Friday, January 11, 2008


A good friend recently asked me "why does cutting the interest rate avoid recession" ....

Cutting interest rates decreases the cost of borrowing for people, businesses, banks, and the government. Banks can "fund" (=borrorow in order to re-lend) themselves cheaper and thus are willing to grant more loans or lower interest loans. Companies can borrow more cheaply to fund new projects which, in general, return a profit. Similarly, people feel more comfortable borrowing money to buy "stuff" (cars, clothes, dinners out, houses) since they know they'll pay less in interest than before. Even if they don't borrow MORE, it still means that the % of their payments which goes to interest decreases, meaning they have more spending money to buy more stuff. In either case, it means companies get busier and make more money. Those companies hire people, give raises, buy "stuff", and pay higher dividends. Their stock price goes up. Both these eventually put money back in people's pockets, and the cycle repeats itself.

Supposedly, the cycle repeats 7 times ... meaning every dollar not spent on interest creates 7 dollars of "wealth" for the country. Part of this increase is due to the fact that, as the economy gets better, loan default rates decrease. This causes banks' "risk appetite" to increase. We see this in two ways:

  1. They lower the percentage of assets they hold in reserve. This means they can lend more money without increasing funding or interest rates. Economists call this "increasing the velocity of money" and it has the same effect on the economy as literally printing Ben Franklins.
  2. Especially recently with the implementation of Basel II, the become willing to lend to riskier people/projects who previously couldn't get ahold of any bucks. As an aside (to be followed up in a later blog post) this statement goes a long way toward explaining the sub-prime mortgage boom and bust we're currently witnessing.

Another way of answering my friend's question is to put it like this: Any person or company has X amount of income. They have 3 options: save, invest, or spend and they're constantly adjusting the percent of income they allocate to each. Lowering the interest rate DIScourages saving (since it pays less interest), ENcourages spending and investment (since it costs less to borrow). All of these things are good ... as long as they don't cause inflation.

Inflation is a complicated animal. You have to think of it like Sting's message in a bottle. To predict where it will end up, you'd need to know all the tides and storms, winds, currents, boat paths. And even then you'd still be subject to chance and randomness. Its an equation of a billion plusses and minuses which ultimately sums to nearly zero. Figuring out that "nearly" part is what keeps economists up at night. Greenspan is one of the best ever at figuring it out, but the biggest complexity is that, in the time it takes to add it all up, the numbers will have all changed on ya.... Having said that ... yes, too much money in the economy causes inflation ... but so does irresponsible lending, asset scarcity (think of the price of a superbowl ticket the day before the game),

Economics is a social science, not a quantitative one. Literally the only way economists can make their equations bear any resemblance to reality is to always include "plus E" like (1/y)*p = ( i*s / l*m) +E ..... where "E" means the general expectations of the population.

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