Persistently Low Fed Rate… Financial Instability is not the problem, decreased Net Social Benefits is

Edward Lambert | October 9, 2014 12:11 pm

US/Global Economics

Brad DeLong has a post on whether a persistently ultra-low interest rates leads to financial instability.

Pointing to financial instability is pointing in the wrong direction. It is better to point toward net social benefits. A persistently low Fed rate will lead to decreased net social benefits. Here is what Keynes said in chapter 22 of General Theory.

“If we rule out major changes of policy affecting either the control of investment or the propensity to consume, and assume, broadly speaking, a continuance of the existing state of affairs, it is, I think, arguable that a more advantageous average state of expectation might result from a banking policy which always nipped in the bud an incipient boom by a rate of interest high enough to deter even the most misguided optimists. The disappointment of expectation, characteristic of the slump, may lead to so much loss and waste that the average level of useful investment might be higher if a deterrent is applied.” (link)

When net social benefits decrease, you may not see financial instability, but the economy will feel sicker. That is what we are seeing. The economy just feels sick, not so much unstable.

To see net social benefits of something in the economy, we add net external benefits to the net private benefits. Ultra-low interest rates seek to increase the net private benefits for businesses. But ultra-low interest rates give businesses a license to be less productive and less efficient. Thus the “external” social costs from ultra-low interest rates accumulate and we then experience an economy that feels sicker. That is what Keynes touched upon above.

The same logic applies to the minimum wage. If the socially optimum level of the minimum wage is higher, and we raise the minimum wage, we may see unemployment increase for a few months, but when the increased net social benefits “kick in”, then unemployment will settle back down to a better level and the economy will feel healthier.

It then stands to reason, that raising the Fed rate might make the economy look sicker for a few months, but then could make the economy feel healthier over time… which would be a good thing.

But it is too late to raise the Fed rate now. The Fed waited too long. They should have started earlier to raise the Fed rate in a slow gradual but persistent way. Now the markets are too sensitive to rate hikes, which would impact profit rates that have now peaked.

Update: Yes, we are seeing large swings of volatility in the markets this week, but are we seeing a collapse of the markets due to instability? No… The understanding that advanced economies are sick is sinking in. They are sick because the standards for net social benefits have been lowered.

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