The flaw in interest rate adjustments.

The common practice of adjusting interest rates so as to adjust stimulus makes no sense. Reason is thus.

It is widely agreed in economics that the optimum or “GDP maximising” price for anything (including the price of borrowed money) is the free market price, except where it can be shown that the free market is defective or where there is “market failure” to use the jargon. And in the case of the rate of interest, there is no obvious obstruction to the free market working: that is, savers shop around for the bank which offers the best (i.e. highest) rate of interest, and mortgagors shop around to find the bank which offers the best rate of interest from their point of view (i.e. the lowest rate).

The rate of interest is also influenced by the amount government borrows. Unfortunately there is no general agreement as to how much government should borrow. Milton Friedman and Warren Mosler argued that governments should borrow nothing, though Friedman thought there was a case for borrowing in war-time. I argued likewise here. (Title of article: "Government borrowing is near pointless".)

An alternative and popular idea is that government should borrow to fund infrastructure. But a flaw in that idea is that the entire education budget is investment of a sort. So should all education spending be funded via borrowing rather than via tax? There are no easy answers to that, though I argued here a few years ago that (in line with Friedman and Mosler thinking) government borrowing makes little sense.

So in the absence of any totally clear answer to the question as to how much government should borrow, let’s assume the optimum amount to borrow is X% of GDP.

Now let’s assume an economy requires stimulus. One way of imparting stimulus is to simply have the state print money and spend it, and/or cut taxes. And if you think that sounds outlandish, it’s actually not: having government borrow more with the central bank then printing money and buying back government issued bonds (“Gilts” in the UK) comes to the same thing as the above “print and spend” ploy. And the latter “borrow more and then buy back” is exactly what numerous governments have done since the 2007/8 crisis.

Note that that does not alter the above mentioned X%. At least there is no obvious reason why X should change simply because of some stimulus. I.e. a dose of stimulus will raise GDP by some percentage, but if for example there’s an argument for having government borrow to fund infrastructure and nothing else, then the total amount invested in infrastructure will presumably rise pari passu, more or less. Thus borrowing to fund infrastructure will remain at X%.


Interest rate adjustments.

A second way of imparting stimulus is to cut interest rates, and that’s done by having the central bank print money and buy up government bonds. But that reduces the amount of government borrowing to below X%. I.e. the total amount of government borrowing is then less than its optimum or “GDP maximising” level.

Provisional conclusion: stimulus should always be imparted essentially by having the state print money and spend it, and/or cut taxes.


What’s the economy for?

The latter conclusion ties up with a very common sense observation, namely that the basic purpose of the economy is to produce what people want, booth in terms of what they choose to buy out of their disposable income and in terms of the publically provided items (free education  for kids etc) that people vote for at election time.

That is, given a need for stimulus (i.e. assuming the economy is working at less than capacity) the types of spending that need boosting on the basis of the latter “basic purpose” idea, is household spending and public spending. And households and the authorities responsible for public spending can, if they see fit, spend some of that extra money on extra interest to fund more borrowing.

But there is no obvious reason to assume that given a need for stimulus, that it’s JUST borrowing that needs to be boosted.