Lowering Interest Rates May Not Be The Best Way To Stimulate The Economy

It is a general belief in economic circles that, when the economy slows down, one of the ways to promote economic growth is to lower interest rates. This is often true, but not always. In the case of China, in particular, it may be even less true. In other words, lowering interest rates may not be the best choice to stimulate the economy, and it is even less useful in order to achieve the famous re-balancing of the economy towards consumption. Why is it? Two main reasons: low interest rates create misallocation of capital and, actually, encourage private savings. Both things are not good for sustainable economic growth.
The standard theory goes that, with lower interest rates, the cost of money is cheaper, and therefore corporations (and governments) are encouraged to invest. Higher levels of investment, in turn, help stimulate economic activity. The theory holds relatively well in the short-term; that is, an extra dollar of investment tends to increase economic output by, roughly one dollar, during the current year. However, to make this growth sustainable, the original investment also needs to generate returns in the following years. Good investment projects do indeed generate future returns on a sustainable basis; bad investment projects, however, do not produce returns and, in order to sustain economic output (GDP) growth in the following years, higher and higher levels of investments are required. An example to clarify the concept: if we invest one hundred dollar to build one kilometre of motorway, the GDP increases, roughly, by one hundred dollars. If that motorway remains empty, no cars drive through it and the new motorway does not contribute, even indirectly, to the development of that region, then this project has produced no return. The following year, if we need to achieve a 10% GDP growth, we need to build an additional 1.1 kilometre of motorway and, therefore, we need to find additional 110 dollars to invest. A vicious circle is thus created. Some people call it ‘a bubble’.
Chinese economists know exactly what I am talking about. However, even Western economists, especially American, Greek, Spanish and Irish, to name a few, are very familiar with this concept: in a low interest rates environment, borrowing money from banks or financial markets is relatively cheap, so the corporate and government sectors tend to borrow more but pay less attention to the actual future returns of their investments. Why? Because, the so-called “hurdle rate” or required return on investment is lower than during periods of high interest rates. If projects do not produce high returns, it is not much of a big deal, because the following year money can still be borrowed at cheap rates and, therefore, finding those additional 110 dollars for the extension of that motorway is much easier. Everyone is happy: corporate managers can expand their business activities; banks lend more money and post higher profits (banks always lend money at rates higher than they borrow – the spread -, so loan volume affects profits more than absolute level of interest rates); local government officers are happy because they can boast ‘development’. None of these people care —as indeed they should— about the long term benefits of those investments; when the time of reckoning arrives, they will have moved on to other careers and higher positions. The history of the world, both in the West and in Asia, tells us this often happens. Bankers can’t believe their luck. Unfortunately, we know how the game ends. This is the mis-allocation of capital effects (there are other effects on capital allocation, but for the time being, this will suffice).
Let us turn our attention to how private saving rates are affected by changes in interest rates. Both common economic theory and common sense suggest that when returns for a certain project are higher, and there is no increase in the risk involved, investment in that particular project tends to increase. Now, investing in a project can take the form of either equity or debt; private individuals who place their money in bank accounts are basically investing their savings in that bank: they are lending money to the bank. What happens normally is that, the higher the interest rate the bank will pay, the more people are encouraged to lend them money. Hence, under normal circumstances, low interest rates tend to attract lower savings, while high interest rates attract higher savings. Since, people can either save or spend (in consumption) their income, it follows that low interest rates encourage consumption, while high interest rates encourage savings. We know that one of the components of GDP is private consumption and, therefore, common belief suggests that low interest rates promote consumption and promote economic growth.
In China, the opposite happens, as discussed in depth in a recent paper published by the IMF: Chinese people behave like a ‘target saver’, that is, they have in mind a certain amount they need to save by the time they reach retirement age, and choose the amount to save so that their ‘retirement’ goal is achieved. Because this target goal is fixed, the equation is reversed and it follows that when interest rates are high, the money that needs to be saved is lower that when interest rates are low. Therefore, private saving rates are higher when interest rates are lower, and private consumption increases when interest rates are higher.
In conclusion, high interest rates can help better allocate capital, encourage investment in return-generating projects and, even, stimulate consumption and promote the rebalancing of the economy.

3 Comments

  1. Arnold Reply

    Thank you for this new way of looking at the effect of the target saver. Never thought about it that way.

  2. Analyn Reply

    Econ major, actually. Revolving cderit is like a cderit card debt. All banks in a country have cderit cards with all other banks (except they normally don’t charge each other an arm and a leg that’s reserved for the customers ), and the shortest short term interest rate possible is the interest rate on banks’ cderit cards with other banks.Measuring banking profit is a bit convoluted banking panics happen because it gets too convoluted for the banks themselves.

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