Saturday, December 11, 2010

Martin Wolf is wrong to back low interest rates.

Martin Wolf in the Financial Times attacks the idea that low interest rates are unfair to older people (who tend to be lenders / savers). This article is not up to Wolf’s usual high standards.

His first argument is that older people have benefited from “huge capital gains in their houses”. Completely irrelevant! Not everyone owns a house: some rent. And second, the gain in value of one’s house is no benefit, unless one trades down to more humble accommodation. And third, some peoples’ houses are worth far more than others, plus some people have more than one house!

Martin Wolf’s argument above is a bit like arging that men should pay a higher rate of tax than women because men tend to earn more. The way to a more equitable distribution of post tax income is INCOME TAX. The sex of individual taxpayers is irrelevant.

If there is something wrong with large capital gains on large houses or second homes, then fine: introduce a tax on those gains. Though any such tax (and thus Wolf’s point about house price increases) is rendered somewhat irrelevant by the fact that at least in the U.K., capital gains tax is payable on second homes, plus the value of everyone’s main residence is included in estate valuations for inheritance tax purposes when they die.

Wolf then argues that given excess debt, excessive leverage and weak financial sectors, low interest rates will help profligate and irresponsible lenders and borrowers rectify their mistakes. Well it’s not the job of pensioners (or anyone else) to subsidise or come to the rescue of the irresponsible.

Walter Bagehot advocated, quite rightly, that where a bank is in trouble, the central bank should provide TEMPORARY assistance based on QUALITY collateral and at PUNATIVE rates of interest. If the bank cannot produce quality collateral or pay those punative rates, then it does not just have a temporary liquidity problem: it is bust. Bankrupt. It should be closed down.

Of course politicians HATE taking the latter bull by the horns. It means disruption, which might lose them votes (but benefit the country in the long term). “Kicking the can down the road” is so much more appealing for politicians. And there is another bonus, at least in the U.S.: the irresponsible lenders who are rescued with taxpayers’ money then continue contributing to said politicians’ campaign funds.

Subsidies for the irresponsible are themselves irresponsible.

Martin Wolf then claims that “with higher rates, house prices would fall further, unemployment would rise, more loans would default and banks would fall back into difficulties.”

The idea that higher rates of interest have to lead to higher unemployment is nonsense. Of course it is perfectly true that ALL OTHER THINGS BEING EQUAL higher rates MAY lead to higher unemployment: certainly adjusting interest rates is a popular way of supposedly regulating aggregate demand.

However there are plenty of authorities who have questioned the effects of interest rates on demand and hence on employment levels. For example, the Radcliffe Report in the U.K. in 1960 concluded that interest rates were a poor way of regulating demand.

And Scott Sumner, Prof of economics at Bentley University (U.S.A.) thinks likewise.

But more important than the questionable effects of interest rates in regulating demand is the above “other things being equal” point. The flaw in Martin Wolf’s argument here is as follows.

Suppose we were to adopt what might be called the above purist Walter Bagehot approach and keep interest rates relatively high. And let’s also assume that high interest rates DO curtail demand. The result – no question about it – would be raised unemployment.

However, interest rates are not the only factor determining employment levels! That is, there are well known ways of boosting demand (and employment) other than adjusting interest rates. E.g. an unfunded deficit with the additional or new money channelled into household pockets would raise demand: pretty much what Keynes advocated, as did Milton Friedman.

To summarise, we could perfectly well go for higher interest rates, and compensate for any demand reducing effects by boosting demand by other avenues.

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