Do Low Interest Rates Really Help The Economy?

[airborne18]

The idea behind a stimulus is to create jobs. Economically that's exactly what adding troops does, and fast, most notably in WWII. Please see the Feldstein article.

You're conflating the two: economic stimulus and R&D dividends. R&D is more beneficial in my view, and R&D can also be a stimulus and create jobs, but it's hard to do quickly.

That was intentional, it is the same basis for the space industry. The shuttle was a failed program, but the reason for keeping it around was for public relations and r&d money.

Defense spending funds a lot of University and private research, that is fact. Between medical and defense, those are the two primary sources of research funding.

I will read it, but the issue in WW2 was that women for the first time entered the workplace, that is why having a complete generation of men in the military was a stimulus. So it is not really the same thing.

 

[airborne18]

Unfortunately, that is not true. Military spending is targeted to very narrow economic zones with narrow geographical impact. Want to build a couple of new frigates? The contract will go to Bath, ME or to Ingalls in MS. Neither area is as heavily impacted by our poor economy as the national average.

Of the large sawmills in ME, all have closed down but one. Stimulating the housing industry would bring back some of those jobs, including wood-cutters, log-yard owners, brokers, etc. That would be a widely-distributed benefit. Building a new ship is not.

It is because defense spending grows the entire economy. Defense contractors have thousands of suppliers and so does the DOD. But it has to be spent on new projects.

We don't have housing anymore. I actually like the notion that alternative energy conversion be a new avenue for the home industry, the problem is that we need a stronger economy to spark that.

Our production has very few options. Defense is probably the best return on spending.

 

[John Creighto]

There are a few reasons some consider low interest rates detrimental

1) It is a form of market control. Market controls result in a misalocation of resources (invisible hand theory)

2) Low interest rates create a disincentive to save.

3) Low interest rates cause market cycles by first causing a credit expansion.

4) The American public has no capacity left to borrow.

5) The cheap money will be used by corporations to invest abroad rather then at home.

The last point is discussed in the following article:

http://robertreich.org/post/1033774961/warning-why-cheaper-money-wont-mean-more-jobs

 

[CRGreathouse]

1) It is a form of market control. Market controls result in a misalocation of resources (invisible hand theory)

2) Low interest rates create a disincentive to save.

3) Low interest rates cause market cycles by first causing a credit expansion.

4) The American public has no capacity left to borrow.

5) The cheap money will be used by corporations to invest abroad rather then at home.

#1 is a very strong argument against artificially-low interest rates. #2, #4, and #5 are bad arguments IMO. #3 is interesting, because it suggests that the optimal rate will be somewhat above the market rate (though not too much above, else the reverse of #1 kicks in).

 

[mheslep]

There are a few reasons some consider low interest rates detrimental

1) It is a form of market control. Market controls result in a misalocation of resources (invisible hand theory)

#1 is a very strong argument against artificially-low interest rates.

I'd say #1 is an argument against any kind of extreme interest rate control, not just low rates.

The missed elephant in the room in discussions about abolishing interest rate controls is how does the government control the money supply in an expanding economy? The government prints the money. I'm interested in some 'out there' schemes that envision taking away that exclusive power some day, but until then the government owns the presses and must have a mechanism for putting the money into play, not too fast, not to slow.

 

[talk2glenn]

John, all of your arguments are repeats and no more valid now than when made originally. For brevity, given that you organized them in a single post, I will attempt to organize my final response similarly.

1) It is a form of market control. Market controls result in a misalocation of resources (invisible hand theory)

This is no invisible hand theory, even if it were true. Firstly, interest rates are a market function - as said, neither the United States nor the Federal Reserve have the power to set rates in the economy. However, both the Treasury and the Reserve Board have broad tools to incetivise changes in rates towards target levels.

This is a form of market internvention, not control, and does not result in a "misallocation of resources" (there is no such thing; there is no absolutely preferable resource allocation, only scarce resources to satisfy infinite demands and competing mechanisms for rationing their distribution - there are however competing efficiency levels between models). It is not true that economic theory regards the "free market" as strictly preferable to a structured market. Consider gravity - we do not cry foul when engineers build floors to beat gravity. Instead, we consider this a reasonable means of "controlling" gravity. Without them, you'd free fall to sea level. Market law is no different. There are natural causal relationships (normative economics), and there are desirable outcomes (positive economics). Interest rate manipulation is about positively influencing the interest rate market to achieve some desirable outcome (like keeping your economy from falling off a cliff, as hand railings do the same vis a vis gravity).

2) Low interest rates create a disincentive to save.

This is true, and is a good thing. People save when they lack confidence in their individual financial futures. Social safety nets and stable economies discourage savings, which promotes economic growth, in the long-run. In the short run, central banks can use interest rate manipulation to discourage savings during crisis periods.

3) Low interest rates cause market cycles by first causing a credit expansion.

This is not true. Market cycles are natural - they would occur in a flat interest rate environment (consider the numerous recorded cyclical boom/bust periods during the pre-Englightenment era, when there were no formal currency markets or lending mechanisms). Good interest rate policy can mitigate natural cyclical effects; bad interest rate policy can have the opposite effect. This is an argument for interest rate manipulation, not against it.

4) The American public has no capacity left to borrow.

This is not true. There is no absolute "debt ceiling". You as a consumer of debt can borrow as much as someone is willing to lend you. Theoretically, you could borrow an amount approaching infinity, if you could find willing lenders.

5) The cheap money will be used by corporations to invest abroad rather then at home.

This is mostly wrong. Corporations have an incentive to invest wherever capital is cheap. Low domestic interest rates relative to those in foreign countries encourage investments at home, and discourage investments abroad. Further, low interest rates deflate currency values, further discouraging investment abroad and encouraging export growth. To invest abroad, companies must purchase foreign currency. You cannot simply borrow dollars in the United States and use those dollars to buy factory space in Malaysia.

It is true that the increased exports can have the effect of encouraging direct foreign investment, because domestic corporations become flush with foreign currency, and it is often more practical to invest that currency than convert it (at cost). This is not generally considered a bad thing, however (it helps lower the trade deficit, for one).

 

[airborne18]

This is mostly wrong. Corporations have an incentive to invest wherever capital is cheap. Low domestic interest rates relative to those in foreign countries encourage investments at home, and discourage investments abroad. Further, low interest rates deflate currency values, further discouraging investment abroad and encouraging export growth. To invest abroad, companies must purchase foreign currency. You cannot simply borrow dollars in the United States and use those dollars to buy factory space in Malaysia.

It is true that the increased exports can have the effect of encouraging direct foreign investment, because domestic corporations become flush with foreign currency, and it is often more practical to invest that currency than convert it (at cost). This is not generally considered a bad thing, however (it helps lower the trade deficit, for one).

Talk2glenn is correct. Global corporations have to face the cheap dollar.

 

[mugaliens]

It is because defense spending grows the entire economy. Defense contractors have thousands of suppliers and so does the DOD. But it has to be spent on new projects.

It has to be spent on necessary projects, those which provide significant value to the taxpayer base at large. Spending for the sake of spending, whether on the DoD, the national highway system, wherever, merely shifts funds from the taxpayers to the DoD and contractors, where anywhere between 10% to 70% of those funds are lost in the cogs of the machine.

Defense is probably the best return on spending.

Hardly. Have you any idea of the billions of dollars which go missing in the defense industry every year?

 

[turbo]

Hardly. Have you any idea of the billions of dollars which go missing in the defense industry every year?

Thank you! We desperately need to build and rebuild or repair infrastructure right now. It's pretty hard to hide overruns in asphalt costs, gravel, etc unless you're operating in a state that is totally corrupt. Maine is very rural, and we are a critical cross-road for trade between Maritime Canada, PQ, Ontario, and the NE states. Our roads and bridges are falling apart, costing us (and the truckers using the roads) lots of money in unnecessary repairs.

You can hide an overrun in a control system for a defense contract pretty easily, but when gravel costs $X/yd locally and you are charging significantly more against a contract, it will be noticed quickly. It's time to authorize and fund the building of infrastructure projects that have been identified as those having the most positive impacts on our local economies.

 

[brainstorm]

The missed elephant in the room in discussions about abolishing interest rate controls is how does the government control the money supply in an expanding economy? The government prints the money. I'm interested in some 'out there' schemes that envision taking away that exclusive power some day, but until then the government owns the presses and must have a mechanism for putting the money into play, not too fast, not to slow.

Fiscal policies? The problem, imo, is that it's incredibly unpopular to tax at all, let alone tax without spending. So how is the government supposed to stimulate fiscal conservation? Interest rates can only go so low before they would have to become negative to slow down the circulation of money. If the government runs a surplus, people would complain that the money has to be spent or else they would say that if it isn't going to be spent then there's no reason to tax it in the first place.

The problem is that there's a culture that views more money and spending as always being good. The only way people ever think that the economy is running badly is if they want more money and they're not getting it. No one ever seems to recognize the need for fiscal constraint to cool down a hot market. The possibility of true fiscal constraint has become totally hidden behind the barrage of choices about how to spend.

How do you reel in the money supply with monetary policy or fiscal policy that always couples taxation with spending?

 

[mheslep]

Fiscal policies?

The thread is about the impact of interest rates, and thus by definition is not about fiscal policy, only monetary.

...Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.

http://en.wikipedia.org/wiki/Monetary_policy

And lowering interest rates is done (in an attempt) to boost the money supply, not lower it.

 

[CAC1001]

One quick question on interest rates, is it increasing or decreasing the money supply controls interest rates, or raising or lowering interest rates controls the money supply?

For example, the Keynesian liquidity trap concept:

In its original conception, a liquidity trap resulted when demand for money becomes infinitely elastic (i.e. where the demand curve for money is horizontal) so that further injections of money into the economy will not serve to further lower interest rates. Under the narrow version of Keynesian theory in which this arises, it is specified that monetary policy affects the economy only through its effect on interest rates. Thus, if an economy enters a liquidity trap, further increases in the money stock will fail to further lower interest rates and, therefore, fail to stimulate.

http://en.wikipedia.org/wiki/Liquidity_trap

However note it also mentions at the very top:

The liquidity trap, in Keynesian economics, is a situation where monetary policy is unable to stimulate an economy, either through lowering interest rates or increasing the money supply

What do they mean by "...or increasing the money supply" if the way you lower interest rates is by increasing the money supply? Is there an alternative method?

 

[mheslep]

What do they mean by "...or increasing the money supply" if the way you lower interest rates is by increasing the money supply? Is there an alternative method?

One: QE, as a last resort, because apparently it is not clear how well it works.
http://en.wikipedia.org/wiki/Quantitative_easing

 

[loseyourname]

You can target interest rates by controlling the money supply or target a money supply. The Fed currently targets interest rates but it hasn't always chosen this path. It can also make changes to the discount rate and reserve requirement to implement monetary policy, but it rarely does, almost never changing the reserve requirement and only using the discount rate for dire emergencies like 9/11.

But you can always further expand the money supply even if interest rates are at zero. You can also purchase longer-maturity bonds to target rates further out on the yield curve. The Fed can also manipulate exchange rates by buying and selling foreign currency, though it tends to avoid doing this.

There are plenty of tools in the toolbox, all of which can have a stimulative effect.

Read Ben Bernanke's speech from 2002, Deflation: Making Sure "It" Doesn't Happen Here. Remember the Fed has twin mandates of full employment and price-level stability. Nothing it has done has put much of a dent in unemployment, but a large point of the quantitative easing measures and other programs was to avoid deflation and prop up price levels via dollar devaluation as well as asset purchases to directly prop up specific asset prices. That part of the program has worked perfectly well, but actual GDP growth depends entirely on what investors and spenders actually do with all of this new money. The only portion of GDP the Fed can directly control is export demand via dollar devaluation as well as its other methods of exchange rate manipulation, but it's only likely to ever go halfway with this and neither the G20 nor the US Treasury are even happy with just the dollar devaluation.

Plus, other countries need to comply. Export demand grew in the immediate wake of QE1 and the US trade deficit shrank, but then other countries devalued their currencies, too (especially the Euro but that wasn't intentional) and the trade deficit ended up exactly where it had been prior. The reason the G20 hates this is they don't want to see an assault on currencies resulting in a trade war.

 

[brainstorm]

Remember the Fed has twin mandates of full employment and price-level stability. Nothing it has done has put much of a dent in unemployment, but a large point of the quantitative easing measures and other programs was to avoid deflation and prop up price levels via dollar devaluation as well as asset purchases to directly prop up specific asset prices. That part of the program has worked perfectly well, but actual GDP growth depends entirely on what investors and spenders actually do with all of this new money. The only portion of GDP the Fed can directly control is export demand via dollar devaluation as well as its other methods of exchange rate manipulation, but it's only likely to ever go halfway with this and neither the G20 nor the US Treasury are even happy with just the dollar devaluation.

I have the impression that although the government is often accused of using economic interventions to reduce "the gap between rich and poor," that what it really does is stimulate the maintenance of class-distinctions in GDP distribution. Freddie/Fannie, for example, used to be billed as programs that would make it possible for everyone to own a home, but the net effect of the mortgage underwriting was to inflate housing to its highest possible price, thus relegating low income buyers to ghettos, etc. I wonder if ceasing the propping-up effect of asset prices would not actually "reduce the gap between rich and poor" more than fiscal stimulus since it is easier to distribute fiscal stimulus unevenly than it is to distribute losses. Losses during a recession disproportionately affect those with more to lose, which has a greater effect in terms of "closing the gap" of wealth disparities, no?

I'm not necessarily claiming that wealth-disparities are good or bad. My point is just that politics tends to view government subsidies as geared toward closing the gap, whereas I think it ultimately has the opposite effect. To me this is hypocrisy to claim to be helping the poor while really just fattening the middle-class while leaving the poor and disenfranchized in the same position they are always left in. Why not just sell fiscal stimulus and government subsidies as a way to promote more elite lifestyles among the middle-class? The only reason this would fail is because part of middle-class culture is denying one's relative elitism and spoiled lifestyle. If you don't believe me about this, see if no one responds to this posts by vehemently denying that the middle-class is spoiled, claiming that they just live comfortably and that should be a fundamental right (except for the poor and working class never seem to get access to that right).

 

[mheslep]

[...]Nothing it has done has put much of a dent in unemployment, but a large point of the quantitative easing measures and other programs was to avoid deflation and prop up price levels via dollar devaluation as well as asset purchases to directly prop up specific asset prices. That part of the program has worked perfectly well,

That remains to be seen. Bernanke has to eventually exit all that colossal QE without either 1) creating substantial inflation or 2) imposting draconian interest rates to prevent 1)

 

[CAC1001]

I have the impression that although the government is often accused of using economic interventions to reduce "the gap between rich and poor," that what it really does is stimulate the maintenance of class-distinctions in GDP distribution.

Government programs doing the complete opposite of what they were intended for? No surprise there.

I'm not necessarily claiming that wealth-disparities are good or bad. My point is just that politics tends to view government subsidies as geared toward closing the gap, whereas I think it ultimately has the opposite effect. To me this is hypocrisy to claim to be helping the poor while really just fattening the middle-class while leaving the poor and disenfranchized in the same position they are always left in.

Really? I have always viewed it as the opposite: that it's the poor who get help and subsidies, while the middle-class who are left struggling. If you're poor, you can get Medicaid, food stamps, subsidized housing, etc...if you're middle-class, you don't get any of that.

There's what you call the "working poor," those who earn barely enough to getby, but just enough to not qualify for government programs.

Why not just sell fiscal stimulus and government subsidies as a way to promote more elite lifestyles among the middle-class? The only reason this would fail is because part of middle-class culture is denying one's relative elitism and spoiled lifestyle.

I think there are a lot of solidly middle-class people who would deny that they are "spoiled" in any way.

If you don't believe me about this, see if no one responds to this posts by vehemently denying that the middle-class is spoiled, claiming that they just live comfortably and that should be a fundamental right (except for the poor and working class never seem to get access to that right).

Working class = middle class most of the time from what I've seen. A hardworking blue-collar worker to a hardworking doctor, all work hard, one may be solidly middle-income, the other more upper-income, but they're all what woudl be deemed middle-class. And I have never heard anyone claim that a comfortable lifestyle is any "fundamental right." You are supposed to have a fundamental right to go out and work as hard as you can and make as much money as you can to live a comfortable lifestyle, but otherwise, society doesn't owe you a thing.

 

[loseyourname]

That remains to be seen. Bernanke has to eventually exit all that colossal QE without either 1) creating substantial inflation or 2) imposting draconian interest rates to prevent 1)

"Has worked." I'm not trying to predict the future. It's obviously pretty risky and the Fed Board is fairly divided about it. I'm not endorsing the program, just saying that, to this point, we've avoided deflation, which Bernanke obviously fears more than inflation, and to the larger point, the Fed can still do plenty even with interest rates at zero.

 

[WhoWee]

Now that the election is over (remember when Obama said there are things he's doing that we don't know about?).
http://news.yahoo.com/s/ap/federal_reserve;_ylt=AnIi6CJ3pr6KkVUqOyDNL5dh24cA;_ylu=X3oDMTJvOTBkMXA4BGFzc2V0Ay9zL2FwL2ZlZGVyYWxfcmVzZXJ2ZQRjY29kZQNleHByZARjcG9zAzcEcG9zAzcEc2VjA3luX3RvcF9zdG9yaWVzBHNsawNmZWRwb2lzZWR0b3U-

"The Fed's credibility is on the line, as is Bernanke's. The Fed chief has been credited with preventing the Great Recession from turning into the second Great Depression.

"Getting this decision right is critical to Ben Bernanke's legacy," said Kenneth Thomas, a lecturer in finance at the University of Pennsylvania's Wharton School. "He can't afford for it to backfire."

A bond-buying program of around $500 billion would likely provide only a modest boost to growth in the final months of the year. Even with that, the unemployment rate is expected to stay above 9 percent by year's end.

One option is for the Fed to announce its intention to buy a specific amount in bonds over a set number of months. After that, it would assess, at each meeting, whether it should buy more. Its decision would hinge on how the economy is faring.

The Fed will announce its purchases one day after the nation votes for a new Congress. High unemployment, meager wage gains and soaring home foreclosures have frustrated many voters. Republicans are expected to score big gains.

The anticipated move by the Fed has sharply divided economists, according to an AP Economy Survey released last week. Roughly half said such bond purchases, if they reduced rates, could spur Americans to spend more, strengthen the economy and lead to more hiring.

But the other half countered that another round of stimulus won't provide much help. Some worry it could lead to new threats later on. These include out-of-control inflation or a wave of speculative buying that inflates bubbles in the prices of commodities or bonds or other assets."

Printing money to purchase bonds - to keep rates low - to stimulate the economy - half of the experts disagree - Fed's credibility on the line...to be continued?

 

[mheslep]

"Has worked." I'm not trying to predict the future. It's obviously pretty risky and the Fed Board is fairly divided about it. I'm not endorsing the program, just saying that, to this point, we've avoided deflation, which Bernanke obviously fears more than inflation, and to the larger point, the Fed can still do plenty even with interest rates at zero.

Right, I wanted to emphasize the on going nature of Fed action, which could be like the man falling off a high rise and upon passing each floor, saying "so far so good". Or not?

Also, I'm not yet sanguine on the effectiveness of QE, from a lack of full understanding I expect. Yes we have more or less a desired outcome, but that does not prove causality. For instance, I've read here and there that the ongoing clearing of the housing bubble is really the inflation/deflation driver, and that by comparison the Fed action (beyond interest rates) is a party noise maker, at least until housing works itself out. So I'd like to see more evidence.

 

[vela]

You can target interest rates by controlling the money supply or target a money supply. The Fed currently targets interest rates but it hasn't always chosen this path.

Is this true? I know the Fed used to try keep interest rates stable back in the 70s only to have its policies produce stagflation. I was under the impression that after that, the Fed, starting with Volcker, mainly focused on keeping inflation in check, which essentially meant not letting the money supply grow too quickly.

It can also make changes to the discount rate and reserve requirement to implement monetary policy, but it rarely does, almost never changing the reserve requirement and only using the discount rate for dire emergencies like 9/11.

An econ professor likened the difference between adjusting the discount rate or reserve requirement vs. open market operations to control the money supply to the difference between using a meat cleaver vs. a scalpel to cut meat.

 

[WhoWee]

Here's an update on "QE - 2"
http://www.businessinsider.com/new-york-fed-quantitative-easing-2-2010-11

"The New York Fed plans to purchase securities worth $850 to $900 billion in the second round of quantitative easing.

It works like this: There will be an additional amount of purchases worth $600 billion (that's the headline number from the Fed today).

But there will also be a reinvestment of $250 to $300 billion from payments associated with other securities it already holds.

That makes QE2 feel a whole lot bigger, and closer to the top end $1 trillion number that was mentioned."