This week the US Federal Reserve announced it anticipates holding its official interest rate, the target federal funds rate, near zero, at least through mid-2013. The official statement read, ‘To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee currently anticipates that economic conditions-including low rates of resource utilization and a subdued outlook for inflation over the medium run-are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.’
What on earth were they thinking when they made this announcement? Presumably it was designed to reassure investors that they would continue to supply cheap liquidity for a prolonged period? However, well intentioned it may have been, it appears only to have confirmed how sick they perceive the economy as being!
As I have noted before, the Keynesian principal of government deficits rising as the economy slows down, to ‘pump-prime’ and re-instigate growth, has clearly failed over the last 4 years in the US, the UK and the eurozone. The underlying problem in these countries has continued to be national spending in excess of income, whether by individuals, businesses or the government. And low interest rates of course continue to encourage spending – that is what they are designed to do.
For a sustainable solution, everyone in these countries actually needs to spend less – or more accurately, a smaller percentage of their income. What would encourage this would be higher interest rates, not lower.
Of course, if you are poor, with significant debts, struggling to make ends meet, then any increase in interest rates will lead to an almost total pass through to a decrease in consumption – there is no saving anyway, it’s just a question of dividing up your income and borrowing between different outlets, so more interest payments means less spending on other goods and services. On the other hand, if you have savings, whether in the form of bonds, bank accounts or pensions, a rise in interest rates will probably not all be passed through into consumption – you are already saving, so arguably you will save even more when your income rises. This inequality in the marginal propensity to spend in response to an increase in interest rates, would reduce overall demand in the economy.
That is why you need higher growth to solve the fundamental debt problem – so that the savings ratio can rise without aggregate demand falling. The conundrum facing policy makers is how to encourage this growth as well as a rising savings ratio. Low interest rates haven’t worked. High public sector deficits haven’t worked. Devaluation of the currency has worked to a limited extent, but it can only be effective in one currency area at the expense of another.
One possible solution is for money to be lent to people who will spend it in a way that will generate growth – namely small and medium sized businesses which have excess demand for their products, but can’t finance the expansion they need to meet this demand. These are the people that the banks have failed – despite exhortation by various governments to lend to such entrepreneurs, risk aversion and a necessity to rebuild their balance sheets has deterred the banks. Somehow a forced return to lending seems necessary, but it is unclear who should police or organise this –another instance of where the free-market banks themselves only see the individual risk-reward ratio, not the social utility of increased lending.
A second solution is for the surplus nations to increase their spending on goods from the deficit nations, but that of course is not in the gift of the deficit nations to engineer!
Immediately after the Fed’s decision, Todd Harrison, a well known commentator on the Wall Street Journal’s Market Watch, wrote a piece entitled ‘The Second Side of the Financial Storm’. It concluded, ‘Debt reduction and the rejection of — and guilt projection toward — materialism will continue what began in 2008. It won’t just be about doing more with less, but doing less… period, and finding happiness through avenues other than money.’
One wonders what politician in the US is going to dare say that to the 25% of 16 to 19 year olds in the country who are unemployed! Especially after witnessing the recent news from the UK, where the rioters on the street frequently say they are targeting ‘the rich’, and a system they perceive has left them without skills or any hope of an affluent future.