock-bottom interest rates in the mid-zeros, Peter Schiff DID decide to rent rather than buy a home, and is better off because of it - despite the fact that real estate was running rampant at the time.
On the other hand, if we expect the new money to cause very high price inflation, then it may make sense to borrow the money and spend it on durable consumer goods as fast as possible, and that DOES depend on what everyone else is doing.
Of course, with money being fungible, it might be that the cases aren't actually that dissimilar... But, I'm not sure that behaviorists would let us claim that loaned money is actually perceived as fungible...
Von Pepe: Yes on both counts. I have to revisit my earlier distaste for this explanation. I think it's not the whole story, but it shows that even with perfect foresight, the Fed has to screw things up. Or at least, distort things. I guess there wouldn't necessarily be a crash if there were perfect foresight...
Lucas: You're misunderstanding what I'm saying. Let's say the pure market interest rate (no Fed) would be 5%. Then the Fed prints up $100 bills and says, "Get your red hot $100 bills here, only 4% interest."
You are saying that once the rate gets pushed down to 4%, people might be wary of investing in a project that needs a 4% rate to stay healthy. Right I agree.
But I'm saying the interest rate will get pushed down to 4%. Even people who would have invested in a sound project at 5%, will go ahead and borrow at the cheaper rate from the Fed guy. If they don't take his money, someone else will.
Lucas: You're misunderstanding what I'm saying. Let's say the pure market interest rate (no Fed) would be 5%. Then the Fed prints up $100 bills and says, "Get your red hot $100 bills here, only 4% interest."
You are saying that once the rate gets pushed down to 4%, people might be wary of investing in a project that needs a 4% rate to stay healthy. Right I agree.
But I'm saying the interest rate will get pushed down to 4%. Even people who would have invested in a sound project at 5%, will go ahead and borrow at the cheaper rate from the Fed guy. If they don't take his money, someone else will.
Well, the caveat "unpredictable time is the key". Many who sat it out since 2002 just went out of business because their competitors took the cheap money and drove them out of business with lower cost of capital, more modern technolgy, and lower selling price. So, if you are uncertain of the time - you can die by your competitor now or by the meltdown later.
Schiff may have "lost" money by being too early on the sideline in the boom.
Schiff may have "lost" money by being too early on the sideline in the boom.
# posted by : January 9, 2010 at 5:29 PM
: January 9, 2010 at 5:29 PM
This is fantastic!! I'm doing a series that explains things in even more basic terms and guess what was up next? Interest rate setting!! You are really one of the clearest writers Mises.org has. Oh wow--may I be so bold as to say 'great minds think alike'--LOL--just pulling your leg! ;)
# posted by : January 9, 2010 at 7:02 PM
: January 9, 2010 at 7:02 PM
Bob, haven't you already critiqued the utterly idiotic paper of Dumpster and Carfooli on the basis that the situation described by ABCT is not a prisoner's dilemma at all (and pretty obviously so, I might add)? Are you retracting that now?
# posted by : January 9, 2010 at 10:00 PM
: January 9, 2010 at 10:00 PM
Sanchez, yes I criticized that paper in an unpublished manuscript that I still think is pretty sweet. My point there was that the canonical (oops maybe that sounds too dogmatic...) ABCT definitely carried the flavor of misleading entrepreneurs, and that's why I didn't like going straight Prisoner's Dilemma to deal with the rational expectations objection.
So yeah, in that paper I came up with a formal model where the agents used Bayes' law blah blah blah and still I generated "booms" and sluggish growth by having the Fed mess with the interest rate. The trick was that there was noise and so the Fed made the interest rate signal noisier.
But I am now coming around to seeing that there would definitely be distortions even with perfect foresight. I think maybe it wouldn't be a "business cycle" though, it would just be something else, like maybe a pure wealth redistribution to the bankers from the rest of society.
But in the real world, since there is uncertainty (even with rational expectations), you get the worst of both worlds: redistribution and a malinvestment.
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So yeah, in that paper I came up with a formal model where the agents used Bayes' law blah blah blah and still I generated "booms" and sluggish growth by having the Fed mess with the interest rate. The trick was that there was noise and so the Fed made the interest rate signal noisier.
But I am now coming around to seeing that there would definitely be distortions even with perfect foresight. I think maybe it wouldn't be a "business cycle" though, it would just be something else, like maybe a pure wealth redistribution to the bankers from the rest of society.
But in the real world, since there is uncertainty (even with rational expectations), you get the worst of both worlds: redistribution and a malinvestment.
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