Interest rate adjustments are nonsense.

By way of celebrating the recent rise in interest rates in the US, let’s run thru the litany of false logic behind interest rate adjustments.

The first problem is that while adjusting demand is an important function of the state, there is no earthly reason to do that by JUST changing borrowing, lending and investment activity. That is, THERE ARE households and firms which DO NOT borrow or lend to any great extent, while there are obviously others which borrow or lend significant amounts. And interest rate changes will influence the behavior of the latter much more than the former. There is no good reason for that distinction.

That is, given inadequate demand, the solution is to raise demand for ALL PRODUCTS or at least for a wide variety of products. I.e. there is more no reason to confine the change in demand to those who borrow heavily, than there is to confined the change in demand to chewing gum, cars, education and lollipops.


The free market’s cure for recessions.

Indeed, that “increased demand for almost all products” is exactly what happens under the free market’s cure for recessions: wages fall, which raises the value of the monetary base and government debt in real terms, which increases the private sector’s assets in real terms, which encourages spending (as pointed out by Krugman). That phenomenon is sometimes called the “Pigou effect” though Krugman doesn’t actually mention Pigou in that article. Obviously the Pigou effect doesn't work too well in the real world, though to judge by the 1800s, the free market does actually cure recessions eventually.

Of course if the change in demand IS NARROWLY focused (as under interest rate cuts), the extra demand will eventually trickle out to the rest of the economy, but that’s still no excuse for the initial narrow focus or distortion of the economy.

In short, when demand is adjusted, it should be adjusted by fiscal means or least to a significant extent by fiscal means because that normally involves stimulus for a broad selection of economic activities. That is, if for example personal taxes are cut, that increases spending by most households. Those in the UK who live just on the state pension would’nt be much affected by that, but their income can be increased by other fiscal measures: e.g. increasing the state pension.


Artificially high interest rates.

A second absurd aspect of interest rate adjustments is that the state has to artificially inflate interest rates if it’s going to go be able to subsequently CUT them.

To explain why, it is first necessary to clarify the distinction between two quite separate functions performed by the state: first, states (i.e. governments) often borrow so as to fund infrastructure and similar invetments, and second, governments borrow SIMPLY to rein in demand and/or raise interest rates.

To keep things simple, let’s assume the state funds infrastructure etc out of tax, or if it does fund them out of borrowing, then relevant bonds are kept separate from “as currency issuer” bonds. I.e. those infrastructure bonds could be issued on the same basis as a private sector firm might issue bonds, with bond holders standing to make a loss if the relevant projects go over-budget (as was the case with the French-English Channel tunnel).

So that’s infrastructure put on one side. Now let’s consider government as currency issuer and interest rates.

The amount of currency (i.e. base money) the state basically needs to issue is whatever amount keeps the economy at capacity. The state can of course issue an excessive amount, and deal with  the resultant excess aggregate demand by borrowing some of that money back. But what’s the point of that? All it does is to artificially raise interest rates.

To repeat, in order to use interest rate adjustments to influence demand, governments have to issue an excessive amount of money and borrow some of it back at an artificially inflated rate of interest.


Inequalities.

Even more absurd is that process of issuing an excess amount of money and borrowing some of it back increases inequalities. That is, the less well off have to pay taxes to fund artificially high interest payments to the cash rich.

And alternative way to implement stimulus is for government to borrow and spend the money borrowed (and/or cut taxes). Plus it then has to buy back enough of those bonds to make sure the initial borrowing does not raise interest rates.

Apart from creating work for paper pushers and bankers in the world’s financial centres who take their cut at every turn, that process doesn’t make much sense, particularly given that the effect of borrwing is DEFLATIONARY. What’s the point of doing something that has a DEFLATIONARY element when the object of the exercise is the opposite, namely stimulus? That makes as much sense as throwing dirt over your living room wall before re-decorating it.

In short, why not do what Keynes suggested in the early 1930s, namely just have the state print money when stimulus is needed and spend it, and/or cut taxes. That comes to nearly the same thing as the Pigou effect.


Lags.

Interest rate adjustments might make sense if they worked more QUICKLY that fiscal policy, but all the evidence is that there is not much difference “lag-wise”.

Moreover, there is evidence that interest rate adjustments are not all that effective. As Jamie Galbriath put it, “Firms invest when they can make money, not when interest rates are low”.

And what do you know? The above policy of having government simply create new money and spend it in a recession is what’s advocated by a number of those who back full reserve banking. See here. And that in turn comes to much the same thing as the Pigou effect.


Controlling inflation.

Of course there needs to be tight control of the amount of new money created under the system advocated here. But that’s easily done by having some sort of committee of economists make that decision, like the EXISTING central bank committees that determine interest rate adjustments, QE and so on. Indeed, under the existing system and under the system proposed here, the job of that committee is the same: to determine the amount of stimulus needed.

And finally the above is not to suggest that adjusting interest rates is a tool that  should NEVER be used. In an emergency obviously it’s a useful tool. But normally interest rate adjustments don’t make sense.