Thursday, April 30, 2009

“Interest rates” are going in the wrong direction

Q: What should “interest rates” do in the face of a recession?

A: Not what you’ve been hearing from the chatterati.  Pardon me for quoting The Politically Incorrect Guide to the Great Depression and the New Deal author Bob Murphy two days in a row, but . . .

    Even though it flies in the face of everything you will hear from Nobel laureates, Harvard professors, and CNBC commentators, in the onset of a financial panic — where liquidity is at a premium — short-term interest rates need to rise dramatically. It is analogous to the prices of flashlights and canned food during a hurricane that knocks down power lines. The price needs to shoot up in order to ration the available units to those who need them the most.
    By the very same token, when investment banks realize that their assets aren't worth nearly as much as they had thought, and the supply of "loanable funds" shifts way to the left, then market interest rates need to rise. The price of renting a generator goes up during a hurricane, and the price of renting cash ought to go up during a financial panic.

If you follow the link where Murphy says, “short-term interest rates need to rise dramatically,” you’ll find a historical comparison: that “smack dab in the middle of the 1920–1921 depression” US interest rates were around 7 percent.  Following the crash of 1929, The Fed cut US rates down to a record low of 1½ percent by May 1931 to try to fix their crisis.

Guess which one worked?  Guess which method kicked off a recovery? 

The fact you don’t hear much about the Great 1920–1921 Depression gives you a clue which one.

So, why do higher interest rates work in a recession?  Simply put, it’s because the economic boom we’ve just enjoyed was (in the final analysis) paid for  out of a pool of real savings – out of saved capital – and too much of it has now gone.  It’s been squandered.  Consumed.  Used up.  It’s been squandered on profligate living. It’s been consumed in malinvestments.  It’s been and it’s still being used up.  As “Mish” says, “We are in this mess because the pool of real savings has been depleted and it is time to stop spending and replenish savings.” 

How do we do that? Come on, you know this one. Anyone familiar with supply and demand should know what happens to prices when supply is drastically diminished, and what would happen now to interest rates if we didn’t have a government flunky tampering with them. 

What needs to happen now therefore is that the pool of real savings needs to be built up, not further diminished in cheap loans.  What needs to happen now is that zombie firms and malinvestments are liquidated so that their assets can be reallocated and recovery can begin.  What needs to happen now, as Murphy says, is what would happen quite naturally in the absence of our all-powerful central banks.

    It's actually easier to see if you forget about a central bank, and just pretend that we were living in the good old days when banks would compete with each other and there was no cartelizing overseer. Now in this environment, when a panic hits and most people realize that they haven't been saving enough — that they wish they were holding more liquid funds right this moment than their earlier plans had provided them — what should the sellers of liquid funds do?
   
The answer is obvious: they should raise their prices. The scarcity of liquid funds really has increased after the bubble pops, and its price ought to reflect that new information.

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17 Comments:

Blogger Jeff Perren said...

There's also a moral dimension: simple justice. People, like yours truly, who have saved for years and gain income through it, have seen all their investments go to zero worth. Money market funds now pay squat. CDs pay squat. Bond prices have adjusted to account for the fact that interest rates are diddly.

Once again, the shitheads who can't leave their fingers (now entire hand, pressing with all their might) off the scales have ruined millions of "not rich" people.

4/30/2009 10:15:00 am  
Blogger PC said...

Exactly right, and I'm indebted to you for pointing it out. [Couldn't resist the pun.]

It's impossible to say everything in one post, and I couldn't see a way to easily weave in that theme -- but the flip side to this low interest fetish is exactly as you say, and is almost entirely unnoticed by the cognoscenti: that Debtors are surviving at the expense of Creditors, whose capital is being consumed.

4/30/2009 10:38:00 am  
Blogger PC said...

So where's the inducement to save?

4/30/2009 10:38:00 am  
Anonymous Sus said...

Where's the inducement to save?

But that's just it in a nutshell, isn't it. This almost fanatical belief in the stimulation of consumer *spending* -- first and foremost -- in order to supposedly get out of recession?

4/30/2009 10:58:00 am  
Blogger heisenbug said...

There is no inducement to save. What little savings New Zealand had disappeared the day after the Government decided to levy tax on interest earned, effectively making the returns - taking inflation into account - less than zero. Another unintended consequence of meddling?

4/30/2009 12:40:00 pm  
Anonymous LGM said...

The "gullible man" isn't always as stupid as the "educated" like to think. Given the dire income situation faced by those relying upon their savings (relying on fixed automatic investment instrument returns) over the last decades, one of the better approaches was to to borrow heavily and get leveraged. Many "gullible" people did exactly that. Of course, now it isn't the best thing to have been doing- assuming that the borrowings were all directed at consumption. Then again, if there was no PG involved, perhaps it wasn't a bad strategy at all.

LGM

4/30/2009 12:49:00 pm  
Blogger teh steve said...

So I guess what eventually happens is that people will rather spend their money on items (tv, fridge) than save.
Happened in Zimbabwe, albeit for different reasons.

4/30/2009 12:55:00 pm  
Blogger Jeff Perren said...

It's also incredibly stupid because interest is a bank's income and low rates make it harder for them to stay in business. That's fine, of course, because putting them under still more pressure creates the conditions that make it easier to nationalize them, Obama's ultimate aim.

But, then, that's ok because - after all - bank's are all evil and stuff since they "don't contribute anything real to the economy" by the reasoning of a Progressive (and the many "little people" who have bought that line).

4/30/2009 01:14:00 pm  
Blogger heisenbug said...

Jeff Perren: 'banks are all evil and stuff since they "don't contribute anything real to the economy"'

Exactly, hence the saving paradox the Keynesians talk about. They ignore that the banks take your savings and invest them for you, by lending to (hopefully) productive enterprises. Apparently investing in production (creating wealth) is bad, but spending (consuming wealth) is good. Why are so many people seeing this stuff ass-backward??? It's not rocket science.

4/30/2009 02:18:00 pm  
Blogger Jeff Perren said...

"Why are so many people seeing this stuff ass-backward?"

I keep trying to avoid the conclusion but the best explanation I can arrive at is (a) that's what they're told by the media (though why they continue to give them any credence whatever, I can't imagine); and, (b) most people are so un-intellectual they can't even grasp such a simple idea.

Fortunately, there are many exceptions among conservatives and libertarians who do understand these things. It's a good thing, too, otherwise I'd probably be on a perpetual murder spree... :)

4/30/2009 03:39:00 pm  
Blogger Tom M said...

"interest is a bank's income" strictly speaking, interest is a bank's revenue. The profit it makes is the difference between the rates it lends at and the rate it borrows at.

I also think the 'moral dimension' is overstated. There's always a tradeoff between savers and borrowers when the central bank sets an interest rate. Not everyone that has a mortgage is an irresponsible buffoon that deserves bankruptcy. No matter how they set the rate, somebody has to lose a little.

4/30/2009 08:11:00 pm  
Anonymous LGM said...

Firstly, it is silly to carry on as if bank nationalisation is some new and dire occurance. The banks were effectively nationalised long, long ago. They are really retail franchises for the central bank.

Think on it.

Second, while in an ideal world interest charged on asset backed loans would be the primary income source for banks, these days it is the leveraging of fractional reserve operations that provide the bulk of their "income."

--

In the previous stage of the inflationary economic cycle, the easiest approach for many individuals was to borrow and leverage, so long as they were in a position to avoid issuing a PG. That isn't the best strategy any more. Further, it is likely that most people spent up their borrowings on simple consumption and nothing better than that. They'll likely suffer some.

Still, the point is that in an inflationary environment it is an error to be caught holding large cash balances or to invest in conventional automatic instruments for the purpose of storing savings. Certainly the value will only be eroded further and further over time. Following that pathway results in net cost and the erosion of value.

Many people who are considered "gullible" or "silly" realised what the situation presented and preferred to spend now and borrow now- paying back with devalued dollars in the future or even walking away and never paying at all. Perhaps not so gullible after all.


--

It is difficult to expect moral behaviour from those operating within an amoral system.

LGM

4/30/2009 09:51:00 pm  
Anonymous Elijah Lineberry said...

Excellent post, Peter; I am pleased someone has not joined the 'Mexican Wave' about the interest rate cut and pointed out it is actually a bad thing at this time.

One further consequence of this absurd RBNZ move is the dollar will be lower than it should be; were interest rates much higher, in addition to encouraging proper savings and investment, it also means the dollar rises which means our living standards rise as imports become much cheaper (not to mention the substantial capital inflows into NZ to be invested).

Once again Bollard shows himself to be a fool.

5/01/2009 02:24:00 pm  
Anonymous PhilBest said...

This is certainly a most interesting thread.

I would like to raise something that I have been arguing at great length on other blogs. I agree with what this blog stands for, but nevertheless I feel that there are areas of blame that are being let off too lightly because the best people are focusing their intelligence on the very real problem of central banking and base interest rates.

There is something uniquely bad about the current crisis. Monetary policy certainly is to blame for one bubble after another; but share market bubbles have not been anywhere near as damaging as the current housing bubble.

Bubbles all divert investment away from productive activity as long as there are prospects of greater returns from participation in the bubble. Share market bubbles and dot com and other genre specific bubbles involve persons getting willingly involved to the extent that they can save or borrow money.Then when the bubble bursts, it is those people who have lost their "capital", and there is of course further fallout in the finance system according to just how stupidly institutions have got involved in financing bubble activity.

But housing price bubbles are much worse because they attract participation from a much wider range of people. The price of shares going up unrealistically high does not give almost the entire population a source of increasing collateral for debt of almost any kind. A housing price bubble, IN THE ABSENCE OF SUPPLY keeping prices under control, will only be brought to an end when it has literally sucked an economy dry.

The capitals above point up my main concern. Why have house price bubbles only been an economy-destroying phenomenon now, when monetary policy swings and sharemarket bubbles have been a feature for decades? The answer is that in the past, a housing boom consisted of malinvestment in the building of houses, too many new houses. This is because land supply rationing politics had not become the fashion it has in the last 20 years.

There is an exception that proves the rule: England has had these periodic massive spikes and crashes in house prices for decades already, consequent on having the land rationing policies already. It just seems that the connection has been elusive.

While I agree completely about central banks and base interest rates, I would argue that if the supply of land is restricted, a house price bubble could occur and destroy an economy even under a gold standard. I would argue that the land supply issue is actually the most important of the two right now.

I made an extended argument on THIS otherwise unused thread, with links to the research that I am quoting in support.

http://www.interest.co.nz/ratesblog/index.php/2009/04/09/housing-special-why-the-march-housing-market-surge-is-an-indian-summer/

Note that I have made similar arguments on interest.co.nz and had long debates with the people who think that capital gains taxes are the answer. I think there will be a lot more intelligence on here. (Capital gains taxes have not prevented house price bubbles anywhere in the absence of land supply freedom).

Note that California is the source of nearly HALF the destruction in the USA - whole swathes of the USA with minimal property development restrictions experienced next to no price escalation and next to no price collapse. Talking about "The USA's housing bubble" misses the point. But do refer to that link if you are interested to know more.

5/01/2009 03:59:00 pm  
Anonymous PhilBest said...

The link to interest.co.nz article did not work. Please Google PhilBest/Cox/Utt/Moran and you will find it.

5/01/2009 04:03:00 pm  
Anonymous Anonymous said...

Jeff, you are right on -- what is happening is a massive transfer of wealth from mddle class savers to the banks and the government (redundant?). Your savings are being used with virtually no cost of funds -- but what choice do you have other than risky investments? The Federal Reserve and the Treasury want you to spend or take risks -- screw 'em -- I'll keep my money, even if it's a wasting asset.

6/04/2009 01:25:00 pm  
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2/09/2010 06:43:00 pm  

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