Friday, February 12, 2016

The problem with low interest rates

Money is a complicate concept.  For the purposes of this discussion, we shall treat money as grease for an economic engine.

While there are other explanations for it, this is the one that is most applicable for current economic theory. 

First, some back ground - current economic theory has changed dramatically since the 1950's.  Before then we did not attempt to use interest rates to fight inflation.  In the 60's that changed.

The basic idea was that inflation was caused by not enough grease in the system, so we applied more grease (lower interest rates = more lending from banks = more money available for use).

The problem is this what happens when you lower interest rates and the banks don't lend more money?  This began to happen recently, mainly because interest rates hit extreme lows.  Small difference in interest rates give little if any impact.  Lowering from 15% to 7% will have a huge impact, but from 7% to 3% is small, and from 3% to 1% is no impact at all.

You see, you can't just apply grease to the system and hope it goes where it is needed.  There are times when banks won't lend more even if you PAY them to borrow money from you (negative interest rates to the banks).  Once you go negative, the bank can simply borrow money, hold on to it without lending anything then give less back to you and make a profit.  No need to lend at all.

We need a more modern system of applying the grease.   We need to apply the grease not to the banks and hope they lend more, but directly to the parts of the economy that need it the most.

What would those parts look like?   There are several places to look at.  One is new businesses.   If you want to rev the economy up, offering to make more generous Small Business Loans - for guarantees, surety bonds, and Venture Capital, - works well.

Another is to look at parts of the economy that NEED the grease but aren't getting it.   Currently a major source for that is College debt loans. They can't be refinanced, no matter what happens to current interest rates.  Often they are held by hard working, intelligent college graduates.

So another thing the Fed could and should do is to refinance any education loan that has no late payments for the past 5 years.  It could even be set up to automatically work whenever the Fed lowers interest rates to banks - boom, instant refinancing allowed.   The people that benefit from this would be exactly the ones who could make use of the grease.