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Would Higher Interest Rates Boost US Growth?

BERKELEY – Blackstone CEO Tony James recently published a column in the Financial Times titled “To revive America’s economy, raise interest rates.” This is a very bad idea.

Let us imagine that we have been transported to a parallel universe, one where the US Federal Reserve has not held interest rates at or near zero. Instead, this Fed has gradually raised interest rates for the past six years, and the federal funds rate is now 400 basis points higher than it currently is. Before looking at what this alternate-universe economy would look like, let us review what has happened in the real world.

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In the fourth quarter of 2015, households, businesses, and foreign investors saved $940 billion in the United States. Of that amount, $185 billion was invested in newly issued government bonds, and the other $755 billion flowed into interest- and dividend-paying savings vehicles such as loans, corporate bonds, and new equity issues, which in turn added to the US private sector’s productive-capital stock.

In our hypothetical scenario, $755 billion in new savings vehicles would not have been created in the fourth quarter of 2015 to fund investment. With higher interest rates, that $755 billion could still have been as high as $735 billion, or it could have dropped to as low as $700 billion. In any case, we know that it would have been lower, and that the liquidity balances that support spending would have been deprived of $20-55 billion.

Perhaps James only talks to firms that do not rationalize their investment plans when interest rates rise; but many firms certainly do. For example, interest rates play a major role in the construction business, especially on the coasts, where real-estate values are especially sensitive to financing costs and available cash flows. Increased financing costs and reduced liquidity can also dampen consumer-goods purchases and prevent small businesses from expanding.

The Fed could respond by adding to the economy’s cash stock, but then interest rates would fall, and we would be exactly where we are now. On the other hand, if the Fed maintained the higher federal funds rate, financial flows would be diverted away from productive investment and into idle cash balances, spending would decrease, and the economy would enter a new recession.

At this point, James would object that this is not what he wanted at all. He would have expected the confidence fairy to show up and spur production and demand across all economic sectors, so that businesses still would have created $755 billion in new savings vehicles, aside from government bonds, in the fourth quarter of 2015.

With the confidence fairy’s arrival, everything would indeed be fine: the economy would be stable and close to full employment, interest rates would be higher, and the negative effects of abnormally low interest rates that James lists would all disappear. According to James, these effects include “companies substituting capital for labor to an unnatural degree”; economic hardship for “the elderly and others who depend on income-producing investments”; higher retirement-savings requirements; “systemic risks” in the financial system as investors buy “esoteric assets” to “grasp for higher returns”; and lower bank profitability from lending.

But these problems would not be averted by the Fed independently raising interest rates. Rather, businesses must create savings vehicles and make investments, to which the Fed can then respond by allowing interest rates to rise, in order to head off excess demand and high inflation.

The Federal Open Market Committee cannot dictate this process from the Eccles Building in Washington, DC. But the Fed has now tried to induce the creation of more savings vehicles, in part through $3 trillion in purchases of long-term securities.

The Fed has removed an annual $30 billion in duration risk from private-sector balance sheets – which bond issuers previously had to pay savers to bear – and that freed-up risk-bearing capacity has presumably been used to fund risky investment projects. But surely James would agree that financial organizations that assess and bear duration risk are not necessarily competent to judge other risky ventures.

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If we want more savings vehicles to push up interest rates in loanable-funds markets, so that the Fed can then increase the federal funds rate, there is an obvious solution: the government itself should create savings vehicles. For example, a government-sponsored infrastructure bank could start borrowing $100 billion every quarter to finance infrastructure projects. With that, concerns about abnormally low interest rates would be a thing of the past.

In the meantime, the Fed should certainly not take the lead in raising interest rates when there is no evidence of excess supply in savings vehicles. To do so would be akin to building a half-mile landing strip in the Pacific Ocean in 1944, and thinking that cargo-bearing B-17s would suddenly start to land.