Artificially low interest rates have created bubbles – Analysis – Eurasia Review

By Frank Shostak*

In his June 21 New York Times Article “Is the era of cheap money over? Other commentators have argued that these low interest rates have inflated bubbles everywhere as investors are desperate for something that will produce a decent rate of return.

Krugman expresses strong disagreement that the drop in interest rates caused bubbles and that the drop was artificial. For Krugman, the Federal Reserve sets short-term interest rates, which in turn determine long-term rates. He then suggests that there is no such thing as an interest rate unaffected by politics.

The columnist then argues that what matters for Fed policy is the natural rate of interest, which is consistent with price stability and economic stability, that is, economic equilibrium. This means that the key objective of Fed policies should be to target the policy rate to the natural rate in order to achieve this equilibrium state. Given that the natural rate was on a downward trend, it is not surprising that the key rate followed suit.

Why does the natural rate tend to fall? According to Krugman, the downward trend was caused by demographics. “When the working-age population is slowly growing or even shrinking, there is much less need for new office parks, shopping malls, or even housing, hence low demand.” Krugman warns: “These demographic forces are not going away. On the contrary, they are likely to intensify, in part because the rate of immigration has fallen. So there is every reason to believe that we will soon return to an era of low interest rates.

Krugman also says the Fed’s interest rate policy has been in line with the neutral rate, which has fallen very sharply. Again, the main reason for this decline is the aging of the population and the declining demand for infrastructure investment. However, does it all make sense?

Interest rates and the Fed

Also according to Krugman, the Fed is the key factor in determining interest rates through its control of short-term interest rates. The Fed influences short-term interest rates by influencing monetary liquidity in the markets. By injecting liquidity, the Fed lowers short-term interest rates. Conversely, by withdrawing liquidity, the Fed exerts upward pressure on short-term interest rates.

In this view, long-term rates are the average of current and expected short-term interest rates. If today’s one-year rate is 4.0% and next year’s one-year rate should be 5.0%, today’s two-year rate should be 4.5% ((4 + 5) / 2 = 4.5%). Conversely, if today’s one-year rate is 4.0% and next year’s one-year rate should be 3.0%, then the two-year rate should be 3, 5% (4 + 3) / 2 = 3.5%.

In this logic, it would seem that the central bank is the key to the process of determining interest rates. However, is this the case?

Time preferences and interest rates of individuals

We believe that individual time preferences rather than the central bank hold the key to the process of determining interest rates. What it is about?

An individual who has just enough resources to sustain himself is unlikely to lend or invest his meager means. The cost of the loan or investment for him is likely to be very high – it could even cost him his life if he were to consider lending part of his means. Therefore, he is unlikely to lend or invest, even if he is offered a very high interest rate. Once his wealth begins to increase, the cost of the loan or investment begins to decrease. Allocating part of one’s wealth to loans or investments will undermine to a lesser extent the life and well-being of our individual at the present time.

We can deduce from this, all other things being equal, that anything that leads to the expansion of the wealth of individuals is likely to lead to a decline in the premium of present goods relative to future goods. This means that individuals are likely to accept lower interest rates.

Note again that interest is the result of individuals placing greater importance on goods and services in the present over identical goods and services in the future. The higher rating is not the result of capricious behavior, but of the fact that life in the future is not possible without first sustaining it in the present. Therefore, the various goods and services necessary for the maintenance of a man’s life at the present time must be of greater importance to him than the same goods and services in the future.

The decline in time preferences, that is, the decline in the premium of current goods over future goods due to the expansion of wealth, is likely to manifest itself in a greater willingness to invest wealth . With the expansion of wealth, individuals are likely to increase their demand for various assets, financial and non-financial. In the process, this raises asset prices and lowers their returns, all other things being equal.

Typically, a major factor in the gap between observed interest rates and the time-preference interest rate is central bank action.

The Myth of the Neutral Interest Rate

Again, according to popular thought, the neutral rate is one that is compatible with stable prices and a balanced economy. Therefore, according to this thinking, in order to achieve economic and price stability, Fed policymakers should steer the federal funds rate toward the neutral rate range.

In the context of the neutral interest rate, to determine whether monetary policy is restrictive or accommodative, it is not enough to pay attention to the level of money market interest rates, but rather to compare the interest rates of the money market with the neutral rate. Thus, if the market interest rate is above the neutral rate, the policy stance is restrictive. Conversely, if the market rate is below the neutral rate, the policy stance is relaxed. So, whenever the money market rate is in line with the neutral rate, then the economy is in a state of equilibrium and there is neither upward nor downward pressure on the price level.

In the popular framework, the neutral interest rate is formed at the point of intersection between the supply and demand curves. The supply and demand curves as presented by popular economics come from the imaginary construction of economists. None of the figures underlying these curves come from the real world; they are purely imaginary. According to Ludwig von Mises, “It is important to realize that we have no knowledge or experience regarding the shape of such curves.”

Consequently, this implies that it is not possible to establish from the imaginary curves the neutral rate of interest. The use of sophisticated mathematical methods does not solve the problem of non-compliance with the neutral rate. So what does Krugman rely on to suggest that the neutral rate is trending lower? No way. Unlike Krugman, the Fed, being a major source of monetary creation, contributed to the formation of bubbles.

Conclusion

Unlike Krugman, the main source of money creation “out of thin air” is the central bank. Therefore, various bubble activities created are the result of Fed monetary pumping and nothing else.

*About the Author: Frank ShostakApplied Austrian School Economics’ consulting firm provides in-depth assessments of financial markets and global economies. Contact email.

Source: This article was published by the MISES Institute

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