The Broader Market

by Jordan Eizenga

TBM has received commentary advocating for higher interest rates, spending cuts and generally contractionary economic policy.  Their arguments are based on a logic that seems to confuse the right policies to prevent a crisis for the right policies to respond to one.  Their logic is as follows:

1. Interest rates were kept very low through the 2000s, which allowed households and businesses to borrow very cheaply throughout that period.

2. Cheap credit allowed individuals to purchase homes beyond their financial resources and created a housing price bubble.

3. We all agree that cheap credit, high debt levels, and inflated house prices (exacerbated by the securitization process) are the primary culprit for the financial crisis.

4. Therefore, interest rates should rise so that households and businesses borrow less, save more, and debt levels and housing prices drop.

This logic is correct - if one were to apply it to pre-recessionary, pre-crisis periods.  Increasing interest rates when an economy is hot makes sense: inflation rates, housing prices, consumer spending, and household and business debt levels are usually high during such periods.  Making incremental increases to interest rates counters inflation and slows down the growth in asset price levels and credit creation.

However, responding to a financial crisis and pulling an economy out of a recession calls for a fundamentally different policy response.  In today’s economic environment, households and business have built up surpluses.  Private enterprise is not hiring.  Aggregate demand is low and deflation seems to be the greater threat (and not inflation).  Basic economics tells us that increasing interest rates now would make deflation even more likely, which would have disastrous effects on the economy.

We need to be careful not to misapply the lessons of what got us into this mess as the lessons for what will get us out of it.