Why higher interest rates are cause for joy

By Rob Murphy, below, Managing Director, Edison Group

Given what’s happening in the economy – and in the financial markets – you could be forgiven for having a somewhat negative outlook. However, less than positive news is not everything. No one except savers likes high interest rates. They could support a struggling currency, but when borrowing becomes more expensive, there is less money available for businesses and consumers to spend, undermining demand. The result, in the short term, is slower economic growth. On average, wealth will increase more slowly – or even decrease. So why are higher interest rates cause for joy? Basically, it is because they are one of the correct remedies for the current global economic situation. Inflation has returned with a vengeance. And despite what we had hoped, this inflation is not transitory, it is structural.

Inflation is bad because it makes people poorer, especially low-income people who tend to spend a greater proportion of their income. Inflation took hold as governments and central banks created huge amounts of liquid assets during COVID-19 (think income support and quantitative easing), while the production of goods and services dropped dramatically. When there is relatively more money than things to buy, prices rise. Rising interest rates cause people to spend less and increase business costs, bringing demand back to non-inflationary levels.

So higher interest rates will fight inflation, even though they may make us poorer. There are other reasons why higher interest rates will also be beneficial in the long run. Money has been cheap since the great financial crisis of 2007-2008. This made it possible to borrow cash and use it for profitable – but barely – economic activities for almost 15 years.

This is detrimental because low-performing companies drag the economy down – they slow the pace of innovation. Doing something established and predictable can be attractive when the money is cheap. But when the price goes up and your margins disappear, the only way to generate profit is to do something new and more productive.

Of course, not all businesses will be able to scale up. Thus, higher interest rates will lead to a series of creative destructions. Zombie firms that are wiped out by rising interest rates will be replaced by more productive ones.

So here is the ultimate reason to be joyful. Not only should higher interest rates reduce inflation in the short term, but in the medium term they should also encourage innovation and productivity growth. Productivity will also tend to reduce inflation in the medium term, because society is able to produce more goods and services per unit of resource, which, as any good economist knows, is the only way to sustainably increase total wealth in the whole economy. If we get it right, more people will come out of poverty.

The mechanics of how higher interest rates reduce inflation are not entirely obvious. I like to explain it using my version of Caveman Economics.

  1. Our cavemen use seashells as currency – they trade these rare trinkets for food, clothing and tools.
  2. One day, the caveman society falls ill and many hunters and gatherers are unable to hunt and gather.
  3. Suddenly there is a danger that people will no longer be able to earn the shells they need to live. There is cured meat in the store and a few healthy hunters and gatherers can still come out, but how will people be able to pay for these goods? Luckily, the Seashell Keeper can go to his secret bay, harvest many more, and distribute them to everyone in proportion to what they earned. By running down the meat shops and not being able to buy as many animal hides or pay the sick tribesmen drummers to entertain themselves, the group is able to feed themselves and even save a few extra shells.
  4. Fortune shines on our tribe as the shaman consults the oracle and finds a miracle cure for the disease using bat saliva and pangolin poo collected from a previous expedition to a distant land in the is. Suddenly, everyone is better and rushes to buy everything that happened – fresh meat and the latest models of animal skins. However, there is a cost that they did not consider. As society as a whole has been unproductive, there is less to buy. Hunting and gathering takes time and there are bottlenecks as people wait to get the food, tools and materials they need. With demand rising and supply falling, prices rise as our cavemen compete with each other by offering more shells for the things they want. With anything costing more, everyone has to charge more. Inflation has happened.
  5. It’s troubling. Some of the poorest people can no longer afford their fair share of the group’s production and may go hungry. The wise caveman economist then steps in and she realizes that the way to prevent inflation is to add an interest rate on the shellfish. If the interest rate is high enough to offset inflation, wealthier cavemen will save a few shells rather than spend them, reducing demand. Hyperbow – which can kill three times as many bison. He couldn’t get the seashells needed to do it ahead of time because no one was incentivized to lend them to him (after all, he’s a bit of a weirdo), but now he has plenty. This innovation leads to a much more successful hunt. The supply of meat increases. Reduced demand and increased supply prevent inflation.

This story from Caveman Economics clears up confusion about government actions during the pandemic. As fewer people worked, governments supported them without needing them to be productive. Governments financed this by borrowing – they issued public debt in the form of government bonds to be repaid many years later.

However, in many cases central banks then bought the bonds, through quantitative easing. And that creates a circular flow of cash that starts and ends with the government. Governments thus borrowed at zero cost – the central banks that buy the bonds will reimburse the interest to the governments.

The effect was to increase the supply of money in the economy, when there was less productive activity in a world cut off by the blockages and supply bottlenecks they have created. This led to individuals and businesses arguing over lower supply by offering to pay higher prices, setting off a chain reaction as more businesses faced higher costs. This inflation was exacerbated by central banks continuing to create more money thinking inflation was transitory.

What does this show? A larger supply of money in the face of a smaller supply of goods and services raises prices and can then trigger structural inflation – especially if workers start demanding higher wages in response to an increase in the cost of living.

Higher interest rates are now needed to stem rising prices. Money must become more expensive. As demand falls, it equalizes the supply of goods and services. Interest rates can then return to a natural level compatible with a decline in long-term inflation.

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