Inflationomics

Why the Fed Didn’t Raise Interest Rates

So the Fed didn’t raise short-term interest rates, again.  Is the economy still too weak?  Does it need more stimulus?

How do low interest rates stimulate the economy, anyway?  They don’t.  They simply help people to spend more money that they don’t have (stimulates more borrowing)…which gives the economy a temporary boost, but adds more debt.  And right now, too much debt is a problem.  Why?  We’ll get to that…but first, what else do low interest rates do? They also penalize savers.  When savers don’t save (because they don’t get a return on their savings), no capital is accumulated.  Without capital accumulation, an economy shrinks.  Its workers have more trouble competing in the world markets.  Their real wages decline, and with them, their standards of living.  Capital is what makes capitalism so successful.  The more capital that’s accumulated, the more productive people will be, and the better their living standards.

Do you want to have a booming economy?  Make it attractive for people to invest in!  Give them a return on their investment!  If they can’t get a reasonable return with relatively low risk, they’ll seek a higher return elsewhere. Or, they’ll find riskier investments, or both.  In recent years, capital has been drawn to sub-prime lending and the emerging-market economies because of the favorable returns found there.

Sub-prime lending (too much debt) is what causes asset bubbles…which are followed by bursting bubbles as debtors default because they can’t service the debt…just what we had in 2008 and don’t really want more of.  Too much debt becomes a big problem when anything goes wrong because there’s no money in reserve to call on, and when you need to borrow money is exactly when no one will lend it to you.

Yet, the emerging market economies don’t always know how to behave when the inflows of capital stop, either (but then, neither do the developed economies).  China limited the sale of stocks for major shareholders (over 5% ownership interest) when their stock market crashed, making it impossible for investors to limit their losses.  Who would want to invest there?  They also limited short selling, which is one of the fastest ways to make money when a market is over-extended and crashes.  The government got in the way of the market’s mechanisms for correcting previous maladjustments.

Switzerland made the mistake of tying its currency to the Euro and having to untie it on the eve of the European Central Bank’s (ECB’s) embarking on more quantitative easing.  The Swiss recognized the flaw in the ECB’s policies and distanced themselves.

The bottom line is that central banks around the world are reacting (in various ways) to the excess liquidity created by the Fed through U.S. dollar printing, its low interest rate policy, and the recent threat of rising interest rates.  Nevertheless, they really don’t have much choice if they want their exporters to remain competitive in the global economy.  They will continue to print more of their currencies, as will the Fed in the United States…creating a race to the bottom and impoverishing their people.

Will the Fed raise rates this year or next?  If the world economy holds together that long, it probably will, just to make the point that it’s not crying “wolf.”  Will the Fed print more money?  Yes, because that’s the only thing it knows how to do, and it thinks it can solve the world’s problems by printing more money and keeping interest rates low.  How wrong it is—keeping interest rates low doesn’t solve problems, it just masks them.  The longer the Fed props up the tower of debt, the more people will be crushed when it falls.  Ideally, interest rates should be set free so the market can undergo the necessary corrections.  But those in power don’t want that because they would fall from power and the United States wouldn’t be able to pretend it’s the richest country in the world any more.  So, what will happen?  The Fed will try to keep interest rates low and print more money to prop up the economy for as long as it can.

Robert F. Sennholz

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