The Media Endlessly Talks About Interest Rates—Are They Even an Effective Economic Tool at This Point?

By Marshall Auerback, a market analyst and commentator. Produced by Economy for All, a project of the Independent Media Institute

The one silver lining in the nomination of political hack Steve Moore to the Federal Reserve is that it might spur a productive discussion on the benefits (or lack of them) of monetary policy as an instrument of economic growth. This is principally because it’s just one ingredient for what is necessary to instill economic growth, and not a particularly good one at that. A more direct approach is via appropriately targeted and sufficiently large fiscal actions.

In regard to monetary policy, low interest rates kept in place for a long time can actually constrain economic growth unless they are coupled with sensible compensating fiscal policy, due to the adverse income impact to savers emanating from a resultant lower income stream. There is also a problem of political legitimacy when so little of the funding is explicitly approved by Congress, and is left instead to the discretion/creation of the Federal Reserve (which has historically tended to prioritize the narrow interests of finance over the rest of the economy). And Steve Moore, a leading advocate of cutting rates to promote additional economic growth (even as he has historically championed spending cuts), will simply perpetuate the (unfortunately) widely held notion of monetary policy as an effective cure-all, if his ideas gain policy traction within the Powell-led Federal Reserve.

In fact, what is truly required is well-formulated fiscal policy and less monetary policy activism, precisely the opposite of today’s prevailing trends. Solvency per se is not the issue. The key here is how the money is spent, lest fiscal policy become as diffuse in its effects as monetary policy has become, as well as discredited politically because of perceived ineffectiveness when long-standing structural issues (such as inequality) remain unaddressed.

Moore, a Heritage Foundation fellow and former Wall Street Journal editorial board member, has called for the Federal Reserve to cut rates in order to spur faltering economic growth.Here’s the problem: interest rates are a diffuse tool to manage economic growth. For every distressed borrower who benefits from lower interest rate charges, there is a saver adversely affected by the resultant loss of income. Additionally, as Bloomberg columnist Noah Smith argues, “Cheap credit does a poor job of weeding out zombie companies that compete for scarce resources.” In fact, a case can be made that low rates actually exacerbate prevailing deflationary trends. Low rates lower investment threshold returns, and reduce the costs of holding inventory, both of which can create oversupply, as well as perpetuating asset bubbles—a highly toxic combination that prevails in the United States (indeed, globally) today. Even with lower unemployment, the U.S. economy is largely characterized by middling growth, spread too thin and too inequitably. Moore’s policy prescriptions would likely make things worse.

Low interest rate regimes have also helped to promote reckless financial engineering that has enabled corporate CEOs (and their trusty investment bankers) to inflate profits and sustain company share prices as high as possible, often at a cost of ignoring the strategic long-term planning required to handle global competitive challenges from overseas companies that are slowly eating our proverbial lunch. In essence, therefore, lax monetary policy has become the handmaiden of the “speculation economy.”

In general, the Fed’s obsession with interest rates and bond yields (along with the corresponding shape of the yield curve) has obscured the manner in which such rates have provided a low-cost laboratory for the creation of Frankenstein-like instruments of financial mass destruction. Furthermore, as Professors L. Randall Wray and Scott Fullwiler have argued, “this was made even worse by the Fed’s cultivation of a belief that no matter what goes wrong, the Fed would never allow a ‘too big to fail’ institution to suffer from excessively risky practice. If anything, this encouraged more risk-taking.”

The real paradox of using monetary policy in general is that it only “works” to the extent that it induces the private sector to spend more out of current income, or encourages binging on private debt (which low rates can facilitate). If current income is adversely impacted by weak income flows, however, the interest rate is a highly flawed tool to solve the underlying problem, especially if it means simplistically cutting rates further, as Moore advocates. Such an action can foment bubbles in a multitude of assets—stocks and real estate being two of the most prominent examples—the collapse of which ultimately creates greater deflation, as well as exacerbating income inequality. This is because asset bubbles create huge increases in income for top earners, particularly in the finance sector, due to the relentless expansion of credit brought about by prevailing low rates. Changes in technology, and increasingly poor and outdated regulation in the context of a rapidly globalized financial system have accelerated a trend of asset growth and accumulation increasingly being funneled into fewer and fewer hands at the top.

When asset bubbles burst, the economically distressed sell to those with higher prevailing cash balances, setting the stage for further increases in inequality during the subsequent cycle, as the post-2008 environment clearly has done. As a New Economics Foundation report argues, “The process is self-reinforcing because increasing wealth accrues both higher income returns and greater political power.” This means that those with the highest amount of wealth have the means to lobby governments to maintain status quo policy structures that perpetuate inequality.

Cutting rates at this juncture simply perpetuates current bubble-like conditions and therefore will make the ultimate outcome worse when the bubble inevitably bursts. Moore’s policy prescription of cutting rates is therefore akin to giving a junkie another shot of heroin, rather than dealing with the underlying addiction itself. Moreover, the single-minded focus on interest rate levels has (per Fullwiler and Wray) diverted the Federal Reserve’s attention “away from its responsibility to regulate and supervise the financial sector, and its mandate to keep unemployment low. Its shift of priorities contributed to the creation of those conditions that led to [the 2008] crisis.”

By contrast, fiscal policy can also deal more effectively with the pathology of inequality via targeted spending, which can impact distributional outcomes, as it means directing funds toward those with the highest spending propensities (as opposed to the 1 percent, who generally save more of their income, which means less bang for the fiscal buck). Contrary to prevailing neoliberal theology, economic redistribution in such circumstances actually enhances an economy’s growth potential, rather than hindering it.

But we also want to avoid the fiscal zombie mindset as well. The key is ensuring that deficits are used toward productive job creation, not a perpetuation of crony capitalism. All too often, fiscal policy has been used in service of the latter. This means it has become somewhat politically discredited as an instrument of policy by both parties: in the first instance back in 2009 because the initial fiscal rescue package was insufficiently robust given the loss of almost $2 trillion in economic output in the United States alone. Then-President Obama’s $700bn stimulus package, while helpful, mostly kept the recession from being far worse rather than enabling a significant economic recovery, which later led to Republican charges that the policy was ineffective. (By contrast, on the monetary policy front, financial institutions received commitments from the Federal Reserve that may have been as high as $29 trillion, according to a report from the Levy Institute.)

More recently, the benefits of Trump’s highly touted tax “reform” have proven to be more apparent than real. The whole premise behind the lower corporate tax rate was that it would result in literally trillions of dollars allegedly parked offshore being repatriated back to the United States, resulting in a surge of job creation. However, as financial writer Alex Kimani has illustrated, “corporate America brought back just $664.9 billion of offshore profits, or just 16.6 percent of the $4 trillion Trump said they would return as a result of the tax overhaul.”

In reality, even Kimani’s analysis overstates the case. There has been no massive dollar “repatriation” as such. These dollars have always remained deposited in U.S. bank accounts, but have simply been classified as “offshore” via accounting legerdemain in order to exploit lower corporate rates abroad. As Yves Smith of Naked Capitalism points out: “Apple… managed to get a special deal with Ireland that allowed it to report corporate profits nowhere for tax purposes, kept the cash related to its Irish sub in banks in the US and managed it out of an internal hedge fund in Arizona.”

Given the prevailing deficit phobia that afflicts both political parties (depending on which is in power), this kind of gimmickry with minimal benefits being experienced by the bulk of the population has legitimized a political narrative against additional fiscal spending, on the grounds that it didn’t do what it promised to do and placed the United States closer to national bankruptcy.

While it is true that government that creates and issues its own currency can never run out of money, a policy that ignores how funds are spent can easily produce undesirable outcomes (such as inflation or rising inequality). One of the great post-Keynesian economists of the 20th century, Hyman Minsky, insisted (in the words of one of his students, L. Randall Wray), “that the impact of the budget on the economy depends on where spending and taxing is directed. Military spending and transfers, for example, are less productive and therefore more inflationary.” And yet this is precisely where much of Trump’s new spending is being directed, even as vital social spending is being cut back. Unfortunately, this has led opposition to Trump to fall into the intellectual cul de sac of obsessing about debts and deficits, rather than focusing on what we do with those deficits.

And as the paltry benefits of last year’s tax package have largely dissipated (to the extent that they created any economic benefit at all for the bulk of Americans), the focus has come back to the Federal Reserve just as Steve Moore’s nomination has been announced. A decade on from the collapse of the 2008 bubble, the latest data on inflation shows an invidious combination: Consumer Price Index figures are now rising at their lowest level in almost two years, but virtually all core inflation, reports Rana Foroohar from the Financial Times: “was in rent or the owner’s equivalent of rent (up 0.3 per cent). Core goods inflation, meanwhile, was down 0.2 per cent.” This means higher house prices at a time when quality affordable housing is still out of reach for the average American. Lowering interest rates, as Moore suggests, will likely exacerbate the housing bubble, and fuel additional stock market speculation, without fundamentally doing much to promote further spending power on the part of the average American citizen. Meanwhile, the relative absence of a proper role for fiscal policy means that the toxic prevailing macroeconomic imbalances (such as ongoing huge levels of household indebtedness and wealth inequality) will continue.

Every tool and target deployed by the Federal Reserve has simply restored an unhealthy status quo ante in financial speculation, while the comparative diminution of fiscal policy has left us with an inefficient economy that still leaves tens of millions of workers behind in terms of wage gains, access to decent public infrastructure, and denial of quality health care. Imagine if some of those trillions of government loan guarantees, standing credit facilities, and bailouts to various financial institutions had gone toward more productive uses. How much better would the U.S. economy look today? Regrets aside, it’s becoming increasingly difficult to make the case that cutting interest rates alone is a panacea. In fact, in the current context, it may well make things worse.

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30 comments

  1. Jim A.

    IMHO, the main issue is that corporate investment is not credit constrained, it is demand constrained. There is no reason to expand if they can’t sell more of their product. In aggregate, consumers are constrained more by lack of income to service current debt than they are by the access to credit. The result is that lower interest rates are neither as effective at juicing the economy, or triggering an inflationary spiral as they have been in the past. Indeed to the extant that all the juicing has boosted prices, it has only boosted the prices of assets that are expensive enough that they are bought with borrowed money: real estate, college degrees, and stocks.* This “new normal,” has yet to percolate through to the movers and shakers, so even as some urge ever lower interest rates to boost the economy, others worry about inflation, and neither seems to realize that MOST of the extra credit just boosts income inequality. It would be funny, if it wasn’t so serious.

    *especially PE and Leveraged buy outs.

    Reply
    1. Detroit Dan

      Well said, Jim A. I’ve struggled a bit try to explain to relatives what you state so clearly here.

      Reply
      1. Andrew Thomas

        Great work by Mr. Auerbach. The amazing aspect of this to me is that this even has to be belabored after the record of the past 50 years. The Friedmanesque cult of privatization, balanced budgets and savage austerity has been a complete failure, if it was ever anything other than an utterly phony, and very successful, program to destroy even the possibility of social democratic governance, and to suck all wealth and power upward to a tiny elite.

        Reply
  2. BoulderMike

    From the article: “For every distressed borrower who benefits from lower interest rate charges, there is a saver adversely affected by the resultant loss of income.”

    The problem with this statement is that it assumes proportionality. In fact, even with low and decreasing interest rates by the Fed, borrowers (consumer borrowers that is) continue to pay more and more, higher and higher interest rates, while savers get lower and lower interest rates. When the Fed lowers rates, financial institutions don’t traditionally lower rates they charge to consumers. It is a double edged sword that benefits the wealthy/corporations and punishes every one else.

    Reply
        1. Andy Raushner

          More like the end of growth. The economy simply can’t grow that fast anymore. So the system is dying. Neither higher or lower rates will solve that. Neither will fiscal policy.

          Reply
  3. Sol

    More and more people recognize this formula isn’t working, but what will it take to change course?

    The heat death of the universe. Non-responsive systems continue to the point of catastrophic failure.

    Reply
  4. Winston Smith

    There is nothing to fear as it appears that the President is preparing to appoint Herman (Hurricane) Cain to the Fed. Once the background check is complete. This is not a joke apparently-reported by Axios

    Reply
    1. allan

      As always, there’s always a Tweet. If only the Tsar knew:

      Herman Cain @THEHermanCain

      Don’t be alarmed by rising interest rates; they reflect economic strength and demand for capital

      8:05 AM – 18 Dec 2017

      But you have to feel some sympathy for Moore – imagine having been passed over for Cain.

      Reply
    2. Andrew Thomas

      Oh, hell, at this point, why not? How about RinTin Tin? Do the appointees have to be living bipeds?

      Reply
      1. Andrew Thomas

        On second thought, that was a lousy implicit comparison. Despite Herman Cain having previously served on the Kansas City fed ( a factoid of which I knew not) he is well-known because of his batshit crazy public performances, which makes him very much like Trump. Rin Tin Tin, on the other hand, was, upon information and belief, a very good dog. As Emily Litella said so well, never mind.

        Reply
  5. Summer

    For crying out loud, if they keep doing the same types of policies that lead back to feudalism, then that is the intention.
    It’s not “muddled thinking” on the Fed’s part.
    It’s “muddled thinking” on the part of anyone emotionally and intellectually invested in the sanctity of non-sanctified institutions.

    Reply
    1. djrichard

      One thing that cracks me up about the water carriers for the sanctity of the Fed Reserve is how they’re bent out of shape by Trump trying to influence the interest rates. And yet when members of the Fed Reserve weigh in the federal deficit (which is the purview of the legislative and executive branch), nobody has qualms about that, even though their opinions are pro-austerity (the federal deficit is bad).

      But yea, the name of the game for the Federal Reserve is simply to make sure that their liquidity pump doesn’t run in reverse (deflation). Except for when they want deflation – when there’s too much froth and too many playahs at the table. And if that means slowing down the velocity of money as they re-inflate afterwards, to protect the playahs that are TBTF, then so be it. If you’re simply labor, you have the Fed Reserve’s sympathies, as they keep establishing new normals in slowing down the velocity of money and slowing down the economy.

      Reply
  6. Louis Fyne

    feature not a bug.

    Fiscal stimulus helps the ironworker and truck driver. And helping the native-born blue collar is sooo 1933 in DC.

    Monetary stimulus helps the Wall Street, Silicon Valley and CEOs issuing debt for share buybacks or acquistions.

    Reply
  7. Samuel Conner

    As a companion to the famous “Moore’s Law” regarding the time trajectory of transistor density in semiconductor devices, perhaps we could have a new meme, which I humbly suggest be named “Moore’s Flaw”, regarding the stimulative effect of tax reductions on high earners.

    Reply
  8. kgw

    “The Culture of Contentment,” 1992, by John Kenneth Galbraith…Wherein he points out the timing involved in the balancing of monetary policy and tax policy. And, where he points out that those with all the wealth are quite contented with the monism of monetism.

    Reply
  9. Andy Raushner

    This will probably will end with nationalization of investment….down the road. I really don’t see monetary or fiscal policy helping anything. I think people underestimated innovation and population growth as the main drivers to make the debt useful. The latter is reaching environmental constraints and the former is in a slump in terms of creating new markets. So debt to growth has crashed.

    Reply
    1. Summer

      And market concentration / monopolization to for that cherry on the top of the great extraction machine.

      Reply
  10. chuck roast

    Jim A…”There is no reason to expand and sell more product…” if you are running a monopoly. You simply raise the price.

    Interest rate suppression not only incites asset bubbles it leads pension funds like (insert name) to search for yield in the worst, most risky places. In the case of my pension fund, we have dog-catchers and secretaries sitting on the Board evaluating proposals from a conga-line of con-men. It will not end well.

    When asset bubbles burst, the economically distressed sell to those with higher prevailing cash balances, setting the stage for further increases in inequality during the subsequent cycle…” Surf around a bit and you can find a couple of very large REIT’s that are composed entirely of single family dwellings accumulated during the mass defenestration of the marginal homeowners in the GFC. Warren says that she has a plan to address this issue.

    Military spending and transfers, for example, are less productive and therefore more inflationary.” Keep in mind that one of the primary functions of fiscal Keynesianism is to maintain the consumption gap in aggregate demand. When the military keeps getting tanks, the economy functions pretty well. When everybody has a refrigerator, the economy doesn’t function so well.

    Reply
  11. Bernalkid

    When everybody has a refrigerator, the economy doesn’t function so well.

    Very funny and insightful, but not ha ha.

    Reply
  12. Kiers

    DON’T take the Trumpian bluffs. Moore will deflect and shimmy and jive left right up down. The media will parse his every word. We are all being gas-lighted. Moore is coming from the Koch machine. As is Trump. They would LOVE for you to discuss rates, velocity, how many angels can fit on an economic pinhead. The Fed may even chime in with it’s PhDs. The Hollywood studio connected media are not here to educate you.

    Moore in all likelihood has a looooong list of deregulation for banking that he can sneak in while we are all discussing rates, velocities, the weight and size of angels wings etc etc. The Koch/Trump psy-op is amazingly successful. When Trump is gone, America will heave a big sigh of cathartic relief and revel in the SAME policies set in stone, as fresh, a fasle rebirth. It’s a con job.

    Reply
  13. Sound of the Suburbs

    It is much easier to see the flaws in Left wing ideologies.

    They are put together in a few minutes down the pub, on a Friday lunch time.

    Let’s wipe out the Bourgeoisie to create a better society. Another couple of minutes to work out the details and Pol Pot would be ready to go.

    The Right put a lot more time and effort into it.

    In 1947, Albert Hunold, a senior Credit Suisse official looked for a group of right wing thinkers to form the Mont Pelerin Society and neoliberalism started to take shape. They spent decades scrabbling around for suitable ideas to bolt together into a right wing ideology. They made sure all the ideas fitted together and were logically very consistent.

    Only time would reveal the flaws in this cleverly, crafted ideology.

    There was something for everyone at the top.

    Those that leaned to the traditional left were the new “creatives”.

    How is getting people to buy things they don’t want in the first place creative? At the pinnacle of their career they might come up with a slogan like “Beanz Meanz Heanz” if they are really outstanding.

    It involved a complete distortion of reality.

    The national income accountants can’t work out how finance adds any value (creates wealth), but bankers led the way when wealth creation was all important. Banks create money not wealth, but no one knew the difference.

    Activist shareholders were applauded as they ransacked companies built up by other people and loaded them up with debt. No one could see what was wrong.

    Capitalism has two sides, the productive side where people earn their income and the parasitic side where the rentiers live off unearned income.

    In 1984, income from rent, interest and dividends over-took earned income in the US. The Americans are on the wrong side.

    It’s time to reap the whirlwind.

    We need to find out how the economy really works by going back to the basics.

    What is capitalism?

    Economics, the time line:

    Classical economics – observations and deductions from the world of small state, unregulated capitalism around them

    Neoclassical economics – Where did that come from?

    Keynesian economics – observations, deductions and fixes for the problems of neoclassical economics

    Neoclassical economics – Why is that back?

    We thought small state, unregulated capitalism was something that it wasn’t as our ideas came from neoclassical economics, which has little connection with classical economics.

    On bringing it back again, we had lost everything that had been learned in the 1930s, by which time it had already demonstrated its flaws.

    We need to go back to the Classical Economists to find out what capitalism really is and build up from there. Much of what has been learned since is still useful and they made great advances in the 1930s and 1940s, which have since been lost.

    What is money and where does the money supply come from?

    Our knowledge of privately created money has been going backwards since 1856.

    Credit creation theory -> fractional reserve theory -> financial intermediation theory

    “A lost century in economics: Three theories of banking and the conclusive evidence” Richard A. Werner

    http://www.sciencedirect.com/science/article/pii/S1057521915001477

    Modern monetary theory has established how public money creation works.

    What is real wealth creation?

    It’s measured by GDP and we need to remind ourselves what this is.

    It’s back to the basics and we need to build up from there.

    Reply
  14. Sound of the Suburbs

    Money and debt.

    If there is no debt, there is no money.

    The money supply ≈ public debt + private debt

    We confused making money with creating wealth.

    Money comes out of nothing and is just numbers typed in at a keyboard.

    https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf

    Bank loans create money and bank repayments destroy money and this is where 97% of the money supply comes from.

    Money and debt are like matter and anti-matter they come out of nothing and go back into nothing.

    We now know how you create money, how do you create wealth?

    In the 1930s, they pondered over where all that wealth had gone to in 1929 and realised inflating asset prices doesn’t create real wealth, they came up with the GDP measure to track real wealth creation in the economy.

    The transfer of existing assets, like stocks and real estate, doesn’t create real wealth and therefore does not add to GDP. The real wealth creation in the economy is measured by GDP.

    Inflated asset prices aren’t real wealth, and this can disappear almost over-night, as it did in 1929 and 2008.

    The ideal economy has steadily rising, supply, demand and money supply; the new money covering the new goods and services in the economy.

    Achieving the ideal money supply for the economy, bearing in mind the way it is created, is not an easy task.

    https://cdn.opendemocracy.net/neweconomics/wp-content/uploads/sites/5/2017/04/Screen-Shot-2017-04-21-at-13.53.09.png

    Before 1980 we (UK) were doing it right.

    Debt rises with the money supply and you need to ensure the economy can stand the debt repayments. If GDP grows with the debt you won’t have a problem. Banks were lending into the right places that result in GDP growth (business and industry, creating new products and services in the economy).

    After 1980 we (UK) were doing it wrong.

    Financial liberalisation; where bankers could earn more money from lending into all the wrong places that don’t grow GDP with the debt (real estate and financial speculation).

    Asset prices have boomed everywhere as bankers have been lending to inflate asset prices rather than creating real wealth as measured by GDP.

    We have been creating the money supply in the wrong way and when you create the money supply by inflating asset prices debt deflation is sure to follow as the repayments on that debt destroy money.

    Debt deflation is a shrinking money supply and Richard Koo shows what the Great Depression looked like in the US money supply.

    https://www.youtube.com/watch?v=8YTyJzmiHGk

    Richard Koo shows the US money supply (8.30 – 13 mins):

    1) 1929 before the crash – June 1929
    2) The Great depression before the New Deal – June 1933
    3) During the New Deal – June 1936

    Richard Koo’s video shows the “New Deal” also worked by increasing the money supply, which had been shrinking in the debt deflation of the Great Depression. Debt deflation is a shrinking money supply caused by banks going bust and the repayments of bank loans destroying money.

    The money supply ≈ public debt + private debt

    Once it was working, they reduced Government borrowing and plunged the nation back into recession again. The enormous public spending and borrowing of WW2, eventually sorted things out.

    Reply
    1. Sound of the Suburbs

      Now we know why real estate booms are so good for the general economy.

      Bank lending creates money, which pours into the economy fuelling the real estate boom; it is this money creation that makes the housing boom so good for the general economy. It feels like there is lots of money about, because there is.

      Now we know why real estate busts are so bad for the general economy.

      The real estate bust is bad for the economy because the opposite takes place, and money gets sucked out of the economy as the repayments overtake new lending. It feels like there isn’t much money about, because there isn’t. The economy is heading towards debt deflation.

      Reply

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