New Polity

Bartiromo

A couple debates ago (at this point, it almost seems like a good way to keep time), CNBC’s Maria Bartiromo asked Rep. Ron Paul if it was his position that higher interest rates would be good for the economy. Paul, careful to avoid the trap, focused on how artificially lowering interest rates devalues everyone’s savings—an entirely accurate response, and undeniably good politics. His answer did not, however, meet the question head on. That’s a task I’ll take on here.

The best answer from an economics perspective would have been, “it depends”—not very exciting stuff, I know, but the fact is that under certain circumstances higher interest rates can be exactly what the economy needs, under others low interest rates can also be immensely beneficial. It’s all a matter of how many people are saving versus how many people are borrowing, how much is being saved versus how much is being borrowed.

Since an interest rate is the price of a loan, to fully understand the issue we have to understand the loanable funds market. Just like any other market, prices are determined by supply and demand, with savers supplying the loanable funds and borrowers demanding them.

If the demand for loans is relatively high compared to the supply of savings, or if the supply of savings is relatively low compared to the demand for loans, interest rates will be high. If the demand for loans is relatively low compared to the supply of savings, or if the supply of savings is relatively high compared to the demand for loans, interest rates will be low.

High interest rates send the signal that savings are relatively scarce; they encourage saving because savers are able to achieve a high return on their investment. Low interest rates send the signal that savings are relatively plentiful; they encourage borrowing because loans are cheap.

Since borrowing is the flip side of investment, low interest rates and the borrowing they encourage are generally considered good things for the economy. When interest rates are low because of a relative abundance of savings, it is indeed a good thing for the economy.

So how could low interest rates ever be bad? Why does “it depend”?

The answer is that our central bank, the Federal Reserve, has the power to manipulate interest rates based on its own policy objectives, not the actual amount of savings in the economy. When it artificially lowers interest rates, it sends the signal that there are more savings than actually exist, encouraging borrowing beyond what the market can justify. People are less careful with their money than they should be, they make a ton of bad investments, and we end up with a bubble that eventually bursts, just like the housing bubble burst in 2008.

Apologists for the Fed will reply that when it injects new money into the loanable funds market, these new “savings” are an adequate replacement for real savings. Here’s why they’re wrong.

Real savings are the result of some legitimate market activity. People “get money”, to put it colloquially, when they provide a real good or service to someone else (loans do not break this rule, as the lender gives up the use of his wealth so that it can be used by the borrower, providing the borrower with a product for which the lender is entitled to compensation). Fake savings, the kind injected by the Fed, are the result of nothing more than a printing press, not legitimate market activity.

To put it plainly, making more money doesn’t help us unless the Fed can also make more useful things for the money to buy. Unless money represents a useful good or service, it’s just so much paper (actually, cotton and linen, but that’s beside the point).

When interest rates are lowered with printed money, false signals are sent. We borrow too much and save too little. Bad loans are made and bubbles are inflated. When the bubbles burst, as they all must, the financial establishment tells us the answer is for the Fed to lower interest rates further and inflate new bubbles to dupe us into thinking we’re wealthy once again. But the wealth is illusory, and the artificially low interest rates just set us up for another disaster.

To summarize: low interest rates are good when they occur naturally, bad when they occur artificially. This is because interest rates are prices, prices send signals, and for the economy to function properly signals have to be accurate.