Thursday, 26 October 2017

Interest rate adjustments do not make sense.

Assume an economy needs stimulus. One way to implement it is for the state to run a deficit funded by new base money (as suggested by Keynes in the early 1930s). There is of course more than one way of doing that: more public spending is one, and tax cuts are another. For the purposes of the argument here is doesn’t make any difference which of those two is chosen.

A second way to implement stimulus is to cut interest rates. But there’s a problem or two there, as follows.

Assuming a fall in interest rates is the free market’s only or main way of dealing with recessions, and assuming there is some artificial obstruction to such a fall, then it would make sense for the authorities to try to overcome that obstruction by employing artificial means to get interest rates down.

Unfortunately, neither of the latter two conditions hold. As to obstructions to a fall in interest rates, I’m darned if  I know what they are. Indeed interest rates seem to have fallen all of their own accord over the last twenty years or so.

As to ways of dealing with recessions, interest rate cuts are not the only way. There is another free market “recession ending” mechanism. That’s the Pigou effect: the fact that in a recession in a totally free market, wages and prices would fall, which would raise the real value of the monetary base, which would raise spending. Moreover, there is a very obvious obstruction to that mechanism, namely the “wages are sticky downwards” phenomenon to which Keynes referred.

That suggests that running a deficit funded by new money is better than fiddling with interest rates: instead of the value of the base rising because of a rise in the value of each unit of the base (dollars, pounds, etc), the number of units rises. But the effect is the same (as Keynes himself pointed out, or so Lars Syll told me).

A zero government debt scenario.

Another problem with fiddling with interest rates is this.

Milton Friedman and Warren Mosler argued that governments should borrow nothing at all. Assuming F&M are right (and I certainly do not strongly disagree with them), then how do you cut interest rates? Cutting rates is normally done by having the central bank sell government debt. But if there’s no government debt (as per F&M’s prescription), then rates cannot be cut!!!

Alternatively, if it does actually make sense for government to borrow (and let’s say government debt needs to be X% of GDP), and if debt is then bought back by the central bank so as to cut rates, then the debt will no longer be at it’s optimum or GDP maximising level

Provisional conclusion: interest rate adjustments are in check mate.

The only possible escape from check mate might be available in the form of the claim that interest rates work more quickly than fiscal adjustments. Unfortunately there’s not much evidence to support that idea. According to the Bank of England, interest rate adjustments take a year to have their full effect. Plus if government decides, for example, to spend more on health and education, the effect comes as quickly as new teachers, nurses, etc can be interviewed and allocated to jobs. That ought to be possible in less than a year.

Plus in the recent recession, the UK government implemented two fiscal adjustments at the flick of a switch: it first cut VAT and raised it again two or three years later.

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