So Does This Interest Thing Always Work?

So Does This ‘Interest’ Thing Always Work?

By Derek Beese

In some of my previous posts I have commented on money, value and inflation and that governments use interest rates as the first and principal means of stopping monetary inflation, or to be more accurate, to control the degree of inflation to a level that they want.

Does this always work? A good question and the answer is yes and no. It depends on where you are standing at the time. A man, who had lost his way, met another man along the road and asked him how to get to his intended destination. The answer he got was “that is very difficult and if I were you I wouldn’t start from here”! So the short answer for interest rates is, yes it will always work given enough time — but — if you are so far off course that everything is going pear shaped it will not work quickly enough to get back to where you should be.

Ha – Ha, very clever but what does that mean? Well, if the supply of money is well balanced with the amount of product and both are growing at the same rate the amount of inflation will be negligible and under control and small tweaks in interest rates, up or down, will keep everything rosy. But if the national interest rates have been kept too low for too long this will encourage the country’s people (and businesses) to borrow more and more money to spend which increases the money supply but not necessarily the amount of product. Result = inflation. If this goes on for too long without being reversed then the result is very high inflation and people begin to chase after their belief that this illusion of increasing value is real and will last forever. The Emperor’s New Clothes Syndrome or the Tulip Mania again.

House prices raising so rapidly that people can no longer afford them – very bad news. Increase interest rates to slow demand and get things back towards a balanced situation and those people who have borrowed right up to their absolute financial limits cannot afford the new increased repayments and in time their homes are forfeited and sold to repay the debt. At the same time the demand for houses goes down because the borrowing cost has gone up meaning, fewer buyers, houses for sale are more plentiful and the prices start to drop. Those people who have borrowed the full value of the house now have a problem because their borrowings are more than the value of the house —a thing called Negative Equity. This sequence is like a snowball rolling down a hill, it gathers pace and size as it goes and becomes unstoppable until it eventually reaches the bottom and loses its energy. People lose confidence in the value of the product and that means its monetary value sinks.

When this “fully inflated balloon” situation has been reached, the necessary reduction in demand has very bad side effects because people lose their jobs, which reduces the demand still further and the problem spreads to other product items and affects shops, motor vehicles, transport, holidays and most other things The money supply is contracting dramatically because no-one wants to lend and no-one wants to buy (they are all saving for all they are worth to make sure they do not run out of money to meet their debts). So what is the government to do? The immediate response is to reduce the interest rate rapidly and keep on reducing it until the position stabilizes again. If this does not work and it is unlikely to do so for a long time because confidence has been lost and the rate cannot in any case go below 0%, then the powers that be must start flooding money into the system to support the businesses and services that otherwise will not survive. But the government has to borrow this money which will make the present position easier but at the same time makes “tomorrow” much more difficult when these borrowings have to be repaid. It is a repeat of the original cause of the problem.

If this move fails to stop the slide then lack of confidence in the value of the country’s money will mean that the government will be unable to borrow any more and the last resort is to print its own money which, as has been explained in a previous blog, is self defeating.

This is the point where recession becomes slump as in 1929 and the early 1930s and can only be followed by a surge in inflation many years later when the effect becomes apparent.

This is the present situation in the USA and UK and many other countries throughout the world because in these days of globalisation, the problem spreads worldwide like a disease, but those countries that have been more vigilant and careful can now reap the benefit by being less badly affected.

So this interest thing does indeed always work but it is slow and takes a long time to take effect. If the ship has gone off course too far for any reason and is heading for the rocks there is no time to wait and coarse action must be taken. This can make it heel to an alarming extent and throw all of its contents and people onto the decks and some people will get hurt in the process. But when the correct course has been recovered everything settles down again and it is time to start picking up the pieces. Recessions and even slumps do not last forever but they certainly are not comfortable while they last.

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