The real problem with low interest rates

The longer interest rates are kept artificially low, the greater the imbalances in the economy will be
By David Howden, Adjunct Scholar, Ludwig Von Mises Institute of Canada

In a paper for the C. D. Howe Institute, economist Paul Masson argued that the Bank of Canada should commence allowing interest rates to rise to avoid greater real-estate bubbles and excessive debt.

While his argument that the Bank of Canada’s low interest rate policy destabilizes the economy through potential bubbles and debt buildups is correct, unfortunately, his focus misses the broader problem with low interest rates.

The Bank of Canada is charged with the goal of price stability. To this end, it tinkers with the money supply in a bid to engineer that perfect amount of credit growth to keep inflation around that supposed sweet spot of 2 per cent a year. (One would think “price stability” would be no inflation, but that’s another issue.)

Most people understand that there are some real problems with engineered prices. Any student of a first-year University economics class knows that prices are not generally set by any one person in the economy. They are the result of the interplay between the supply and demand for something.

The idea of relying on Stephen Harper for the price of t-shirts for Canadians is instantly seen for what it is: stupid. Not only would one price for t-shirts benefit at the expense of others, but before too long imbalances would develop in the t-shirt market as the price would not signal to consumers how many they should buy, and producers would have no idea how many they should make.

What makes money different? Very few people seem to have a problem with Bank of Canada governor Stephen Poloz setting interest rates for the Canadian economy. The misgivings that they do have are mostly misdirected, and make for a dangerous situation.

Money is a common denominator. It forms one side of almost every single transaction that takes place in the economy. One may think that “playing God” with money and not letting the market dictate its price and allocation would be dangerous, and they would be correct.

Nobel Prize-winning economist Friedrich Hayek once said that the best test of a good economist is the ability to see not just the direct effects of an action, but those results that are more veiled.

The effects of the Bank of Canada’s low interest rate policy are pretty obvious. Canadians are among the most indebted people in the world today. The superficial picture of the country looks rosy: lots of nice shiny new apartments in Toronto and expensive cars on the streets of Calgary. It doesn’t take a “good” economist to see these things, or to make the connection that cheap money through low interest rates enabled these niceties of life.

The part of the Bank of Canada’s low interest rate policy that is not easily seen is the shift that has silently taken place in the Canadian economy over the past decade, or longer if one’s memory is good enough.

The interest rate is the price that coordinates consumption and production activities. Distorting it, like distorting any price, will have wide-ranging effects through the economy because of the important link that money provides through all transactions.

Consumers will save less and spend more, probably taking on debt in the process. The same goes for government, and businesses. This is adequately covered by the press, and this over-consumption is what most people are really referring to when discussing the ill effects of low interest rates.

But what about production plans. The interest rate is a key variable in finance that signals to producers how long they should be willing to wait before their investment pays off. As rates fall the present value of future cash flows increases, so that producers are enticed to wait longer for them. As rates rise, this present value decreases so producers try to make investments shorter to get their payoffs as quickly as possible. In sum: the lower the rate, the longer the wait.

As the Bank of Canada lowers the interest rate, producers start investing in longer-dated investment projects. Projects like research and development (R&D), for example, will not pay off for a long time (if at all) and investors will have to forgo profits over this time period. Consumers too will have to forgo any fruits from these investments for a long time period until they mature.

It is not that long-dated investment projects are bad; indeed, R&D is a necessary activity in any economy. The question becomes one of balancing it against the other needs of the economy. If you do too much of one action, the tradeoff is doing less of another. Investing too heavily in longer-dated projects means that there is less money directed towards shorter-dated projects.

Infrastructure building comes to mind. As anyone who has driven on a Canadian highway recently can sympathize with, there is woeful investment in maintaining roads but there seems to be no shortage of funding trying to build the next iPhone. Too much investment in longer-dated projects at the expense of shorter-dated one represents what economists call “malinvestment”, and makes for an unsustainable situation.

Unfortunately, the Bank of Canada’s Poloz sees no reason to change the policy of low interest rates he inherited from former governor Mark Carney. This is regrettable, because the longer he keeps the interest rate artificially low, the greater the imbalances in the economy will be.

If you think that roads are in terrible condition now, try to picture what they will look like a decade from now if this policy continues to detract investment from them.

David Howden is an adjunct scholar of the Ludwig Von Mises Institute of Canada and Chair of the Division of Business and Social Sciences at Saint Louis University – Madrid Campus.

Column provided by Troy Media,

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