Talking About the Economy: Interest Rates

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Clarissa

June 9, 2012

I’m still trying to figure out how the capitalist economy works, so please excuse my ignorance. Hopefully, my readers will help me out.

As we all know, there is nowhere one could invest right now because interest rates are non-existent.

Now, the way this was explained to me yesterday is that interest rates are being kept so low on purpose in order artificially to restart the economy. The idea supposedly is that if people have nowhere to invest, they will spend all they have, consume more, and that will restart this economy.

This sounds like a very Soviet idea (central planning and all that). Is this what’s really happening or was the person who told me this misinformed?

The whole thing sounds horribly unfair and wrong.

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17 responses to “Talking About the Economy: Interest Rates”

charlesrowley

June 9, 2012

Clarissa, your instinct is absolutely correct. The Federal Reserve Board is operating basically a central planning operation where they hold interest rates below the market levels. To a considerable extent this is part of their policy of bailing out insolving financial institutions. Down the road, serious mis-allocations of resources will flow from this socialist intervention, just as occurred behind the Iron Curtain. In addition, the massive increase in base money required to drive this policy – base money has doubled since September 2008, will induce serious inflation.

The best safe place to store your savings at the moment is in TIPS – Treasury Inflation-Protected Securities. They pay a low real interest rate, but they must also pay the inflation rate. So as inflation rises these securities rise in value and protect you against inflation-theft by the government.

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1. bloggerclarissa
  
  June 9, 2012
  
  So I’m right that there is something deeply wrong with this practice?
  
  Hah! I’m getting better at understanding the economy!
  
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Spanish Prof

June 9, 2012

Wrong… First of all, there are different reasons why interest rates are low. One of them is to actually stimulate investing: in theory, low interest rates means that, for a small business owner, it is cheap to borrow money from a bank to invest in his/her business . Of course, that would assume that banks are willing to lend money. They are not nowadays, for reasons too long to explain here. What low interest rate do is that they try to incentivize people not to save money in the bank.
As far as Soviet idea, except for the most hard core Ayn Rand lunatics, even hard-core free marketers accept the idea of some kind of central planning in the economy: in this country, regulating the interest rates through the Federal Reserve, for example. Increasing interest rates when there is fear of inflation is another textbook example. Wrong… First of all, there are different reasons why interest rates are low. One of them is to actually stimulate investing: in theory, low interest rates means that, for a small business owner, it is cheap to borrow money from a bank to invest in his/her business . Of course, that would assume that banks are willing to lend money. They are not nowadays, for reasons too long to explain here. What low interest rate do is that they try to incentivize people not to save money in the bank.
As far as Soviet idea, except for the most hard core Ayn Rand lunatics, even hard-core free marketers accept the idea of some kind of central planning in the economy: in this country, regulating the interest rates through the Federal Reserve, for example. Increasing interest rates when there is fear of inflation. If you want to rest assure that we are not in the Soviet Union, do some research on the Federal Reserve under Reagan. I am not judging their actions, just saying that they were not innactive.

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1. bloggerclarissa
  
  June 9, 2012
  
  It just seems horribly unfair that somebody yet again decided to benefit the borrowers and punish people who want to live debt-free. It’s like there is no winning for people like us.
  
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  1. Spanish Prof
    
    June 9, 2012
    
    Ehhh…nothing forbids you from saving as much as you want. You just will not get too much interest in your savings account. As I said, it is a question of economic policy. And it is not fixed. It varies according to the economic conditions. One can agree or not in whether doing X, Y and Z is sound, but to call it Soviet-style central planning is a little too much. But if you are so worried about it, maybe that’s the excuse you need to vote for Ron Paul next time around. He wants to abolish the Federal Reserve based on libertarian principles.
    
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    1. bloggerclarissa
      
      June 9, 2012
      
      If I could find a candidate who’d support the economic principles I like and be socially progressive, that would be great. But whenever a candidate has a position on the economy that I can support, s/he is always hanging out with scary religious fanatics.
      
      That’s the huge dilemma of my life. 🙂 🙂
      
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Spanish Prof

June 9, 2012

By the way, I wrote and published my answer without seeing Charles’. So even though I completely disagree with him, don’t take my comment as a direct reply to him.

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Sean Patrick Hazlett

June 9, 2012

The reason lower borrowing costs are supposed to accelerate economic growth is that they increase investment. Lower rates make it easier for corporations to finance equipment purchases and other capital investment programs. More equipment purchases translate to high sales and by extension, more jobs.

Lower interest rates also make cash less attractive for investors who are looking for higher rates of return. This leads them to invest in other assets like stocks. As investors bid up stock prices, corporations have more currency to invest in new capital programs that help drive economic growth.

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Matt

June 9, 2012

Overall pretty good answers from Sean and Spanish Prof.

Where I would agree with Charles is while the theory advocated by Sean and Spanish prof is pretty much right, there is a strong case to be made that a major (perhaps the main?) motivation is to bail out insolvent banks. While banks were able to sell many of the bad mortgages they had (securitization allowed some loans to be sold to investors), many banks still have the majority of their loans tied up in real estate (personnel and commercial). Since those loans range between 5 to 30 years with fixed rates.. (between 5-8% usually) they can make substantially more money when they can fund those loans by paying under 1 or 2 % interest on short term obligations..

I realize that I am getting long winded and not as helpful as i would like to be, but I think that summary shows the “textbook answer” (from Sean and Spanish) as well as the most feasible “alternative” answer.

While not an Obama fan at all… this issue is actually one where Obama should have been heavy handed in letting some banks go under, recapitalizing others… he would have won the populist vote and ironically would have been very aligned with libertarians and tea partiers… (By having Geithner as Treasury Secretary and Larry Summers in his inner circle.. I guess the die was cast).

Lastly, as a practical matter the ways saver’s can be rewarded in this environment is as follows:

1. Pay down debt (credit card, car, student debt, mortgage.. likely in this order, but not necessarily)

2. Invest in real estate if possible (NOT REITS).. but actually rental homes. People with some time (but much less than you think) and some money can buy rental homes in low-moderate areas for cheap prices. While home prices are crashing.. rental rates are up for many reasons… so that is one way you can benefit Clarissa 🙂

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1. bloggerclarissa
  
  June 9, 2012
  
  I agree that many of these insolvent banks should have been allowed to go under. Obama alienated a huge part of his voting base when he continued Bush’s bailout practices and put Bush’s favorite economists in charge of everything.
  
  It is still a mystery to me why he did it. Now many of his ardent supporters won’t vote for him. Or anybody.
  
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FD

June 9, 2012

I know bugger all about economics. But I do know one of the reasons they’re keeping a lid on interests rates here is to try to keep a damper on inflation – because wages are not rising so cost of living increases are very bad news for the average voter. And thus for the politicians.

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Mike B)

June 10, 2012

There’s really not much hope. The Japanese government kept interest rates i.e. lending to private banks low after their real estate bubble burst back in the early 90s. The Japanese economy never really recovered. The GFC in the USA was the result of a bursting real estate bubble.

The problem is that the private banks have to lend the money they get at very low interest rates to the borrowing citizens, including businesses. They aren’t lending now. Lots of cash sloshing around in the corporations’ control because markets are frozen due to austerity measures being imposed by political States on the citizens. The citizens are the market and the citizens are increasingly unemployed or under paid so they don’t have much to spend. And that’s what the businessmen/women need in order to hire and get commodities (goods and services) produced for sale. No sales on the horizon mean continued recession turning quite possibly into the next Great Depression.

The simple facts of the matter are that real wages in the USA have not risen above what they were in 1964. Meanwhile, real productivity is has increased by 1.5% a year. All that productivity has to have an outlet in markets which are frozen or falling behind in real terms. At the same time, the top 10% of the population has control of 88% of the wealth. If markets are to be restarted so that sales can begin again so that the bankers will have some confidence that lending to businesses will result in the businesses being able to sell the commodities which they employ workers to produce in exchange for wages, real wages and the social wage will have to be increased. However, that would mean that the top 10% would have to have some of their wealth diverted from their control and they don’t want that to happen and, they control the politics in the USA, which means they control the selection and eventual election of the candidates.

As I said, there’s really not much hope….

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1. bloggerclarissa
  
  June 10, 2012
  
  I really don’t see how we can say that people in this country don’t have money to spend. The Missoni popular brand was bought out so fast that their website crashed on the very first day. Crowds of people stormed Apple stores to buy the ridiculously expensive and basically useless iPads. On Black Friday, people physically beat each other up toi buy expensive luxury items. Stores have crowds of customers.
  
  No, I don’t see any of what you are saying.
  
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gudenuf

June 10, 2012

Come to Australia. The banks give you 3.5% interest on your savings account.

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1. bloggerclarissa
  
  June 10, 2012
  
  What makes Australia so special?
  
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Z

June 10, 2012

Also note – business has been done on credit since time immemorial. See Graeber´s book: http://books.google.com.mx/books/about/Debt.html?id=GYhajCQU8XIC&redir_esc=y

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1. bloggerclarissa
  
  June 10, 2012
  
  I still haven’t managed to finish the book which puts me to shame. But I would take anything it says VERY cautiously for reasons I will explain in my review once I do finish it.
  
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