“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.