Adjusting Interest Rates (errr…What’s Really Going On)

September 22, 2008 by Mike Wilson 

This will be short. While we are witnessing some of the most aggressive and interventionalist economic policy we’ve seen in decades this week, I’ve had the chance to be reading ideas from free market gurus like Adam Smith and Frederic Bastiat. I don’t agree with everything Bastiat has to say (I agree with most of Smith’s points) but I wanted to discuss two policies that are used to deal with economic difficulties in the United States and talk about their ramifications.

Fiscal Policy

Fiscal policy is the idea promoted by John Maynard Keynes that when the economy isn’t growing, the quickest and most sure way to increase economic growth is to stimulate demand. This is most efficiently done by deficit spending (he only recommended it over the short term) wherein the government directly plants money into the economy. The “stimulus checks” that went out earlier this year were examples of fiscal policy in the Keynesian sense. Does it work? Growth in the second quarter increased to the extent that economists expected. Does it fix things long term? No. It’s a short term solution, most often in response to fundamental problems with saving and investing. We’ll discuss this in a later post.

Monetary Policy

The second type of financial policy used to adjust the economy is referred to as monetary policy. This idea was promoted by Milton Friedman and implemented during the 1990’s and earlier part of this decade by Alan Greenspan. It’s name, monetary policy, would indicate that it has something to do with money policy, which it does. However, when the Federal Reserve meets to discuss monetary policy it is presented as an adjustment to the interest rate. The lower the interest rate the cheaper it is to borrow money and this cheaper credit encourages the economy to expand. It encourages borrowing for capital investment, home purchasing, car purchasing. It discourages savings (again we’ll talk about saving in a minute).

How, then, does the Fed adjust the interest rate? They do so by affecting the money supply. In order to make money cheaper (lower the interest rate) they do what microeconomics says will cheapen any commodity — they increase the supply of money. They do so mainly by buy bonds on the bond market and thus increasing the amount of circulating capital. With an increased money supply, banks are more willing to lend to each other and to consumers and consumption increases.

Besides the inherent problems with increasing consumption without addressing production and supply, monetary policy (although less traumatic to long-term economic fundamentals than fiscal policy and deficit spending), because of the way it’s described,  has the tendency to impoverish the poor. Increasing the money supply doesn’t make anyone richer. All it does is increase the number of transactions and thus stimulate exchanges, but if there isn’t any more production of labor and capital to purchase, no real growth takes place. But because it is couched in the terminology of “lowering interest rates” instead of “increasing the money supply”, most people don’t realize that it is the money supply that is being adjusted, not the interest rates directly. This affects the laborer more than the owner/merchant in the following way. From Bastiat’s What is Money?:

Under the influence of ignorance and custom, the day’s pay of a country laborer will remain for a long time at a franc, while the saleable price of all the articles of consumption around him will be rising. He will sink into destitution without being able to discover the cause…But this rise in prices is not instantaneous and equal for all things. Sharp men, brokers, and men of business, will not suffer by it; for it is their trade to watch the fluctuations of prices, to observe the cause, and even to speculate upon it. But little tradesmen, countrymen, and workmen, will bear the whole weight of it. The rich man is not any richer for it, but the poor man becomes poorer by it. Therefore, expedients of this kind have the effect of increasing the distance which separates wealth from poverty, of paralyzing the social tendencies which are incessantly bring men to the same level, and it will require centuries for the suffering classes to regain the ground which they have lost.

Remember that this is from one of the most outspoken free market promoters of all time. I think that his assessment is correct. It takes longer for the day laborer, the wage earner, to realize that everything is costing more money because of the increase in supply of dollars, while he is making the same amount of money, than for the business man whose decision-making awaits all the financial news on Bloomberg, FOX, or CNN. One way to lessen this effect would be to change the terminology for what the Fed does: tell everyone that the Fed is increasing the money supply, not that it is lowering interest rates. And be aware when ever anything is done for expediency. There are almost alway unseen costs associated with those interventions.

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Filed under: America, Economics, Monetary Policy, Prosperity
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Comments

One Response to “Adjusting Interest Rates (errr…What’s Really Going On)”

  1. Bill Tiszai on September 25th, 2008 12:29 pm

    I would tend to agree with your comments. The headlines in the credit markets over the last week, however, make me realize governing by principle is much easier when those principles are not tested. I’ve always thought of myself as a supporter of capitalism with as little government intervention as possible. Now, I find myself wondering what price we should be willing to pay to prove the value of this principle. Our financial system and the economy it supports was on the brink of implosion last Thursday 9/18. The next day felt like we took one step away from the edge. This week, we’re holding on, but the peril possibility is still real. I want so much to say, “let the chips fall and teach everyone a good lesson and bring the markets back into balance.” When faced with the possibility of a decade long recession that might personally hit me, I find my resolve weakening.

    Regarding the impact on the poor when increasing the money supply: It’s true, increasing the supply of money, increases inflation, which can decrease the purchasing power of all, but it is felt most by the poorest. We witness in our area, however, the decreaed money supply (via less liquidity) driving down demand for areas in the construction trades. I can now contract for labor at rates available ten years ago. These laborers have less purchasing power than two years ago. Perhaps a prolonged recession will bring prices back into a range where their purchasing power increases, but for the foreseeable future, these guys talk about 2003-2006 as a great time for their profession…even in the face of watching things like housing slip further away from their ability to pay. They might have been frustrated by the challenge to buy a home, but now they are scared when they can’t feed their family. In addition, increased middle classes around the world could prevent commodities from falling back to levels that would allow the purchasing power of these laborers to ever climb back to previous levels.

    I’m not disagreeing with your positions, rather I tend to share them myself. Recent events, however, have thrown examples into my face that force me to ask myself how deeply committed I am to these views…and I’m still working it out.

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