How low interest rates might save the world, and how to get low rates

[intelliot]

Here's an interesting blog post on WiseBread.com:

http://www.wisebread.com/how-low-interest-rates-might-save-the-world

It's a great read. Especially pay attention to the last section:

How to get low rates

The government manipulates interest rates all the time. In the US the Federal Reserve raises rates to head off inflation and then cuts them again to protect the financial system from the harm done by high rates.

Setting the rates too low produces inflation--and leaving the rates low after inflation has begun to rise makes savings grind to a stop. (If your money is worth less every day, why hold onto more than you need just to transact daily business?)

The only way to get lasting low rates is to have very low inflation. During periods when people had great confidence in their money, such as in England and the United States during the gold standard, people made just the sort of long-term decisions I'm talking about. Planting oak trees to be harvested after 400 years is an extreme (and probably apocryphal) example, but there were plenty of real-world examples of investments made and stewardship undertaken that only made economic sense if the discount rate were 2% or less.

A few years ago the inflation rate got down close to zero and the Fed panicked. They're much happier with an inflation rate that runs between 1% and 2%, because they worry that they don't have the tools to stop deflation once it starts. The problem with not driving inflation down to zero, though, is that long-term sustainable behaviour will never make sense when interest rates are high.

If you're going to get $100 after 50 years it doesn't make sense to invest even $9 today, if the discount rate is 5%. If the discount rate is 2% then you might invest $37, and if the discount rate is 1% then you might invest nearly $61.

To make sensible sustainable activity also make economic sense, you need to have very low interest rates. And the only way to get very low interest rates is to have very low inflation.

[tmosley]

It doesn't seem to make sense. Why would people invest more when the rates are low? That is the opposite of how the market works. Low rates cause overconsumption, not increase savings and investment. High rates are what encourage savings and investment, and thus economic growth.

[Zippyjuan]

Businesses will invest more because their cost of borrowing is lower which increases the return on it if they invest the borrowed funds say in new equipment for their factory. Then they can hire more workers to operate it. I think the more important issue in the piece is to have low inflation rates (which in turn mean lower interest rates since inflation is a component of the interest rate charged). But again, I think this is more beneficial to business investments than individual investments or savings. They may be more willing to take on a particular investment with low inflation than with high inflation/ interest rates because they need a lower return on it to be profitable for them.

[tmosley]

In a world where credit comes from thin air, maybe. In the real world, you can't magic up savings, you can only dilute them. With super low interest rates, there are no savings to steal, so the so called investment is all mal-invested in ventures that wouldn't otherwise be profitable (think Starbucks across from a Starbucks).

That is a false recovery, and continuing down that road will eventually totally collapse these United States, and any other state that follows that policy.

Did I fall into another temporal vortex? Is this the Keynes forum?

[enjerth]

It doesn't seem to make sense. Why would people invest more when the rates are low? That is the opposite of how the market works. Low rates cause overconsumption, not increase savings and investment. High rates are what encourage savings and investment, and thus economic growth.

If we HAD savings, a low rate would make investment more attractive than deposits.

But we don't have much for savings. As we already had a low interest rate and many people were heavily invested in the market, a lot of that savings was wiped out in the stock market over the last year, on top of the fact that we had a relatively low savings rate to begin with.

[tmosley]

If we HAD savings, a low rate would make investment more attractive than deposits.

But we don't have much for savings. As we already had a low interest rate and many people were heavily invested in the market, a lot of that savings was wiped out in the stock market over the last year, on top of the fact that we had a relatively low savings rate to begin with.

What do you think the banks do with deposits? They invest them! Once upon a time, they were investments in sound projects that would produce steady streams of reliable profit, rather than today's risky ventures.

High interest rates make more money available to those seeking loans (rather than venture capital), and they price out fly-by-night operations that would only be marginally productive. Low rates encourage investments in risky investments (see the last ten years). When they come crashing down, everyone involved loses their shirt (se the last year).

Honestly, this is a simple lesson, and one that has been repeated at great length in article after article in this forum. I'm disappointed that you side with the controlled economy people on this.

[enjerth]

I'm disappointed that you side with the controlled economy people on this.

What makes you think I'm siding with them? I'm simply agreeing that low rates promote investment. I'm not saying that's what we need. In fact, I think we need a pretty high rate right now. We need to rebuild, starting with savings.

[tmosley]

What makes you think I'm siding with them? I'm simply agreeing that low rates promote investment. I'm not saying that's what we need. In fact, I think we need a pretty high rate right now. We need to rebuild, starting with savings.

You said that low interest rates would increase economic growth, when it is demonstrably wrong. Controlled economy people (ie the Fed) think they can stimulate growth with low interest rates when it has been shown that it causes economies to shrink, due to loss of savings on frivolous loans and poor business plans. Low interest rates indicate that there is a certain level of savings. If you have those types of rates without the savings to back them up, consumers will devour what little they have, causing the bubble to pop.

Read the comic in the sticky. It makes it a lot easier to understand.

[enjerth]

You said that low interest rates would increase economic growth, when it is demonstrably wrong. Controlled economy people (ie the Fed) think they can stimulate growth with low interest rates when it has been shown that it causes economies to shrink, due to loss of savings on frivolous loans and poor business plans. Low interest rates indicate that there is a certain level of savings. If you have those types of rates without the savings to back them up, consumers will devour what little they have, causing the bubble to pop.

Read the comic in the sticky. It makes it a lot easier to understand.

I didn't say that it would result in economic growth, I only agreed with the premise that a low rate would stimulate investment, if there were savings to invest, which we don't have.

[tmosley]

Well, that isn't really true either. Low interest rates would cause people to consume their savings, which happened in the late 90's. It makes people think they are richer than they are. High interest rates have the opposite effect, but provide an easy channel for making more money (by depositing savings in banks to get 10-15% interest).

[krazy kaju]

It doesn't seem to make sense. Why would people invest more when the rates are low? That is the opposite of how the market works. Low rates cause overconsumption, not increase savings and investment. High rates are what encourage savings and investment, and thus economic growth.

Wrong. Low rates cause an increase in consumption and investment - oveconsumption and malinvestment. That is why there is an inevitable bust; you cannot have resources simultaneously consumed and saved.

[tmosley]

Wrong. Low rates cause an increase in consumption and investment - oveconsumption and malinvestment. That is why there is an inevitable bust; you cannot have resources simultaneously consumed and saved.

I said they cause an increase in consumption. I disagree that they increase investment in general. Rather, it causes malinvestment as business ventures that don't merit investment are able to get bank loans. Sound investments are crowded out.

The bust comes when the actual resources that exist in the economy are overconsumed due artificially low rates and easy money.

Note that the only point we are in disagreement on is that low interest rates do or do not increase total investment. We both agree that it increases malinvestment, both in absolute terms, and as a proportion of total investment. I think that low interest rates decrease total actual investment because it has discouraged savings, which is the source of all real investment. Even there, we may be saying the same thing. Even though there may be more dollars loaned out, there is less productivity backing that money, thus there is less actual investment.