Guest Post: How low interest rates screw up the economy

Hat tip to Caleb over at TANSTAAFL CANADA! for this excellent post explaining how low interest rates screw up the economy, a common theme on this site.  Caleb has given his permission for this re-post.

My favourite thing about getting news online are the comments. No longer do letters to the editor need be to thought-out and expressed coherently. No longer are the opinions of the readers filtered through the editor’s pick-and-publish criteria of newspaper letters. On the internet, one can read a story and immediately comment on it. Then other people can disagree and before you know it, the comment section has become an online debate.
I like going to the CBC website to do this. For those who aren’t aware, the CBC is a Crown Corporation (fancy term for State-sanctioned Media) and more often than not, portrays the State in a favourable light. A perfect example is the current debate on low interest rates. The CBC is not alone in editorial slants that praise the BoC’s work. Plenty of news outlets praise low interest rates as helpful to Canadian families, and criticize Mark Carney when he tries to raise them.

This post is a brief overview of what interest rates actually are, and why keeping them artificially low destroys the economy.


Hayek once said something along the lines of: “Before we can even ask how things might go wrong, we must first explain how they could ever go right”. Let’s do some explaining:

Note – this is the simplistic version. Things are more complex in reality, but this brief overview should give you some understanding behind interest rate numbers. For more information you could go get a PhD in Economics, use Google or watch this: http://www.youtube.com/watch?v=jFqtTj7TeO0

In a free market economy interest rates represent the amount people are saving and investing for future consumption. The more people save, the more money there is in the bank. When banks finds themselves with an overwhelming supply of money they offers less interest on personal savings. When the supply of money is limited, then banks offer higher interests on personal savings (this is simply supply and demand).

Banks offering less interest on savings indicate to entrepreneurs that people are reducing immediate consumption. Consumers save their money for future gain (i.e. a vacation, a big screen TV, pretty much anything they can’t afford in the present). Since the interest rate is low, and the supply of money in banks is high, businesses are able to borrow more cheaply. Entrepreneurs will take out loans for long-term projects.

These long-term projects eventually bear fruition when people start withdrawing money from the bank to spend. As savings are reduced, the interest banks offer on money rise. This, again, indicates to entrepreneurs that people are consuming in the present. Businesses can still plan for long-term projects, but the interest on loans is higher.

That’s a very basic overview of how the system is supposed to work. Now let’s examine what happens when central banks or governments decide to play around with interest rates.

Let’s say the interest rate is at 15%. Without any involvement from the central bank, the 15% shows that people are spending in the here and now. It’s expensive for people to take out loans, particularly for entrepreneurs wanting to expand their business.

Lo and behold, for whatever reason the central bank slashes interest rates down to 5% (right now Carney’s got it at 1%). You’d think the mass of people would realize their savings haven’t increased, it’s just an arbitrary policy enacted by our central planning authorities. But, for whatever reason the market behaves as if real interest rates really were 5%.


So now there are consumers with little savings, consuming in the present and lower rates making it easier to take out loans. Consumer credit starts to play major role as lower rates for an extended period deplete (and discourage) individual savings. With rates so low, it becomes easier to manage debt loads. The longer the period of lower rates, the more apt people are to take on more debt.

Remember that lower rates also indicate to businesses that people are saving their money and that investment in long-term projects is a viable goal. But since these interest rates are artificially low, the fact is is that nobody is saving their money for future consumption. People continue to consume as businesses embark on long-term projects.

The best, and most recent, example of this is housing. People are piling on debt, consuming everything in sight. First things first, they want a house. The housing sector has to keep up with consumption in order to maintain profitability, so they want to build more houses. The longer interest rates remain low, the more houses are going to be built and the more people are going to buy them via credit.

Left too low for too long, bubbles begin to form. The way to burst a bubble is to raise interest rates. When this happens it becomes apparent how messed up the economy actually is.

The problem isn’t that consumers were spending too much or that businesses were overproducing – the problem is that these resources were misallocated. Normally, interest rates would indicate consumer preference and businesses would allocate resources accordingly. When the central bank messes up the fundamentals, malinvestments are made. Entrepreneurs are still allocating resources for profit, as they always do, but the profit is from phony wealth via low interest rates.

A rise in interest rates makes it apparent that it is unprofitable to continue misallocating these resources. Consumption, too, slows down as it becomes harder to finance debt. This is the bust, the part in the business cycle that people call a recession. As one can see, the recession is actually the cure to the “boom” period prior to. As the economy liquidates all the bad debts, prices (and wages) fall to correct market levels where people begin saving again.

Unfortunately instead of returning to sound free market principles, central bankers usually begin lowering interest rates again, as soon as the economy recovers. In a recession further lowering of interest rates causes all kinds of havoc. The economy can’t restructure itself as more malinvestments are made.

For example – Instead of a deep recession after the dot com crash in the early 2000’s, Greenspan lowered rates that helped fuel the housing bubble. When the housing bubble burst a few years ago (in the US), Bernanke lowered rates even further, fueling the current Treasury bubble. When this bubble bursts you don’t want to be caught holding US dollars (and since the US dollar is the reserve currency of the world, in my opinion, you don’t want to be caught holding any fiat currency).

Bank of Canada Governor Mark Carney’s modest interest rate rises last year weren’t enough to ward off Canadian malinvestments. Not that he could, once you get this beast going there is no “soft landing”. The longer Carney waits to burst the bubble, the more misallocations businesses are going to make and the worst the bust is going to be.

That’s my brief interest rate overview. Be sure to scroll back up and watch that video I linked to before. It’ll give a more in-depth explanation of how central banking, instead of smoothing out “free-market volatility” actually f*** up the economy.

And they f*** it up big time.

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8 Responses to Guest Post: How low interest rates screw up the economy

  1. John in Ottawa says:

    Everyone hates a central bank. They are such visible, easy targets.

    There were booms and busts before there were central banks. The problem was that the booms were to boisterous and the busts were too devastating. In particular, the busts tended to destroy the most vulnerable, the lower economic strata of society. Price discovery takes no prisoners.

    The role of the central bank is to attempt to provide stability. It can be, and regularly is, argued that The Fed has really blown it over the past twenty years. Perhaps that’s true.

    Central banks use monetary policy to maintain stability. The further out of whack the economy gets, the more radical monetary policy has to become. Boomers will remember Volker’s painful remedy back in the 70s. But why was the painful medicine needed in the first place? Fiscal policy!

    Governments use fiscal policy to manipulate the economy and I would argue that fiscal policy can be, and has been, far more damaging than monetary policy.

    Central bankers can get it wrong. They can get too caught up in their mathematical models and their books and their “economic school,” and miss the big picture. But at least they have some financial training and, theoretically at least, no political agenda; they are not simply buying votes.

    Let’s go back to an article that was brought to our attention just today. The article on Calgary’s housing market. In that article, they came to the conclusion that interest rates (monetary policy) didn’t have much impact on prices, but the CMHC extension to amortization periods had a significant impact; several thousand dollars for each year of extension. The CMHC extensions were fiscal policy.

    I’m not sure that I entirely agree that interest rates were an insignificant factor in house price increases, but it would be hard to argue that CMHC policy, fiscal policy, didn’t have a far greater impact.

    Let’s look at it from the point of view of the guy on the street. Ordinary consumers, especially young home buyers, don’t know much about economics, interest rate policy, net present value, the future, and the like.

    What they do know, vaguely, is how much money they think they can spend per month on a house purchase. That’s how much money they “have in their pocket.” The fellow selling the house doesn’t know much more about economics than the buyer. But the buyer does have a pretty good idea of how much money the buyer has in his pocket. This is price discovery.

    So, a buyer figures out that, based on some assumption of average (really current) interest rates, he can cough up $1300 per month for principle and interest. With a 25 year amortization at say, 4%, he can afford and will want to purchase a house for about $250,000.

    Now, through the magic of fiscal policy, run that amortization out to 40 years. At the same interest rate, that same “money in the pocket” will purchase approximately $325,000 worth of house. No seller is going to leave money on the table. Our hypothetical buyer doesn’t get to bypass the $250,000 house and buy a nicer house because the seller of the nicest house in the land has also decided not to leave any money on the table. He will jack up his price to take all the money. That cascades all the way down to our buyer. The seller of the $250,000 house will jack his price up to $325,000 to take all the money. These are theoretical limits; some constraints apply.

    Halving the interest rate (monetary policy) would have about the same effect as increasing the mortgage rate to 40 years, but I expect our intrepid buyer would be suspicious that interests rates may go back to historical averages (4% for this example), and I also expect our intrepid buyer would expect the 40 year amortization period (fiscal policy) would remain in place forever. One seems less risky than the other. Silly buyer. For shear carnage and unintended consequences, fiscal policy trumps monetary policy every time.

    Of course, if you buy the argument that an increased amortization period raises house prices, you buy the argument that the inverse is true. Anyone want to destroy a few billion dollars of asset value before the next election? Hmmm?

    Central bankers clean up the mess politicians leave behind. Crappy job if you ask me.

    • tanstaaflcanada says:

      Like I said at the beginning of my post, I like getting into online debates. Your comment was long, John from Ottawa, so I’ll just reply to some of it.

      “There were booms and busts before there were central banks. The problem was that the booms were to boisterous and the busts were too devastating.”

      Busts prior to central banking were devastating, true, but nothing compared to what we have today. Without a central bank the whole dot-com-housing-treasury fiasco we’re witnessing never would have been possible.

      “The role of the central bank is to attempt to provide stability. It can be, and regularly is, argued that The Fed has really blown it over the past twenty years”

      20 years? According to the National Bureau of Economic Research, recessions of the 20th century include: 1918-1919, 1920-1921, 1923-1924, 1926-1927, 1929-1933, 1937-1938, 1945, 1948-1949, 1953-1954, 1957-1958, 1960-1961, 1969-1970, 1973-1975, 1980, 1981-1982, 1990-1991, 2001, 2007-2009. Not to mention the US dollar has lost 95% of its value since the establishment of the Fed in 1913. So much for stability.

      “Central banks use monetary policy to maintain stability. The further out of whack the economy gets, the more radical monetary policy has to become.”

      Well we know that central banks don’t provide stability, so when they screw up instead of admitting it, they tend to farther in the wrong directions, putting the economy “out of whack” and radicalizing monetary policy.

      “Boomers will remember Volker’s painful remedy back in the 70s. But why was the painful medicine needed in the first place? Fiscal policy!”

      Actually a lot of it had to do with the gold. You’re right that fiscal policy plays an important role, and that was part of the problem, but the major problem was inflation. The US dollar was supposed to be as good as gold, and when world leaders came to the conclusion that it wasn’t, they wanted their gold reserves back. Nixon said no and closed the “gold window.” To combat inflation and return dollar credibility Volker jacked up interest rates — and it worked. For a while at least.

      “Governments use fiscal policy to manipulate the economy and I would argue that fiscal policy can be, and has been, far more damaging than monetary policy.”

      I would argue that it hasn’t. If fiscal debt gets out of control, either taxes need to be raised or the government defaults on its debt. Central banks can use monetary policy to ‘justify’ terrible fiscal policy. Look at how the Fed is giving money to banks, whom buy Treasuries and thus finance America’s deficit.

      “Central bankers can get it wrong. They can get too caught up in their mathematical models and their books and their “economic school,” and miss the big picture.”

      Now that we agree on.

      “But at least they have some financial training and, theoretically at least, no political agenda; they are not simply buying votes.”

      I couldn’t disagree more. Central bankers don’t have to worry about votes, true, but everyone has an agenda. The Coyne Affair is a perfect Canadian example.

      “Everyone hates a central bank. They are such visible, easy targets.”

      Yes, I agree. And it’s about time too. Imagine what the Vietnam War protest movement would have looked like if people had known the Fed was financing the entire thing.

      “Central bankers clean up the mess politicians leave behind. Crappy job if you ask me.”

      Central bankers and politicians make a mess and taxpayers foot the bill. Crappy deal if you ask me.

      • John in Ottawa says:

        The NBER doesn’t officially define a depression, but by general agreement there was only one depression in the 20th century (during which The Fed was formed), but there were five depressions in the 18th century in the US.

        So part of what the Fed is supposed to do is to try to stop a recession from becoming a depression.

        Nixon closed the gold window due to a number of factors. The expensive war was one, peak oil in the US was another. De Gaulle got nervous and demanded gold that the US couldn’t pay.

        Again, though, Nixon closed the window and that was fiscal policy. Volker was left to clean up the mess.

        I’m not sure how the Coyne Affair represents a political agenda on the part of Coyne. He felt that fiscal policy was endangering the economy, criticized the government and wanted to tighten monetary policy. The reaction by the government resulted in his resignation. Again, fiscal policy trumped monetary policy and demonstrated that in Canada at least, fiscal policy will always trump monetary policy.

        Unlike in the US, Carney reports to the Finance Minister and only has “delegated authority.” Our Bank is not independent.

        The whole world went off the gold standard. There simply wasn’t enough gold in the world to allow for economic growth. Fiat currencies and “managed inflation” were the result. Rather than look at absolute values of currency between now and 100 years ago, it is better to look at how long you have to work to buy a car or a refrigerator, or even a house now compared to say, 1950.

        Can’t argue with your last point. Tax payers clean up the mess.

    • Caleb983 says:

      “The NBER doesn’t officially define a depression, but by general agreement there was only one depression in the 20th century (during which The Fed was formed), but there were five depressions in the 18th century in the US.”

      Well I was talking about recessions with those NBER stats. The Fed was formed long before the Great Depression (depression was in 1929, Fed was formed in 1913), although to give credit I don’t think the Fed really had clue what they were doing for the first few decades of their existence. I’ve never heard of depressions in the 18 or 19th century. Bank runs, that resulted from fractional reserve banking, but nothing like the nation-wide depression in the 30’s.

      “Nixon closed the gold window due to a number of factors. The expensive war was one, peak oil in the US was another. De Gaulle got nervous and demanded gold that the US couldn’t pay. Again, though, Nixon closed the window and that was fiscal policy. Volker was left to clean up the mess.”

      De Gaulle just led the global demand. The idea of Bretton Woods was that countries could base their currencies off of the dollar rather than gold. This global monetary policy was doomed to fail from the beginning (and many economists predicted it). Because of fiscal policy (you’re half-right) dollars weren’t retaining their value but monetary policy helped (Fed chairman Arthur Burns was known to give into Nixon’s demands). So yeah, the Fed had to clean up the fiscal mess, but that kind of reckless spending couldn’t have been possible without the central bank’s easy money policies.

      “I’m not sure how the Coyne Affair represents a political agenda on the part of Coyne. He felt that fiscal policy was endangering the economy, criticized the government and wanted to tighten monetary policy. The reaction by the government resulted in his resignation. Again, fiscal policy trumped monetary policy and demonstrated that in Canada at least, fiscal policy will always trump monetary policy.”

      I brought up the Coyne affair just to show that central bankers have their own agenda. It’s not so much fiscal policy trumping monetary policy – both parties work to screw things up. Governments spend into the red and the central bank finances it. It’s like asking what came first, the chicken or the egg. Who is to blame, central banks or governments? Both. But the point of my post is that lowering interest rates fuel these easy money policies that get us into bubbles. It takes more than just a central bank to destroy an economy, but the central bank is the match for the fire and lowering interest rates is like pouring more gasoline.

      “Unlike in the US, Carney reports to the Finance Minister and only has “delegated authority.” Our Bank is not independent.”

      And the Fed reports to Congress. No central bank is really independent from government, they all form the apparatus of “The State.” Despite “official” roles and responsibilities, the BoC and the Fed are practically identical.

      “The whole world went off the gold standard. There simply wasn’t enough gold in the world to allow for economic growth.”

      That is a common economic fallacy. It is the purchasing power of money that gives it value, not the quantity of the money itself. With a fixed supply of money (it doesn’t have to be gold) prices fall as the economy grows. I don’t mean any disrespect, but if one stops to really think about the “not enough gold for economic growth” argument, the more ridiculous it becomes.

      “Fiat currencies and “managed inflation” were the result.”

      And now the State has the ability to keep printing money, which results in rising prices. Inflation is like a hidden tax, it can destroy savings and investment (the key for economic growth). Gold (or any commodity) used as money demands discipline in fiscal and monetary policy.

      “Rather than look at absolute values of currency between now and 100 years ago, it is better to look at how long you have to work to buy a car or a refrigerator, or even a house now compared to say, 1950”

      I partly disagree. The amount I have to work compared to 1950 is a result of economic growth. An increase of goods and services. If the supply of money was fixed then we’d be richer today, but since it has been increasing (almost) every year since 1913, the value has decreased, despite more goods and services being available.

  2. jesse says:

    “The problem isn’t that consumers were spending too much or that businesses were overproducing – the problem is that these resources were misallocated.”

    That’s a great point but I think all three are problems. The “fundamental” issue now is that asset prices are misaligned with the future value they produce. But I also think there is a marked disconnect between business and consumer spending. The big challenge is how to resolve it. Carney is right: it’s not within the BoC’s ability to manage this disconnect but they can offer advice and warnings.

    • tanstaaflcanada says:

      “That’s a great point but I think all three are problems. The “fundamental” issue now is that asset prices are misaligned with the future value they produce. But I also think there is a marked disconnect between business and consumer spending. The big challenge is how to resolve it. Carney is right: it’s not within the BoC’s ability to manage this disconnect but they can offer advice and warnings.”

      I think Carney is chickening out when he says the BoC can’t resolve this issue. Raising interest rates to the assumed market level would resolve these issues, although everyone would hate him for it. Canadians aren’t saving, yet rates are low, so there’s this disconnect with consumers and producers. If Carney jacked up rates then everyone would cut back. Higher rates would benefit savers and eventually the market would bring down interest rates (in my opinion after jacking up rates Carney should resign and we should take steps towards ending central banking in this country — but that’s a whole different topic).

      Raising rates, bursting the bubble, then allowing asset prices to fall should correct any misalignment. Unfortunately if the BoC follows the Fed’s playbook, they’ll try to keep asset prices from falling, perverting and prolonging the correction.

  3. tanstaaflcanada says:

    Like I said at the beginning of my post, I like getting into online debates. Your comment was long, John from Ottawa, so I’ll just reply to some of it.

    “There were booms and busts before there were central banks. The problem was that the booms were to boisterous and the busts were too devastating.”

    Busts prior to central banking were devastating, true, but nothing compared to what we have today. Without a central bank the whole dot-com-housing-treasury fiasco we’re witnessing never would have been possible.

    “The role of the central bank is to attempt to provide stability. It can be, and regularly is, argued that The Fed has really blown it over the past twenty years”

    20 years? According to the National Bureau of Economic Research, recessions of the 20th century include: 1918-1919, 1920-1921, 1923-1924, 1926-1927, 1929-1933, 1937-1938, 1945, 1948-1949, 1953-1954, 1957-1958, 1960-1961, 1969-1970, 1973-1975, 1980, 1981-1982, 1990-1991, 2001, 2007-2009. Not to mention the US dollar has lost 95% of its value since the establishment of the Fed in 1913. So much for stability.

    “Central banks use monetary policy to maintain stability. The further out of whack the economy gets, the more radical monetary policy has to become.”

    Well we know that central banks don’t provide stability, so when they screw up instead of admitting it, they tend to farther in the wrong directions, putting the economy “out of whack” and radicalizing monetary policy.

    “Boomers will remember Volker’s painful remedy back in the 70s. But why was the painful medicine needed in the first place? Fiscal policy!”

    Actually a lot of it had to do with the gold. You’re right that fiscal policy plays an important role, and that was part of the problem, but the major problem was inflation. The US dollar was supposed to be as good as gold, and when world leaders came to the conclusion that it wasn’t, they wanted their gold reserves back. Nixon said no and closed the “gold window.” To combat inflation and return dollar credibility Volker jacked up interest rates — and it worked. For a while at least.

    “Governments use fiscal policy to manipulate the economy and I would argue that fiscal policy can be, and has been, far more damaging than monetary policy.”

    I would argue that it hasn’t. If fiscal debt gets out of control, either taxes need to be raised or the government defaults on its debt. Central banks can use monetary policy to ‘justify’ terrible fiscal policy. Look at how the Fed is giving money to banks, whom buy Treasuries and thus finance America’s deficit.

    “Central bankers can get it wrong. They can get too caught up in their mathematical models and their books and their “economic school,” and miss the big picture.”

    Now that we agree on.

    “But at least they have some financial training and, theoretically at least, no political agenda; they are not simply buying votes.”

    I couldn’t disagree more. Central bankers don’t have to worry about votes, true, but everyone has an agenda. The Coyne Affair is a perfect Canadian example.

    “Everyone hates a central bank. They are such visible, easy targets.”

    Yes, I agree. And it’s about time too. Imagine what the Vietnam War protest movement would have looked like if people had known the Fed was financing the entire thing.

    “Central bankers clean up the mess politicians leave behind. Crappy job if you ask me.”

    Central bankers and politicians make a mess and taxpayers foot the bill. Crappy deal if you ask me.

  4. Pingback: Popularity, Resurgence, Interest, Trojan | will there be a nuclear war in 2012 ?

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