Raise Interest rates NOW !

It should be clear to everyone by now that the economic policies of the Western world are not changing the economic outlook effectively. First there was a three trillion dollar loan and bailout package (along with untold guarantees of debt and marketable securities) aimed at solving a $ 700 billion dollar problem (do the math, that’s four and half dollars of “fix” for each dollar of “problem loans”. Then there is the current regime of near-nil interest rates designed to stimulate lending and investment. How’s that working for you ?

The real issue is the fundamental problem that low interest rates compress the spread a bank can earn between lending and deposits. This squeeze on margins is eroding bank profitability and driving banks to stockpile cash since it is not worth the risk to lend in such a low-spread environment. Keynsian economics has failed on the spending side (and there is precious little evidence it ever really did work) and the monetary policy economics wisdom of the Milton Freidman era are now clearly not working.

Time for something new, folks, and the new approach I suggest is raising interest rates. Why ? Banks need to make money. That is at the root of a lot of the problems in today’s marketplace. Instead of regulating them to death and raising capital requirements willy-nilly we need to embrace the reality that the banking business is a business, and they need a decent margin to engage in it. The banks are not demons, they are intermediaries that we all need to help the flow of capital to investment, the source of all real jobs. If interest rates were, say 6% at the fed funds level instead of near-zero (the prevailing rate of the last two years) depositors could be offered a meaningful rate of return, lenders could earn a more normal interest margin (spread between lending and deposit interest) and lo and behold they would have increased profits and capital.

The contrarian view is that higher rates would stifle investment. I think not. The incredibly low rates currently in effect eliminate any incentive for investment in financial market assets which are essential to econpomic growth. If lenders lend, businesses can get loans. If interest rates are more normal, the quality of investment in business will be higher, as the hurdle rate to make a decent real return would be more reflective of reality. Low rates spawn stupid investing, not economic growth.

Time to wake up and raise rates to cyclically normal levels and get the business work back to normal as well.

David McNab