Interest
rates may not be low enough to get us on the road to recovery but falling
prices should help
Something strange is afoot in the
economy. With interest rates at record
lows in many countries, borrowing should be booming and saving on the decline
but the opposite is true. This suggests
that the economy remains out of kilter without interest rates being able to set
the right balance between savings and investment. Instead, the shortfall in demand due to limited
investment and weak spending may be dragging down prices as a means to put the
economy back to health.
Not
so free market
The self-healing ability of any economy is
one of the central tenants of economic theory.
Prices adjust as a means for the economy adapting to any changes. For example, an increase in the supply of bananas
will trigger a fall in prices and more people eating bananas. A rise in companies looking for software
experts would drive up their wages (the price for labour) and the number of
people wanting to learn more about computers.
Through changes in these prices, the economy moves toward an equilibrium
where everything is at appropriate levels.
Interest rates act in the same way acting
as the “price of money”
to make sure that there is neither too much nor too little savings or
investment. Lower interest rates are
used to make borrowing cheaper and savings less worthwhile. This was the course of action taken by
central banks in order to stimulate the economy by attempting to boost
investment (funded by lending) and spur on more consumption (due to lower
savings). Quantitative easing adds to
this by giving banks more money to lend and less need to entice people to leave
money in the bank.
Still
waiting
The continued wait for a robust recovery
suggests that something remains amiss.
The lack of appetite among companies to expand their operations by
borrowing is both a cause of and caused by weak demand in the overall economy. Spending by consumers is also faltering with people
happy to let money mount up in the bank despite the low returns on
savings. The high levels of household debt
that still persist are another reason for consumers to hold back from spending.
The persistence of the state of low
investment and high savings suggests that monetary policy has not been enough to get the economy back on the right track (although it has helped to prevent a financial
collapse). A further loosening of
monetary policy is not on the books for most central banks. Interest rates cannot be lowered much further
considering that negative interest rates are difficult to implement. Quantitative easing also seems to have run its course while increasing creating negative side effects.
Where
to next?
The inability of interest rates to adjust is
hampering a return to economic growth.
With interest rates not able to go any lower, it may be the case that it
is prices which are instead moving to get the economy back to equilibrium. That is, rather than interest rates falling
to balance out weak lending and growing savings, prices are being depressed by
the lacklustre economy. The hopes for
economic recovery rely on cheaper prices spurring on more spending thanks to
consumers felling richer. Further
impetus would result from the extra spending helping to push up investment and lift
the economy to better match the current level of interest rates.
This route back to recovery may take time
considering that any decline in prices will be limited and wage gains have yet
to take off. There are ways to push this
along of which easiest way would be for governments to temporarily increase spending. Money used for investments in infrastructure
or training and R&D in new technologies would be worthwhile at a time of
low interest rates. Another alternative
would be for central banks to use their money-printing capabilities to transfer cash to consumers. This more radical option would provide a
short-term boost to spending. Sometimes
we all need a little bit extra to get us back on track and the economy is no
different.
