A glitch in the IS-LM model

Many top economists use the IS-LM model to support low interest rates. The LM curve of the IS-LM model is built upon a model of financial markets.


In the graph above, money supply has been pushed far to the right to keep interest rates low. The model implies that the money supply would eventually have to be reduced in order to raise interest rates, but the Fed has other ways to raise interest rates.

But there is a glitch to pushing the money supply so far to the right. Low interest rates help unproductive firms stay in business. And we have had low interest rates for years now.

What is the glitch?

There are more unproductive firms doing business… and the economy has become dependent upon them. Not good…

The Wall Street Journal had an article showing how inequality is growing between identical workers, because productivity differences between firms even in the same industry have widened. (link) So there is evidence that low productive firms have become more prevalent.

Creative destruction is an important part of a proper interest rate cycle. Proper interest rates keep low productive firms at lower levels. These low productive firms drag on productivity, wage growth, investment and potential growth. A higher prevalence of unproductive firms supports the case for low interest rates. But the purpose of low interest rates was not to increase unproductive firms but to keep them from crashing too fast. Now they are not being allowed to crash at all. Thus, the glitch.

An efficient economy where resources are allocated to maximize net social benefits must have a proper interest rate cycle for creative destruction.

The Fed missed the interest rate cycle this business cycle, so the prevalence of low productive firms has increased. It will be very difficult to raise interest rates because the economy now depends on these low productive firms.

A rise in interest rates will push many unproductive firms over the edge and start a cascading downward of the economy. The economy has become more sensitive to interest rate hikes due to an increased prevalence of unproductive firms.

Interest rates will have to go through a properly disciplined cycle to get the benefits of creative destruction. Or the unproductive firms will be pushed out anyway as profit rates decrease at the end of this business cycle. Either way, there will be pain for some.