Is the Interest Rate Still Relevant?

The typical boom/bust cycles that are discussed in Economics textbooks are not playing out the way they used to. The economy was controlled by raising or lowering interest rates to create extra demand or reduce demand by making money easier or harder to obtain. There is now a situation where central banks around the world have lowered interest rates into zero or negative territory and the economic demand is subdued. Why? The book/bust cycle management with interest rates only works if certain assumptions are met.

The first assumption is that people can borrow money and pay it back with future labour. This future work is assumed to be needed because something needs to be provided. A second assumption is that people will want to borrow money to buy things. This assumption held up for the last 100 years due to a larger and larger population. This population was also sharing in the world’s wealth. Is this still happening? What if people do not want to borrow any longer? The reality is not that people do not want to borrow – the reality is that they cannot afford to. This means the economy is including fewer people over time and therefore is shrinking. Most of the spending that propels an economy comes from the volume of transactions from the middle class and poorer people. Can this spending be effective if fewer people have the money or the credit to continue?

The interest rate is becoming irrelevant in terms of controlling the masses, but it is becoming very important in terms of managing the global debt. As the debt amounts get larger, the sensitivity to the interest rate is larger, and the risk of an economic “shock”, “black swan” or “event” occurring is larger. Can any major central bank raise interest rates in this environment? Yes they can, but this is not about managing cycles temporarily. Raising interest rates would lead to collapsing the debt structure or inflating it, causing dislocations in the economy which may last for a long time. Whatever solution is presented for managing the debt will have to be long term because debt grows infinitely.

Rather than focusing on the interest rate, the key will now be to focus on access to money in general. Banks used to use the interest rate as the cornerstone of lending. If it is zero or negative, this no longer applies because banks do not need your deposits to be in business. What they do need is access to the creation of money. The creation of money means permission to print money rather than the cycles of supply and demand for investment and savings. This permission is based on trust or perception rather than what is produced or needed for production in the actual economy.


About joetheinvestor
Joe Barbieri has Bachelors degrees in both Civil Engineering and Commerce from the University of Toronto. He has worked in the Financial Services field for over 12 years, covering positions from Retail Customer Service and Fund Accounting, through to Investment Research on the Institutional side. He has worked in 5 companies, spanning banks, a mutual fund, a Consulting Firm and a Large Canadian Pension Plan. He currently has a Chartered Financial Analyst designation (CFA) from the CFA Institute. He has recently published articles in Pension and Benefits Monitor Magazine as well as the Internet.

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