Are lower interest rates really better for the economy?

Many well-meaning but wrong-thinking economists believe that a weaker exchange rate and lower interest rates will get the economy growing again and create more jobs and prosperity.

While we have dealt with these fallacies on numerous occasions it seems there is always the need for a quick refresher on why these assertions are complete economic drivel and theoretical bunk.

A weaker exchange rate

Most economists are in agreement that currency devaluation has very dislocative effects, but while the proponents of currency devaluation regard it as ‘necessary pain’ leading to a permanent new order, in reality it is unnecessary pain, a net detriment to the whole economy, and has only temporary effects.

They are temporary because wages and prices sooner or later nullify short term ‘gains’ from the devaluation.  The policy is akin to creating a bubble in the beneficiary sectors.  When real forces exert themselves again it is seen that underlying real productivity has not improved and that the sectors are as uncompetitive as before.

The problem is that in the interim capital has been sunk into these sectors, only for many of these investments to be revealed to have been poorly advised.  This then ushers in the next round of political pressure for devaluation and the slippery slope of currency debasement has begun.

More fundamentally, it is a profoundly worrying fallacy the idea that a weaker (or stronger) currency can fundamentally alter the structure of an economy beyond the short term.  A currency is a medium of exchange, yet those in favour of currency devaluation repeatedly call for a manipulation of monetary variables to affect real ones.  If there is one lesson of the past 10 years that we didn’t need to have the misfortune of learning again it is that manipulation of monetary variables (whether it is through artificially low interest rates, reserve accumulation, quantitative easing, or outright currency debasement using a combination of these) creates and exacerbates imbalances in the real economy that sooner or later must correct, with invariably painful consequences.

We see this at a sectoral level (US property, global car manufacturers, empty Chinese office blocks), a national level (over-leveraged households, banking crises, and boom-bust), and a global level (the Sino-US imbalance).

When all is said and done, currency weakness is nothing more than unsustainable monetary stimulus.  It will exacerbate the falsity not eradicate it.  Real prosperity is gained by being more productive, but using the medium of exchange to get there is like chasing after the pot of gold.  The goal-posts will always be shifting.

Instead, SA and other countries need to look deeply at their industrial policies.  Without freer markets, fundamental labour reform, greater work ethic, cheaper communications, better education and training and, most of all, deeper capital formation, it simply will not get there.

Many of these economists believe that countries like South Africa consume too much and produce too little.  As a result, they say, we should weaken the currency to boost exports, thereby improving the trade balance and building foreign reserves, all the while creating more jobs.

While persistent trade imbalances are reflective of a broken system, ironically, a weaker currency policy makes this over-consumption problem WORSE not better!

Again, we cannot lose sight of the fact that currency weakness is of its very essence inflationary.  Inflationary policies, it is hardly in dispute in any serious economic discourse, erode savings and encourage consumption spending.  In fact, not only does inflation encourage more spending and discourage saving, it encourages more debt-financed spending.  As far as capital accumulation is concerned, a weaker currency policy will serve to deter foreign capital not encourage it and local capital will be deterred as savings fall due to the inflationary policy that is currency weakness.

Low Interest Rates

Related to the policy of a weaker exchange rate is low interest rates.  Low interest rates enforced by the central bank are part of a holistic currency depreciation strategy.  Both these are in turn related to inflation.  Some economists might dupe you into thinking either that a) inflation is not such a bad thing, or b) that a weak currency and artificially low interest rates will not be inflationary.  They are either ignorant or lying.

Inflation is one of the most destructive forces to an economy and should be avoided at every turn.  We have much more to say about that here, here and here.

Moreover, it is disingenuous to suggest that inflation will not result from currency weakness and artificially low interest rates.  The very proponents of a weaker currency and low interest rates give the game away by insisting that the central bank’s inflation targets be raised.  Here in South Africa there are calls from many corners for the Reserve Bank’s 3-6% price inflation target to be raised to something closer to 6-9% or more, while only recently the IMF has been calling for the major economies to raise their CPI increase targets from 2% to 4%.

It is obvious, spin it any way you want, lower interest rates facilitate currency weakness (absolutely vs goods and services and relatively vs other currencies) which creates price inflation.  Inflation destroys wealth.

Even worse than creating inflation is that artificially low interest rates create boom-bust cycles which create major economic dislocation.  A society can be incredibly productive, but artificially low interest rates will generate a mismatch between production and consumption.  Under such an interest rate regime, producers’ incentive is to produce for future consumption while consumers’ incentive is to consume in the present.  The mismatch results in a ballooning trade deficit, rising consumer debts, and a production bubble, leading to oversupply of future goods and a painful asset price deflation and recession.

Here’s how we explained it in a recent post,

Artificially cheap credit resulting from new money creation in the system creates a mismatch between real savers and borrowers.  With an artificially low interest rate real savers are no longer being adequately compensated for deferring their consumption, while those who prefer to consume now flock to access the cheaper credit.

Two simultaneous processes take place with regard to savings here.

1. Real wealth generators will start consuming more of their real savings

2. At the same time, their existing unconsumed real savings are being redistributed away from them, undermining real wealth creation activities and thereby discouraging such activities.

Meanwhile entrepreneurs can access credit at a cheaper rate, encouraging them to invest in lower yielding business activities than they otherwise would have had to invest in to make a decent profit.  This gives rise to at least two damaging investment decisions.

1. The first is that entrepreneurs choose to invest in already heavily invested sectors where marginal returns are quite low and markets already quite mature.  They do this because perceived risk is low compared to the potential return to be made on the cheap credit.

2. The second damaging investment decision is that entrepreneurs choose to invest in longer term capital projects that tend to only generate returns after a few years time.  They do this because the cheaper funding allows them to carry the debt burden for longer before returns are generated and because projects funded over a longer time horizon are far more sensitive to funding costs (the rate of interest) than those funded over a shorter time horizon.

To sum up, real wealth creators are consuming more real capital/savings than before and their wealth creation activities are being undermined.  At the same time the capital autonomously distributed to other entrepreneurs is being sunk into lower yielding longer term projects whose success relies on the ability of people to consume in the future.

The problem is that real savings are diminishing, undermining future consumption – the very consumption their longer term business ventures will rely upon to generate profits!

Put simply, a mismatch has occurred between expected future demand and current savings.  Entrepreneurs are making more products than people will need in the future, and not enough products that they need now.  The entire economic system’s time-preference structure is distorted.

Time, effort and talent are flowing wastefully into products no one wants.  Thousands, hundreds of thousands, or even millions of people become employed in jobs producing the wrong goods.  People’s time, effort and talent are being thrust into superfluous endeavours – time, effort and talent that they will never again be able to expend on anything else.

Meanwhile, in many instances capital is sunk into wasteful and superfluous projects.  Some argue that, eventually, demand will be able to justify these wasteful projects.  This may or may not be the case depending on the extent of the excess capacity created in that particular good and the future growth and demographic prospects of the country.  What is true, however, is that the distorted capital structure fails to meet the needs of people optimally, creates wasteful endeavours, creates an over-consumption of real capital, and erodes real wealth creation activities.

Each of these consequences is a loss of real wealth.

The Big Question

So, what about the ‘big question’, which is, how do we create real and sustainable jobs and prosperity?

Well, we would start by scratching “lower interest rate” and “devalue the rand” and “raise inflation targets” off our list.  The reality is that there is no short cut or easy path to growth and prosperity.  Real wealth has always been built slowly and with hard work.  But if there were sound policies the government could enact quickly, radical economic deregulation as a matter of urgency would be among them.  In the South African context:

1. Capital controls will not benefit SA as they do China.  SA needs wholesale deregulation of controls so that local and foreign investors feel at ease investing in SA.  Capital controls create imbalances.
2. Company and personal taxes should be dramatically reduced (halving them would be a great start!) to put capital back in the hands of the dynamic private sector and out of the hands of the sclerotic and squanderous public sector.  The tax regime should be radically simplified to grade-school level in its basic application.
3. Power generation should be privatised quickly and prices move as quickly as possible toward a market related rate.  Once that happens, SA’s natural advantage in coal power will ensure electricity prices migrate lower again over time to very globally competitive rates once more.
4. Communications costs are prohibitively high.  There are many ways to address this through deregulation and restoring private incentives to invest in infrastructure.
5. Labour policies should be drastically altered to favour risk taking entrepreneurs rather than unionised and unproductive labour.  Unions should of course have full freedom to strike, but employers should have laissez faire when it comes to hiring and firing.  In fact, we can see no good reason why the labour law cannot be scrapped altogether and industrial-commercial relations fall under the umbrella of normal contractual law.  After all, free adults should be able to strike up any type of mutually agreeable and beneficial contract they like.  Hiring and firing is not the states business, it is private business.  Minimum wage laws must be scrapped, as should hiring/firing laws and CCMA rigidities.
6. Schools should be privatised.  Billions could be diverted away from a failing school system toward a targeted approach to practical ‘fast-track’ skills to address the ‘lost generation’ problem urgently.
7. Interest rates should be determined by the market because the interest rate is a rate based on society’s time preference.  No central bank can know the correct interest rate.  A market determined interest rate means no central bank interference in the commercial bank lending market which means no central bank manipulation of money markets which means no central bank control of money and currency which means sound money backed by a metallic standard and free market banking and market-determined interest rates.

If SA had enacted these policies in the 1990’s (Mandela’s and Mbeki’s “free-market” reforms were grossly inadequate) we probably would not be fretting with such urgency about our chronic joblessness in 2010.  As for our over-consumption and “American Disease”, it is interesting to see that as soon as consumption activity moderates off unsustainable credit-boom levels our trade account runs right back into balance, if not surplus.

A lower inflation policy and conservative interest rate stance (not what was followed during 2003-2007 as Mboweni was duped by temporarily lower imported inflation) will enhance this and make it sustainable.  Yes, SA is still running a current account deficit because of the importation of capital requirements, but inflationary policies (rand devaluation) will only make this worse by discouraging local savings and investment.

Conclusion

Calls for lower interest rates and a weaker rand are two sides of the same coin.  These policies always lead to more price inflation.  Inflationary policies will make most current economic ailments worse and will certainly worsen the production-consumption equation beyond the short term, not improve it.  For countries with the “American Disease” to consume less and produce more they need a market-determined interest rate and stable currency backed by a metallic standard.