Persistently Low Fed Rate… Financial Instability is not the problem, decreased Net Social Benefits is
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.
NOTE: this is a reposting from another post about the same subject
In America where there are lots of corporate take overs and equity firms that buy other firms and restructure them (usually to be more productive but in some case like Romney did to just destroy them and then get rich off the destruction) limit the low growth that allowing unproductive firms to have access to cheap finance creates? That and given that new firms and start ups also have access to this cheap finance and are more likely to need it then current forms means that there really are no net ill social side effects of keeping rates low while inflation is low.
That is not exactly true… Your logic says that interest rates should stay low forever. So why ever raise interest rates? It will just hinder business growth.
Are you in favor of keeping rates low forever? When do you think rates should increase?
From where I see it the usual reason to raise interest rates is because of too much demand which causes excess inflation (its arguable at what level excess inflation is). So you would raise interest rates when inflation is high and the high inflation is not caused by a supply shock.
I’m having a hard time connecting exactly how raising rates for everyone would result in low productive firms exiting and being replaced by more productive ones.
The link to the old blog post (incase there are replies to me there that you want to see is:
“Pointing to financial instability is pointing in the wrong direction. It is better to point toward net social benefits ”
OK, but can we expect to get improvements in social benefits when there is financial instability?
Seems we got in this mess because the Fed did not tighten in 2004/2005 or so (did not have the wisdom or resolve to “nip in the bud” the last boom as per the Keynes quote in the OP), but instead provided the fuel for the boom which inevitably led to the bust. Now the Fed continues with low interest rates expecting a different outcome.
We will get neither financial stability nor a sustainable improvement in social benefits until Congress and the Fed gets their acts together.
The lesson we ought to learn from study of boom/bust cycles is that it is better to seek optimum economic growth from a long term perspective rather than simply higher growth for today. Seems the same should apply to social benefits.
The Fed ought to begin raising rates because that is the right thing for the long run. There will be short term pain before a return to normal economic cycle, but the alternative is long term stagnation and decay.
The markets have been bid up again with cheap money, so raising rates will cause the markets to fall again -oh my! It is always the same lack of resolve plus short term thinking that prevents the Fed from pursuing long term optimum growth.
The Fed rate did not cause the last recession. There were problems in the financial markets with the derivatives that brought down the markets…
From my reseearch, the Fed rate was pretty on target after the 2001 recession.
And I support everything else you say. … and you say it very well.
Looking again at Fed funds rates over the last 30 years, I was wrong earlier when stating that the Fed did not increase rates in 04/05. The Fed in fact began raising rates in late 04 and continued into mid 06 but seemingly too late to avoid the rampant speculation in housing, mortgage backed securities, and such that made up the bubble.
The Fed’s task in setting the Fed funds rate can be likened to that of tuning a process control loop. When attempting to smooth out the business cycle, Fed actions, if mistimed or too severe, can throw the cycle out of whack so that rather than smoothing Fed actions lead to greater instability.
In reaching for ever better results in the present rather than looking to the long term optimums the Fed’s very low (compared to the previous 20 years) interest rates following the 2000-2001 recession in my opinion set up the boom/bust that followed. Unemployment rates in the depths of the 2000/2001 recession and into 2003 remained at or under 6%, which is not all that bad compared to the long term, but the Fed imprudently sank the Fed funds rate and held it low until mid 04 despite a return to a growing economy over that time. Seems the fed kept its foot on the gas pedal too long and could not apply the brakes fast enough to avoid the crash. http://www.statista.com/statistics/188165/annual-gdp-growth-of-the-united-states-since-1990/
Fed funds rate last 10 years
Fed funds rate last 30 years