The Fed Must Raise Interest Rates

Yes, in a recession. It’s exactly what the economics textbooks tell you is the worst thing to do now — which is exactly why it must be done.

Yesterday, the Federal Reserve cut short-term interest rates by fifty basis points to 1%. That level happens to be exactly where rates sat in 2003 and 2004 to help fuel recovery from the last recession in 2001. A commentary in BusinessWeek asked how low interest rates could go; the answer, of course, is zero, but the author notes that “could trigger a speculative investment frenzy that could feed a bubble that pops, wreaking havoc on the economy.”

You don’t say. It’s not like it takes a rocket scientist to figure that out, considering THAT’S WHAT JUST HAPPENED.

We are in the midst of a consumption bubble. Consumers and government are both spending thoroughly absurd amounts of money that are well beyond their means. The latter is easy enough to explain; politicians want to stay in office and go about buying off constituents, printing money to pay for it, regardless of the future consequences. The former can be partially explained by the increased availability of credit cards and home equity loans, but these are simply enabling devices. In essence, the American public has become accustomed to a rate of economic growth that is not sustainable in the long run, due to a series of positive shocks to aggregate supply:

(1) Following nearly two full decades of depression and war, massive depletion of physical capital at home and abroad required large-scale investment that stimulated the economy and led to the golden age of the 1950s (on which American politics is based, as I noted in 2005).

(2) The large-scale addition of women to the workforce, starting in the mid-1960s, drastically increased the supply of labor, lowering wage costs for firms. Combined with “guns and butter” federal spending at the time, the economy grew at a very rapid clip until the 1973 oil crisis.

(3) The mainstreaming of the personal computer in the 1980s and the Internet in the 1990s led to radical increases in workforce productivity, allowing for accelerated inflation-free growth until the 2000 tech crash.

This decade has not seen an aggregate supply stimulus on the scale of any of these three events, which together led to a six-decade period with only one period of dire recession (1980-1982). The business cycle is not supposed to be so kind. What made the downturn of the early 1980s so severe was Paul Volcker’s determination to eliminate inflation, which had plagued the entire prior decade — to the point where he hiked short-term interest rates to a mind-boggling 20% to kill it. This led to double-digit unemployment, but there is no doubt that the economy was all the better for it in the long run.

So herein lies the problem: We are doing irreparable damage to the national economy in the name of financing absurdly unsustainable growth rates in consumption. The savings rate is practically zero and you’re CUTTING interest rates? In the name of what? Banks aren’t hoarding cash because the fed funds rate is too high; they’re doing so because they don’t know who they can loan money to (as for the last five years, the answer was “anyone with a pulse”). Setting rates at or below 1% is walking right into a liquidity trap, as occurred in Japan in the 1990s; giving them an unregulated pile of bailout money in such a climate of fear leads to what we saw last week: PNC, hours after getting its $7.7 billion check under dubious circumstances, used most of that money to purchase National City Bank.

It’s time to try a new tack: incentivize saving, not consumption. Gradually raise short-term interest rates back to their historic average, replace all income taxes with sales or value-added taxes to make savings tax-free, eliminate barriers to foreign trade and investment, and get slashing with the federal budget. This is the policy mandate that we impose on every country that needs financial assistance (except the sales tax part); it’s time we started taking our own advice.