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Thursday, September 20, 2012

Kevin Drum is an Economic Illiterate

Drum posts today that:
higher inflation would be good. The simplest way to see this is to look at interest rates. Once the Fed has reduced interest rates to zero, it can't go any further. But what if the economy is so bad that all the standard models suggest you need negative interest rates to get the economy back on track? 
What he doesn't realize is that all his "standard models" are wrong.  They say that reducing interest rates is stimulative.  What they don't get is that the government pays the interest  Lower rates mean less money injected by the government into the economy.  So lower rates are deflationary, 180 degrees different from Drum's assumption.

Drum assumes that government lends money to the private sector and that lower rates means lower borrowing costs for the private sector.  However, the private sector does not generally borrow from the government to finance loans.  Rather, there is a pool of money available for loans that is the product of past government deficits.  The money has been spent into the economy by the government, and the government pays interest on this money (Treasury bonds or interest on reserves).

When the Fed lowers interest rates, the opportunity cost of lending by any single bank is lowered, since it will collect less interest on money that is saved.  That will stimulate private money creation (bank lending) in the short run, but those debts will have to be paid back, so the effect is contractionary after a year or two.  In 2012, after 30 years of steadily declining interest rates intended to boost short term private sector debt, there is little more short term gain to be achieved, as consumers are paying back money previously borrowed from the private sector.

So the net effect of continually decreasing interest rates is a double whammy to the economy:

1. Less money is provided to the economy by the government.
2. Private debt can only be juiced so far before it becomes a burden to the economy.

Anyone, like Drum, who imagines that low interest rates generate inflation, is extremely short-sighted.  Take a minute to look at the history of interest rates in the United States and Japan and you will see the proof of the point I am making.  For example: US_Inflation_rate_vs_3month_T_bill_rate --



Note that interest rates track inflation and the two are positively correlated.  Compare this reality to Drum's assumption that interest rates are inversely correlated with inflation...

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