Issues of Interest to Ben Bernanke

December 6th, 2009

Over the last year, the Federal Reserve has increased the monetary base by over 100%. This policy has artificially kept short-term interest rates at their lowest levels ever.

So many different explanations for this policy have been put forward that there seems to be a new one every month. The one undeniable brute fact is that money is the one overriding concern of the Federal Reserve and the one thing it directly controls. Like a small boy given a hammer, who suddenly finds that everything he encounters needs pounding, the Fed’s current solution to every problem is to drown it in money.

If we could really solve the fundamental problems of economics this way, the world would be a completely different place than it really is.

Issues of Interest

To watch the Federal Reserve at work, you would think that an interest rate is like a home thermostat. Feeling a little chilly? Just stroll over to the controls and twist the dial. Economy acting a little sluggish? Have Ben Bernanke turn down the fed funds rate. Before you know it, economic activity will heat up and we’ll all be warm and comfortable.

In 2001 alone, Alan Greenspan’s Fed lowered the fed funds rate twelve times. It must have worked, right? The housing sector took off like a rocket. It must just have been bad luck that things turned out so badly later.

Everybody seems to have forgotten the specific economic function of interest rates. They coordinate the decisions of savers and investors. In other words, they perform the same function across time that ordinary prices do at a point in time.

What Interest Rates Really Do

This is how it works: People decide (say) that they want to consume more goods and services in the future. They’ll need more money, so they save more. This increase in saving increases the supply of loanable funds, which in turn causes interest rates on loans to fall. Businesspeople see the lower interest rates on loans and take out more investment loans. The increase in investment increases productive capacity, which makes it possible to produce more goods in services in the future – which is just what consumers want to happen. What luck!

Except that it isn’t luck, not at all. It is markets working the way they’re supposed to work.

Enter the Fed

Contrast this with what happens when the Federal Reserve Open-Market Committee enacts a stimulative monetary policy. They lower the fed funds rate, which makes it easier for banks to borrow and increase their reserves. The increased reserves are the basis for more loans to business at lower loan rates. Businesses create more productive capacity and produce more goods in the future.

Only the consumers don’t buy the goods. It wasn’t their idea to save more and buy more goods in the future. It was Ben Bernanke’s idea to stimulate the economy that caused the lower loan rates, not consumer savings. As a result, there are gluts of goods in particular sectors – the ones that “benefitted” from the increased investment. When investments don’t pan out, they are abandoned. This produces layoffs and unemployment.

This is how to create a recession – or worsen one.

Household Saving and Portfolio Investment

When households buy stocks, bonds or annuities rather than using the money to support their current lifestyle, the average person calls this investment. An economist calls it saving. No matter what you call it, it is distorted by false interest-rate signals. When Federal Reserve policy artificially lowers interest rates, households not only save less, they choose wrongly among the various saving vehicles. Investment in the stock market rises, because the interest return on competing investments, such as bonds, has fallen. Yet stocks are not made inherently more valuable by the Fed’s money creation.

Economic Coordination

The incredibly large and varied menu of interest rates did not arise by accident. Each of these rates coordinates the behavior of the consumers and businesses affected by it.

Businesses buy new plants and equipment and modernize existing equipment. They need information on when and how much to invest. They need long-term, medium-term and short-term financing. Different interest rates tip off businesses to consumer desires for the future, over differing time periods. Mind you, businesspeople don’t realize that by responding to what they perceive as their costs, they are really responding to the time preferences of consumers. But they are.

Consumers also base their consumption and saving decisions on the market signals provided by interest rates. If the investment demand for loanable funds decreases, causing lower interest rates, consumers purchase more big-ticket items on installments. Their future consumption will involve more use of those consumer durable goods and less spending on non-durable goods. This will dovetail perfectly with business plans to invest less. Consumers don’t realize that they are really responding to the investment plans of businesses. But they are.

Returning to Normal

We are currently in the midst of an unprecedented money-supply expansion by the Federal Reserve. Only when the money creation stops can consumers and businesses make accurate decisions about the future.

Business investment is vital to economic growth. Interest rates of various maturities enable businesspeople to estimate the costs of investment. If current interest rates are obviously unsustainable, this gives them no useful information upon which to make those estimates. Obviously, interest rates are going up – but when and by how much? Unless they can make an educated guess about this, businesses cannot take the calculated risks necessary to support investment.

Consumers’ big ticket purchases – homes, automobiles, appliances, computers, even elective medical procedures – are typically financed. This means that an interest cost is incurred. (Withdrawals from savings incur an opportunity cost measured by the loss of interest income.) In order to judge whether they are getting a good deal or not, consumers need to gauge future interest rates. Interest-rate uncertainty leads to inaction. Spending on consumer durable goods does not increase.

Portfolio investment is also deterred by interest-rate uncertainty. Consider a retiree who wants to purchase an annuity. One drawback of annuities is the risk that interest rates may rise after purchase, leaving the annuityholder stranded in a low-yielding investment. The retiree knows that current interest rates are artificially low. Eventually, they must rise – but when and by how much? Interest-rate uncertainty may leave the retiree’s money frozen inside a company pension plan or fallow in a money-market account. The retiree’s security is endangered. Similar considerations also hamper investment in stocks and bonds.

Thermometer, Not Thermostat

Interest rates are not analogous to a home thermostat. They are akin to a thermometer. Just as the thermometer is an invaluable diagnostic tool to a doctor – one he or she would not dream of distorting by altering the reading – so do interest rates provide invaluable information to businesses and households. Keeping interest rates artificially low does not aid economic recovery – it hinders it.

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