A Third Reason to raise Interest Rates?

I read Paul Krugman, Ben Bernanke and others. They mention two reasons why some people are calling for interest rates to rise…

  1. Possibility of Inflation
  2. Possibility of Financial instability

Now I would like interest rates to rise, but I have never seen any inflation coming. In fact, it seems that inflation will stay low when interest rates stay low in our present economic conditions. I have written about that before in relation to the Fisher effect here on Angry Bear.

As far as financial instability, my concern is more inequality which is subduing effective demand.

But there is a third reason that these economists don’t ever seem to mention… The economic inefficiency of low interest rates.

Look at China. They have over-invested clearly. They have over-capacity in production. Their financial repression with low interest rates has led to over-investment. What do they do now? They roll over debts, keep interest rates low and try to keep these unnecessary firms active. In the US, firms still have debt. They pay interest costs. These low-productivity firms would most likely cut back production, hiring and may even go out of business if interest rates rise. So in order to keep these weak firms active, interest rates must stay low.

Low interest rates make the existence of these marginally weak firms much more possible. Of course, we do not want run-away inflation, nor even financial instability. However do we want these debtor weak firms which weaken the economy?

If we do not want them, we have some options.

  1. We can write off debts, which could include mortgage debts of households.
  2. We can raise taxes on corporations and the rich.
  3. We can close loopholes that allow profits to be hidden overseas.
  4. We can raise interest rates.

A combination of all four options would eventually strengthen our economy.

Imagine a football team that has some weak players. The team is not replacing these weak players.  The team is mediocre from year to year. Then the team starts setting higher standards for its players. It starts cutting weaker players and investing in better players to meet that higher standard. The result will be a better team with better profit potential because they will win more.

If the economy started weeding out weak firms with higher interest rates, they would be replaced with newer-technology firms without old debts from before the crisis. Do you see where I am going with this? Eventually the firms within our economy improve on average. Productivity will increase. Wages have a better chance to rise… and so on.

So arguing that interest rates should stay low because inflation is not likely and bubbles of financial instability should not be popped misses another reason to raise interest rates… to maintain the standard of excellence in the economy in line with medium-run potential. That means raising the Fed rate along an appropriate path so that the short-term real rate rises toward its medium-run natural real rate. Then it is just a matter of how much slack you see for setting that path.

Janet Yellen and the Fed seem to be focused on the slack more than anything. They feel the time is coming to start raising the Fed rate. They recognize that economic growth will slow down some as marginal businesses are tested with a higher interest-rate standard. They may even feel that is a good thing.