Sunday, August 23, 2015
Do low interest rates stimulate economic growth?
Starting in the mid 1990's Japan pursued a low interest rate policy. Unfortunately, the reason the Central Bank lowered rates did not have the intended result. Japan's finance ministers wanted to induce economic growth. Instead the economy faltered. Why? Don't lower interest rates reduce the cost of borrowing for companies? Of course, but unless the companies need to borrow, low interest rates have no effect. Often low interest rates are imposed in times of economic stress. Many companies are unwilling to borrow in such perilous times. Consider the effect of a stagnant economy on Japanese business. In Japan the size of corporate debt went from 147% of GDP in 1990 to 99% in 2011 (Mariko Oi for BBC News, Tokyo, 17-09-2012). One should conclude low interest rates actually reduced corporate borrowing by 50%.
Although Keynesian Economics argues low interest rates are the cure for economic malaise, the facts indicate the opposite. Why? Keynesian Economics is built on the assumption of interest rates driving the economy. The fact is other economic conditions weigh heavier on markets than interest rates. What are these economic conditions? First, it is the confidence in the future of economic management, i.e., the government's ability to manage the economy. Keynesians take this as a given, but business people see it quite differently. Low interest rates are a perfect example. Keynesians see low interest rates as an inducement to business to expand. Business people see low interest rates as an indication of a stagnant economy. Governments see a stagnant economy as an opportunity to utilize Keynesian debt strategy to spark a recovery. A government supported by an economic theory that lauds their economic prowess is a strong inducement for government to increase their borrowing and the national debt. Unfortunately such a strategy did not work during the Great Depression or the Great Recession. It did solidify the business sector's opinion that the economy was in a downward spiral. In the same article noted above Mariko points out public sector borrowing went from 59% of GDP in 1990 to 226% in 2011.
Even if governments behave themselves and do not increase debt, low interest rates are not good for the economy except in the short term. The short term being a couple of years to induce capital purchases put off because of the weak economic situation. I would argue it is never good for the government to try and manipulate the market. But there are other reasons besides my opinion. Low interest rates encourage marginal loans. The group of business ideas that work with a 1% interest rate is not the same quality as those that work at 5%. In addition, the origination revenue banks obtain from low quality loans and 1% interest is marginal at best. A healthy banking sector is fundamental for a vibrant economy. Banks play an essential role in taking the new money creation allowed by a central bank and finding places to invest it. If banks buy notes from the Treasury of a country to earn interest no new business is created that can grow. The interest banks earn in the feedback loop and new business creation expands the economy. It is tax paying job creating business that expands the economy; not money creation by the government. A strong economy can not exist supported on a thin feedback loop. The thinnest possible loop is a low interest government bond.