In this past weekend’s newsletter I was discussing the “End Game” of Keynsian Economics and the fact that Ludwig Von Mises most likely has been correct in his theories all along. However, the chart that really jumped out and grabbed me during my research was the chart of the Fed Funds rate, the overnight lending rate, overlaid against the growth of the economy.
What was so startling to me was that we have all been told that interest rates are bad for the economy. If interest rates rise the economy slows. It sounds completely logical as the cost of money goes up which crimps capital investment, slows hiring which ultimately slows consumption.
If that logic is correct then we have to explain the chart. From really the late 40’s, after WWII ended until 1980 interest rates were in a volatile, but steadily rising trend. However, while sharp sudden spikes in interest rates did in fact slow the economy (a normal business cycle recession) rates declined and the economy reasserted itself. The important note here is that interest rates then climbed to a higher level than before allowing room for the next rate reduction to combat the next recession. During this time frame the economy grew at roughly 5.67% annually.
Since 1980, the Fed has continued combating every potential threat of recession with lower interest rates. However, each policy response, while creating an economic recovery, did NOT lead to higher rate of GDP growth which ultimately pushed interest rates to higher levels as it had in the past. In turn, the Fed has now run rates down to the “zero bound” line and the economy has slowed its annual growth rate to just about 4%.
So what changed? When Reagan entered office and vowed to break the back of inflation and used Keynesian economic theory to do it through deficit spending – something broke. On a chart the change is clearly obvious – you can only use interest rate policy to battle economic weakness in a strongly growing economy that is carrying very low rates of leverage. As we have shown in varied reports in the past – beginning in 1980 the world went “credit crazy” and the impact of increase money supply combined with rising levels of debt from 150% of Total Credit Market Debt to GDP to 354% today has bled the savings of the country dry. Lower savings led to less productive investment and ultimately a lower growth rate.
Today, the problem is that everyone is running around trying to use the same old medicine to cure a totally different illness which is a “balance sheet” recession. This time monetary policy won’t cure what ails the economy; there will be no quick fix through tax incentives or work programs. This time, just like it was during the depression, we are going to have to reduce our debt, increase our savings and start making productive investments again. Just like the Austrian school of economics states – “Low interest rates tend to simulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money. This leades to an unsustainable credit-sourced boom during which the artifically stimulated borrowing seeks out diminishing investment opportunities. The major tenant is that a credit-sourced boom results in widespread malinvestments.”