Snoopy-Typing-Away-1-CVV14J0D95-1024x768

To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.

The real interest rate does not have to be consistent with full employment of labour. The real interest rate can be equivalent to the profit margin, or, average profit margin, of productive business.

When business profits are high, the economic incentive to borrow money rises. Consumers demand more of the good or service that can currently be supplied, therefore prices [and profits] reflect this. New entrants, attracted by the high profit margin enter the field, or, established business expands using borrowed capital. As more businesses enter profitable areas of business, demand for capital rises, which causes a rise in the cost of capital, unless savings increase [supply of capital] commensurate with the demand for capital.

If business profitability is lower than the cost of capital, business will not borrow. If the supply of capital should rise, then the cost of capital will fall. If the cost of capital falls below the profit margins of business, once again there will be a potential demand for capital.

Employment is a cost of production. Employers will hire labour to the point of marginal profit of labour. When that point is reached, no further labour will be engaged. Again, the higher the profitability of the business, the higher the marginal productivity of labour will be and the higher the employment in that business will be.

When the Federal Reserve sets interest rates and set them low as in ZIRP, the cost of capital is set below the profit margins of almost all productive business. No longer is capital allocated to business with the highest profit margins, which are the businesses with the highest consumer demand, capital is allocated to sub-optimal business with low consumer demand.

This ties up and increases the costs of raw materials used in production away from profitable business to marginal business. ZIRP is counter productive. ZIRP distorts the market. ZIRP prolongs the life of low profit businesses [businesses with low demand for their goods and services] and increases the costs of production of profitable businesses through increased competition [prices] in higher stages of production.

Bernanke misunderstands the effect of artificially created low interest rates by the Federal Reserve. The necessity of lowering interest rates in 2008 was caused by a liquidity crisis. A liquidity crisis is a result of fractional reserve lending, which in the 2008 crisis was driven largely through real property speculation.

Advertisements