In our last post we discussed serial financial bubbles and forked tongue syndrome at the Federal Reserve: The Fed Needs To Stop Blowing Bubbles. Along the way we asserted that abnormal sickly low interest rates are inconsistent with a normal healthy economy. Our friend JK raised the objection that the amount of debt extant is an obstacle to higher rates and that prolonged higher inflation is a prerequisite for higher interest rates.
This is a very popular argument, especially with the Federal Reserve and most of the economists cited throughout financial media lite, so let’s give it the thoughtful attention it deserves.
The key weakness is that it overlooks how the debt gets to be excessive in the first place. Debt creation is the means whereby lower interest rates create inflation. At a given price of credit, the amount of debt is more or less in dynamic equilibrium. Lowering the price makes borrowing more attractive, so more money gets lent into existence. The increased quantity of money is inflationary.
But now there is more debt. If the existence of higher debt itself is a valid rationale for lower interest rates, it quickly becomes obvious that this monetary program is a one way street. Lower rates produce higher debt which justifies lower rates … round and round we go. It is an unsustainable model on which to base monetary policy. It will end because it must.
Furthermore, debt itself represents demand for money. Once the initial inflationary impulse from the increased money supply has passed, money demand takes over. Debt represents money demand, which exerts an upward force on the value of the currency. The initial inflationary impulse leaves a deflationary hangover in its wake.
At this point this monetary policy paradigm demands further interest rate cuts to quell the deflationary residue from the last round. The effect is much like that of drug addiction … the patient adapts to the presence of the drug and then requires it just for some semblance of normality, so a higher dose is required to attain the same effect. A pattern of indefinite dose escalation is the end result, also an unsustainable situation. The policy will end because it must.
The question is then not whether it will end, but how. Through voluntary abandonment of the flawed paradigm or eventual destruction of the system it infects. We’ve already seen the process play out empirically as interest rates have been ratcheted lower over several cycles, and experienced increasingly dire consequences, most recently in 2008 and 2020.
The only survivable way out is to abandon the defective policy. A low interest rate policy is fundamentally incapable of curing a disease caused by a low interest rate policy. The path back to economic and financial health unavoidably passes through higher interest rates.