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Interest rates, the flow of funds and perhaps - by default - Armageddon

By James Cumes - posted Tuesday, 22 September 2009


There certainly is a compelling need for us all to think through the nature and impact of movements in interest rates if, in future, we are to achieve stability in our national economies as well as globally.

Interest rates and the availability of credit raise fundamental issues with which we must try to deal more efficiently and knowledgeably than in the last 40 years.

When interest rates are raised, a direct cost is immediately added to production. No offset to this de-stimulus is provided by government or any other source to hold production up.

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On the other side are our famous inbuilt stabilisers which since the 60s - and for many economies long before the 60s - held up consumer demand, if not at its pre-hike level, at something approaching that level.

This was the way it went when Federal Reserve Chairman, William Martin - about to retire and leave his heritage to the unfortunate Arthur Burns - raised interest rates in July of 1969. That was the month man walked upon the Moon. We were astonishingly smart in our exploration of the solar system but not so smart in our financial arrangements.

Even before unemployment went up, Nixon was quick to point out that his inbuilt stabilisers would maintain the incomes of those thrown out of work; but production fell by something like 7 per cent in just 12 months.

We got stagflation.

And from the United States, it spread everywhere.

I am not saying that consumer demand will stay up or increase with a hike in interest rates. Rather consumption will fall less than production and this imbalance will increase consumer inflation rather than reduce it.

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In thinking about these issues, we must be careful not to let dogmas repeated over the decades get in the way of the "truth" as revealed by the empirical evidence.

Since 1969, most highly developed countries such as the United States, major European economies, Canada and Australia have experienced chronic inflation. Virtually all of our currencies now buy a 10th or even a 20th of the real goods and services they bought back in 1970.

This has been despite the efforts to “fight” inflation by appointing diligent and "independent" central bankers and despite the creation of such miraculously booming economies as the Asian Tigers, China and India - a miracle achieved crucially by the self-destructive policies of the countries suffering from chronic inflation.

We have gutted our industries, accumulated massive debts, become the most obsessive gamblers in human history and the goals we alleged were our purpose have never been reached. Indeed, all we have done is to score the most startling series of "own -goals" in economic and financial history. Those goals scored against ourselves are already having social, political and strategic consequences going far beyond those revealed in the fluctuations of the Dow or the collapse of individual banks. They go to the survival of the sort of global community we have claimed to be trying to create since the end of World War II.

Let us have a closer look at some of the more "technical" issues and, in particular, at interest rates and the flow of funds.

The empirical evidence on the impact of interest-rate hikes seems overwhelming. More than 60 years ago, Keynes seemed to view such hikes much as I do. He was ignored so it is not surprising that my views on the subject have been ignored for some 40 years.

That does not mean I am right. What it does mean, however, is that we should look at the record carefully and determine whether we have led ourselves up the garden path in our policies to "fight inflation". I say this, too, in the light of our casual dealing with the whole concept of inflation. There is a chronic failure to draw a sufficient distinction between consumer-price and asset-price inflation.

A hike in interest rates will almost certainly have an impact on asset-price inflation probably, to all intents and purposes, the same as the "damp-down" effect an interest-rate hike will have on fixed-capital investment.

However, once again, we must be careful.

If central bankers, in their wisdom, hike rates slowly and marginally, the acquisition of assets - by speculators, for example - may be encouraged rather than otherwise, at least for a time. The tipping point, when it comes, may be difficult to identify.

I do not want to be dogmatic on the point, but Greenspan’s interest-rate shenanigans may have had this effect on speculators and others especially during the latter years of his reign.

We must also distinguish carefully between interest rates and credit. In certain situations, the crucial consideration may - critically - be credit availability rather than the level of interest rates.

In recent years in particular, the free flow of virtually all kinds of capital globally has meant great volatility in flows and substantial increases in the carry trade. A revival of the carry trade seems under way right now with the US dollar participating significantly in the outward flow of funds.

Whether the latter is so or not, the unregulated flow of funds is a high-risk situation that we dare not ignore if we are to achieve stability and real growth in a more stable future global financial system.

So we must look at the flow of funds and the general availability of credit rather than focus our attention entirely - as we have tended in the past to do - on moving interest rates up or down. In the past, our central bankers have tended to engage in a simplistic yo-yo exercise. This will not give us the dynamic stability we want in the future.

Leaving that aside, however, we must also consider the fundamental issue of what low or lower interest rates mean if we decide that interest-rate hikes do not "fight inflation" but intensify the inflation as it tends to be identified by the man in the street, that is, consumer-price inflation.

If an interest-rate hike does in fact stimulate consumer-price inflation, then should we logically conclude that lowering interest rates does not intensify inflation - as we have been asked to believe - but rather reduces it?

I have maintained - since 1969 at least - that a cut in interest rates will promote fixed-capital investment and, through the beneficial impact on real investment, real productivity and real production, will lower consumer-price inflation - at the same time of course as it will tend to enhance asset-price inflation. There will be a period during which the impact on housing prices, for example, might be relatively small but it will, in the longer term, be necessary to manage the flow of funds to avoid the housing and other bubbles from which we have suffered so acutely during recent decades.

If our financial and economic management is sound, this will yield a satisfying situation at a certain interest-rate level which will deliver stable growth at stable consumer and asset prices.

However, we must consider the situation if interest rates sink or are cut to such low levels as we see in the United States and some other countries at the moment.

A logical expectation would be that, if lower interest rates produce lower inflation, at some point of reduction lower rates will turn inflation into a highly dangerous deflation most societies will want to avoid at all costs.

While we should not bind ourselves too closely to historical precedents, we should recall what happened during the Great Depression which lasted a full ten years from the Great Crash of the New York Stock Exchange in 1929 to the outbreak of World War II in 1939.

Only the war got us out of the Great Depression and freed us from what was, for the most part, a Great Deflation.

We must also bear in mind that the collapse of the bubbles in Japan in the late 1980s and early 1990s was followed by a painful period of deflation which still afflicts the Japanese economy to a significant extent. During most of that period, Japanese interest rates have been at or near zero.

That has encouraged the carry trade but it has not sufficiently stimulated domestic real investment in Japan. On the contrary, even nominal interest rates at zero have meant, for the fixed-capital investor, real interest-rate levels which can often be a decisive deterrent to the real investment crucial to employment and real economic growth.

These issues are complex. They deserve much more sound, professional, imaginative attention than they have received so far.

Keynes famously said we are all imprisoned by the ideas of some defunct economist. That is certainly true today. Even after decades of appalling error, we still stick to dogmas about interest rates which have their origin almost two centuries ago. We still neglect even to ponder the need to control the flow of funds whose chaotic, casino-like character seems even now to be reappearing and reinforcing risk under the genial protection of our central banks and treasuries.

So I suggest we try to shake ourselves free of the dogmas - or ideologies - of the past in order to rescue what are the most vital of those ideologies. In particular, we need to assess carefully how seriously capitalism itself is at risk and what we must do to preserve it.

We should also recall that the Great Depression could not really be said to have ended without the intervention of World War II and the fundamental reappraisal of our economic and financial policies to which that appalling conflict led.

We do not want a World War III to deliver us from our present mess. I do not believe that to be our "only option". But we have not yet begun to tackle the real issues, some samples of which I have identified above.

So far, we have been more obsessed with bailing out banks so guilty in such a plethora of ways that, if they are "rescued", we must never allow them to behave with such arrogant irresponsibility again.

Through our democratic institutions, we must determine the right paths to take - and the banks, innocent or guilty, must come along with us.

It is not enough to talk about new, tougher regulations, recapitalisation and disciplining the bonus culture. Though necessary, those proposals do not go nearly far enough. We must reform the fundamentals of the way the economy and its financial system work, both domestically and globally.

We must do this in the comprehensive way we reformed our domestic and world economy after World War II. Anything less will not be enough. Rather I would hope we would do more, more strenuously this time, because the social, political and strategic stakes - going far beyond the economic and financial stakes - are even more compelling this time.

If we do not get it right now, the opportunity to have a second go may never occur.

The rescue of the economic system after World War II was achieved by governments acting together. We must seek to achieve stability and sustainable growth now through governments acting together again. The "public option" cannot possibly be ignored. On the contrary, it must be warmly embraced.

That does not mean that capitalism as our economy’s essential system will or should be abandoned. On the contrary, just as after World War II, it must be preserved and strengthened in ways that resort to the "public option" alone can accomplish.

We need governments to participate in "recovery" from our present difficulties on much the same scale as during and after World War II. We should not shrink from that. It offers a future for prosperity and peace in the world community which is infinitely superior in quality to bailing out zombie banks and restoring some facade of acceptance to Wall Street and the financial system which have failed us - and the democratic capitalist system - so miserably and so irresponsibly in the recent past.

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About the Author

James Cumes is a former Australian ambassador and author of America's Suicidal Statecraft: The Self-Destruction of a Superpower (2006).

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