The big flaw in artificial interest rate adjustments.

There is a widely accepted principle in economics, namely that government should intervene in the free market where there is what is called “market failure”. A classic example of market failure is monopolies which exploit their monopoly powers to make unacceptably large profits.

The artificial interest rate adjustments implemented by central banks are an obvious case of intervention in the free market, and the popular justification for that is that central banks do that when there is a clear case of market failure in the form of a recession which market forces are failing to deal with fast enough.

Unfortunately there’s a monster flaw in that argument, namely that the failure of interest rates to fall all that much in recessions is not the market failure that causes recessions to last longer than we would like. Indeed, it’s puzzling that anyone should think THAT IS the relevant market failure because the market for loans is at least on the face of it to be very much a genuine free market. That is, there are millions of would be borrowers and lenders out there and thousands of intermediaries trying to bring lenders and borrowers together. That is just the sort of scenario where markets work well.

In fact the market failure which prolongs recessions is the failure of wages and prices to fall. That is, given a perfectly functioning free market, wages would fall (in terms of money) and prices would fall. That would increase the real value of the money supply (base money in particular), which in turn would encourage spending, which would put an end to the recession. That “falling prices ends recessions” phenomenon is known as the “Pigou effect”.

But of course the Pigou effect does not work in the real world because of Keynes’s well known “wages are sticky downwards” phenomenon. That is, in heavily unionised sectors, it is often plain impossible to cut wages, and even in non-unionised sectors, trying to cut wages can be more trouble for an employer than it is worth.

To summarise, there is no obvious market failure when it comes to interest rates, but there is a glaring market failure in the form of wages and prices not falling in recessions.

Thus the logical cure for recessions is not artificial interest rate adjustments: the logical cure is something like the Pigou effect, that is increasing the real value of the private sector’s stock of money. And that is easily done via a helicopter drop.

However, it seems a bit silly to set up an entirely new system for distributing money to all and sundry, given that we already have such systems in place. That is, plain old public spending (funded with new base money) feeds money into the private sector, and where public spending takes the form of simple transfer payments (e.g. state pensions or unemployment benefits), increased spending there would amount to a helicopter drop.

As for those on the political right who aren’t too keen on more public spending, money can always be distributed to households via tax cuts.

Another advantage of increased public spending as compared to helicopter drops is that there is what might be called an “immediate fiscal effect”. To illustrate, if government and central bank create money and hire a thousand extra teachers, employment rises the minute those teachers start their jobs, i.e. before the money supply increase effect kicks in.

That “immediate fiscal effect” also applies to tax cuts: there is plenty of empirical evidence that while households obviously save a proportion of the extra income they get from a tax cut, they also spend a significant proportion.  However, there is probably little difference between tax cuts and helicopter drops when it comes to the immediate fiscal effect.

The above arguments against interest rate adjustments form a significant part of a paper of mine which will appear in a journal shortly. There is earlier draft of it at “Open Thesis” entitled “A permanent zero interest rate would maximise GDP”. Watch this space.