Monday, August 20, 2012

"useless as a fire-hose against a tsunami"

From a guest post by Benjamin Cole at Historinhas --

The conventional central bank weapon for economic stimulus—lower interest rates—is as useless as a fire-hose against a tsunami. Yet Western economies are badly in need of a boost.

Accepted. Now... The usual boost is to substitute fiscal boost for monetary, by increased government spending or perhaps by tax cuts that cause the increased spending to arise in the private sector.

But why does the chatter move from specifics (reducing interest rates) to generalities (monetary policy) to alternatives (fiscal policy) and then back to specifics (changes in taxes and/or spending)? Why the diversionary tactic?

Why the loss of focus? Let's start over.

The conventional weapon is to lower interest rates when a boost is needed.

Stick with that thought. Don't let your mind wander. Now: Why does it work? Or (more accurately) why did it work?

The cause is that interest rates go down.
The effect is that the economy picks up. Spending picks up. Economic growth picks up.
How did that work?

Two ways. Either the lower cost of borrowing induces more borrowing (by supply and demand), or the lower cost of borrowing induces more refinancing, which frees up some income to be spent on other things. Or both.

Either way, the reduction of interest rates lowers financial costs. And the effect of the lower financial costs is that economic growth improves... or is supposed to improve.

It used to work. Now it doesn't.

Don't lose the focus. We're looking at monetary policy here. We're looking at reducing financial costs. And, supposedly, we cannot reduce financial costs any more because interest rates are already at zero.

Supposedly. But we *can* reduce financial costs. We can reduce them a lot. Interest costs are not the only financial cost there is, in our economy. There are also principal costs. If we need to reduce financial costs, and we can no longer reduce interest rates (or if interest-rate reduction has become ineffective), then we can try principal cost reduction.

We can try debt forgiveness and debt writedowns and policies along those lines.


Jazzbumpa said...

True enough. But borrowing costs are not zero - not for you and me. Mortgage interest is still above 3%, and I could get a new car loan for 2.75.

These are historically low numbers, not not zero. Only the Federal governemnt gets that.


The Arthurian said...

Still, interest rates are about as low as they can be. We cannot expect additional rate reductions to further reduce financial costs by any significant amount. There is, however, another way to reduce financial costs. We can try debt forgiveness and debt writedowns and policies along those lines.