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Interest Rates and Economic Growth

Why do interest rates have such an impact on the rate of economic growth? Our short answer is that sometimes they don’t – usually, but not always.

According to standard models, a capitalist economy is a dynamic system. The possibility of designing a steady state economy notwithstanding, an economy should always be always growing or shrinking, but never static for any period of time. Economists call the growth “recovery” and the shrinking “recession” or “depression.” When the economy is growing, it is producing more goods and services, adding more value to the Gross Domestic Product and the total national wealth. When it is shrinking, just the opposite is happening.

One of the functions of money is to act as a way to store value. In other words, part of the total worth of the economy exists in the form of currency, be it in a bank account or a billfold, where it will remain (we hope) until called on.

Another function of money is to provide an easy way to measure value – to enumerate the worth of assets. (This whole concept of Value, is important, but we’ll have to come back to it.)

Not all assets are in a form as liquid as money, but most are at least assigned a number that tries to match their financial significance. To make the assets easier to buy, sell or trade, people assign a figure for the amount of currency the asset is worth.

So when the economy is growing, those total sum of these numbers is growing – the amount of currency plus the total money value of all assets. Which is why the money supply is normally growing as well.

But that relationship does not always work if flip it over. In other words, just because the amount of currency and the total worth of assets are increasing does not mean the economy is growing. The money describes the value and it stores the value, but it is not the same thing as the value.

The correlation can get out of whack - one of the definitions of inflation is more money chasing less goods. Deflation, the mirror image where prices are falling and there may be too little money for the amount of good and services, can be even more destructive.

What does this have to do with interest rates? We can say that the way those numbers grow is by thousands of separate people each making decisions – whether to buy something, whether to open or close a business – and their decisions are dependent on their expectations about the economic situation. It’s generally not articulated in this way, but people are constantly making predictions about whether their part of the economy will expand, and how quickly. This is a form of what we’ve been calling Collective Subjective action.

In all the aggregate, maybe the most important predictions are those made by lenders and borrowers. For their part, lenders are constantly risking capital on the economic prospects of others - making loans to individuals, families and businesses in the hope of earning a return in the form of interest payments. That applies to traditional bankers, but also to credit card companies and other financial players.

It’s worth remembering that under the system known as Fractional Banking, loans can actually create money. If a bank gets a deposit of $100, it may keep only $20 on hand, lending the other $80 out at interest. But the depositor still has the right to ask for that $100, it hasn’t disappeared. So the deposit and the new loan exist at the same time, and new money has entered the economy. Other kinds of credit, including government borrowing and credit cards, have a similar impact.

The rate at which this happens is controlled by interest rates, which are guided by the central banks. In the U.S. the Federal Reserve puts money into the banking system or takes money out in order to raise or lower the rate of interest. The more money in the system, the lower the interest rate. And, most importantly, the lower the interest rate the more likely individuals are to make business decisions geared towards growth.

As for the borrowers, individuals are more likely to make large purchases and businesses are more likely to expand if borrowing costs are lower. We can put it this way – if interest rates are low, individuals and business are more likely to attempt behaviors that could result in creation of value, or of more value, in the economy as a whole.

And this new value, once created, is stored in money or in assets that have a worth described as being equivalent to an amount of currency. So we can say the lender creates the money, makes a loan of it to the individual or business, which (ideally) uses it to create value, enough (the borrower hopes) to pay the lender back. And when the debt is retired some of the new money is returned to non-existence and the rest solidified as it is attached to the newly created value - we might say the loop closed with the new parcel of value added to the economy as a whole, increasing the Gross Domestic Product, and the parties freed to go out and do it again.

All right. All of what we’re describing so far is well understood and not controversial, even though it’s being described from a somewhat unconventional viewpoint. But the part to understand is that none of this happens automatically; we might feel like it’s automatic, because we normally don’t think about and articulate all the changes we are making.

This only becomes clear when the normal processes break down. The match between the amount of money and the amount of value works when the economy is growing enough to support this creation of new money. But what if it doesn’t? What if the individuals have miscalculated, the business expansion is a failure, and the new assets are not worth what the borrower and the lender thought? In other words, what happens if the value created is not real, or at least not solid enough to support the amount of currency it has been matched to?

Of course that happens all the time. Assets don’t sell and their price has to be cut, people and businesses miscalculate and default, things don’t always work out. If these problems are rare enough, maybe the borrower and the lender between them can absorb the loss. But what if it happens to a lot of people at the same time? Then you have a problem, maybe even an economic crisis.

Markets are not perfectly rational. They make mistakes, sometimes big ones. And sometimes they get so badly out of alignment that tools which ordinarily work stop having the expected effect. One classic example of when lowered interest rates could not spark economic growth is Japan in the 90's - the crash of the real estate bubble and the deflation that followed was so profound that the central bank cut interest rates to nearly zero, as low as they could go, without much result for years.

This situation is called a Liquidity trap, and it teaches us two things. One, governments have to keep the option open to directly stimulate demand through deficit spending. This bothers some people because it looks too much like socialist style command and control economics, and in fact many of those people even object to central banks controlling interest rates for the same reason.

But we can see that government action softens economic decline by looking at the history U.S. inflation and deflation. Before 1945 deflationary periods and depressions were a regular occurrence. But there have been almost no serious examples (serious by 19th century standards) since the institution of Keynesian principals during the Great Depression.

The other thing we see from the occasional failure of interest rate cuts is to reinforce a point made above - currency (and worth enumerated as an amount of currency) describes economic value, but it is not the same thing as ultimate economic value.

If it were we could raise out collective wealth by printing more money. Or, if we didn't want to do that, we could simply lower interest rates until it stimulated rapid economic expansion. To put it another way, say our economy is described by a powerful equation, and one of the numbers in that equation, one of the factors, is the interest rate. We should be able to change the result of the equation by changing the interest rate number, but it seems we can't always do it.

This suggests that this is because value creation is also dependent on other things - in fact a complex web of social and physical interactions taking place in the society at large.

Let's tease this out a bit farther. Keynesians describe the situation where interest rates don't stimulate growth as pushing on a string - you can get results by pulling, but you can't by pushing. That's because the demand for the loans isn't there. Keynes noted that an economy could settle into a new equilibrium after shrinking, a state of lingering depression. The advantage government spending has in that case is that it can create it's own demand, it doesn't have to wait for the market at large.

But the people haven't changed, the technology hasn't changed, why should the economy be unwilling to respond to an interest rate cut, as it had before? To oversimplify, we can say that a change had taken place in the context, in the web of interactions in which the economy rests, in the millions of unconscious (a better word might be unspoken) estimations the future that guide people's economic decisions.

To make this clearer let's define two things. We can say that the Collective Subjective can approach the Objective, but at the most basic level is not the same thing. What is the collective subjective? In this case it says the behavior of crowds, or of markets – are capable of making intelligent, rational choices, but not infallible.

The other term we need to define here is one we’ve been using as if it were already understood. Maybe because most people think they do understand it. But it’s actually a slippery devil that wriggles out of your hand as soon as you think you have it. That term is value, specifically economic value.

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analysis/economics/interest_rates_and_growth.txt · Last modified: 2010/05/16 17:36 by ram