Interest rates are too low

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What’s gone wrong with the Fed’s aggressive policymaking? The answer is that interest rates are too low for credit to be extended to the risk-takers who will grow the economy. This is simple price theory: when lenders aren’t compensated for putting their money out for hire, the supply of loans falls short of demand for them. In a free-market environment, the interest rate would naturally rise to the market price of credit for supply to meet demand. But this can’t happen when the Fed caps interest rates.

The banking system shows the indicators of this financial disorder. Interbank lending declined sharply in the years after the financial crisis and only bottomed out in late 2011. It is still 70 percent below its pre-crisis peak. In exposing this problem two years ago, Stanford economist Ronald McKinnon warned that the “American system of bank intermediation is essentially broken.” Big banks are reluctant to lend to smaller ones at measly rates of interest, reducing the credit available for would-be borrowers who rely on these regional and local lenders for funds. Today, commercial and industrial loans by small domestic banks are at approximately half the level they were in 2007.

Small and medium-sized businesses are in many ways the lifeblood of the economy, and when they can’t get loans to expand operations or hire more workers macroeconomic conditions deteriorate. It’s no wonder that a high jobless rate has coincided with this credit crunch: small business makes up about half of private sector employment. During periods of economic expansion, small firms are typically the driver of job growth.

Big business has been seen as one of the two main beneficiaries of the Fed’s zero interest rate policy (the other is the federal government). Bernanke has frequently touted rising stock and bond prices in defending his approach. But most of the benefits have been absorbed by financial activity – mergers, buyouts, share repurchases – rather than business expansion. Major companies have become pressured to return cash they could otherwise invest internally to shareholders who are deprived of fixed income thanks to low interest rates. Investment as a share of the economy is half of what it was before the financial crisis. John Taylor, McKinnon’s colleague at Stanford, has shown that investment as a percentage of GDP and unemployment has a strong inverse correlation. Real growth, as opposed to refinancing, requires hiring workers.

Those of us who predicted that the zero interest rate policy would mean high inflation have been proven wrong so far. Inflation is still a concern, and November’s exit polls reporting rising prices nearly tied with unemployment as voters’ top economic worry shows that it is a pocketbook issue. But what is really surprising nearly four years after the recession’s end is the lackluster economy, magnified by high unemployment.

Both parties in Washington have blamed each other for creating “uncertainty” they say has kept the economy in a holding pattern. In articulating the conventional wisdom, New York Times columnist David Brooks recently wrote, “What’s America’s biggest problem right now? It is that business people think that government is so dysfunctional that they are afraid to invest and spur growth.” Warren Buffett, for one, rebutted this idea in his recent letter to shareholders, noting that, “Of course the immediate future is uncertain; America has faced the unknown since 1776.”

What’s distressing about the Fed’s mistake is not that it is unprecedented, but rather that it grew out of established logic. The risk of the Fed being wrong on interest rates was always considered a one-way street: higher rates could cause a downturn or deflation while lower rates could cause asset bubbles or inflation. Instead, easy money has backfired into a credit crunch inflicted on small businesses and job seekers. If the Fed can cause that – if the same policy lever can produce two different kinds of damage – we should reexamine the monetary system that enables this to happen. Economic recovery may depend on it. 

Danker is economic director at American Principles Project, a Washington policy organization