Destroy jobs so as to curtail bubbles? Bonkers.

Conventional economics continues to struggle manfully with a problem it cannot solve, and which functional finance can solve. It’s this. Low interest rates can encourage asset price bubbles. But higher rates might hinder the recovery. So what to do?

As Brad deLong (Prof. of Economics at Harvard) put it a year or so ago, “......in a situation like 2003 should we try to keep the economy near full employment even at some risk of a developing bubble?”

To put that in plain English, conventional economics can involve destroying jobs, increasing home repossessions, families being made homeless, etc so as to discourage gamblers and other undesirables with more money than sense from taking silly bets on asset prices. Now there has to be something wrong there.

What is wrong is so fundamental to conventional economics, that it’s advocates won’t believe it: it’s that interest rate adjustments just aren’t a good way of regulating economies.

A better way, is simply to alter government income and/or spending and let interest rates look after themselves. And the reason is desperately simple. Altering government income and spending can be done in a way which is almost free from distortionary or directional effects. In contrast, interest rate changes are very distortionary.

To illustrate, reducing interest rates benefits borrowers and hits savers. Well, that is distortionary for a start: it involves benefiting one half of the population of the population, and hitting another half.

As the INDIRECT effects, reduced interest rates will encourage a very small proportion of the population (and firms) to make very large capital investments. That is distortionary again.

Doubtless the benefits of an interest rate change eventually “trickle down” to the economy at large. But how long does that take? Two years? Four years? Macroeconomic adjustments which are slow to act can easily be worse than useless. For example, if an adjustment is aimed at escaping a recession, and the main effect is to exacerbate the next boom, that is worse than useless.

In contrast, changes in government income and/or spending can have an immediate and less distortionary effect. For example the payroll tax reduction long advocated by Warren Mosler is distortion free in that it immediately benefits every employee in the country. That of course leaves out pensioners, the unemployed and few other groups. But with a little ingenuity, these latter groups can be allowed to join in the fun, e.g. via a temporary unemployment benefit increase. As for pensioners, countries with a state pension schemes can make temporary changes to the state pension. For example the U.K. has temporary and variable state pension supplements in Winter to help pensioners with fuel bills. It isn’t rocket science.

To summarise, any asset price bubbles that derive from an interest rate reduction derive precisely from the distortionary effect of interest rate reductions: the fact that the initial benefits land first in the laps of borrowers, in particular those tempted to borrow large amounts on the strength of the rate reduction.

So the solution is: don’t use interest rate adjustments as adjust economies.

Note added 9th July: Martin Wolf in the Financial Times doesn’t appreciate the problems with interest rate adjustments. He said (7th July) “expanding the interest elastic parts of the economy is the best way to climb out of the hole”.