Effects of Low Interest Rates – Part 2

As mentioned in my previous post, “Effects of Low Interest Rates Part 1, the easy monetary policies created by central banks and governments is what fuels economic booms and their consequent busts. Keynesian government intervention skews the business cycle: the creation of credit expansion undoubtedly provides growth, but this growth is now part of an artificial economy that is ultimately on life-support. This article provides a more in-depth look at the dynamics of low interest rates in our economy.

Higher savings will lead to real lower interest rates

Subsidized Real estate InvestingWhen the majority of people are depositing their savings into banks and contributing to a high savings rate for their country, this creates an environment of higher levels of cash reserves in banks: in other words,  a nation of savers creates a situation where banks have enough capital to lend for new business ventures. As part of normal supply and demand characteristics in a free-market, lower interest rates will be adjusted to loan out this extra savings in deposits. In this case, interest rates fall in order to provide incentives to loan out money. In turn, the investment horizon for this capital is longer term and is primarily used to finance capital projects (“high orders”) and away from producing consumer goods (“low orders”). When all the excess savings in the bank are loaned out, the banks are operating at their minimum reserve requirements; interest rates then naturally increase to account for the shortage of savings in deposits, since the excess supply of money has been exhausted though loans.

What are the effects of low interest rates when they are artificially suppressed?

If, however, central banks intervene in the market to suppress interest rates to pump an artificial stimulus into the markets, this provides the illusion to entrepreneurs that there is real excess savings in banks that would supposedly account for a longer term vision and increase of demand for capital goods.

This is a fallacy. Entrepreneurs in this scenario are lead into making malinvestments, for when the suppressed interest rates are allowed to increase to their normal levels, the malinvestments fail. The longer the suppression of interest rates, the more malinvestments are created and the more systemic damage it will create in any given economy when interest rates return to normal (and corrections are inevitable).

Construction and real estate are two of the main beneficiaries of capital good investments when interest rates are low. The inverse applies for high interest rates, as more capital is spent on a shorter-term vision on consumer goods and away from capital goods.

Why do interest rates continue to be suppressed?

The money supply is critical to the health of a modern economy. If a lid is put on credit expansion, there will also be a limit to economic growth. Governments must go further and further into debt to keep a healthy economy from growing. This is the main reason why our governments must increase the debt ceiling continuously. From the perspective of the average individual, however, it becomes obvious that countries cannot continue to pile on debt forever, as this is wholly unsustainable.  The money supply must contract to maintain proper reserve requirements. Instead of experiencing a normal, healthy correction, central banks prop up our economy by lowering the interest rates for additional debt to be accumulated. However, this method is ruinous to any economy in the long run, and will only postpone an inevitable, larger decline.

At the moment, our economy is sustained by artificial stimuli, and once the ‘drug addict’ (the artificially-stimulated economy) decides to be free and clear (no more quantitative easing), it will suffer a major downer (economic recession/depression). However this downer is essential for getting back to a functional and feasible economy where the malinvestments and market inefficiencies are liquidated.

Any ‘suffering’ created by a credit reduction is the consequence of the initial expansion, and we must go through it to eliminate the inefficiencies and malinvestments made by the errors of misguided entrepreneurs, albeit an error promoted by the government itself.

Yet, we should not hold our breath for this necessary correction, as deflation from the credit contraction is political suicide for those in government. Our government will most likely continue to prop up the economy and print the necessary money until hyperinflation sets in and destroys the value of our fiat currency

Post below your thought. I would like to know if you have any questions.

 


  • Dimitri

    Great article. I agree wholeheartedly. The government won’t do anything unless their hand is pressed to do so.

  • http://www.economicreason.com Chris Ferreira

    Absolutely, raising interest rates to a normal level is bad for their image, however, the pain that it would cause the markets is necessary to liquidate mal-investments and any inefficiencies in the market.

  • Frank the skank

    So with home ownership at 70% and with all the new mortage regulations, do you think the end is near or are there more ways for the goverment to kick the can furhter?

    • http://www.economicreason.com Chris Ferreira

      Exactly, as banks start to get worried about excessive debt and defaults they raise regulations to protect themselves, however, easy-cheap debt is what fuels the real estate mania.

      No one knows for sure how long this will last, but there are many signs that then end is near. Scotia Bank recently sold their 68 floor corporate headquarters in Toronto, is that a coincidence?

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