|Montreal, October 11, 2003 / No 130|
by Harry Valentine
Over recent months, numerous op-eds calling for lower interest rates have appeared in various Canadian newspapers and business publications. The authors of these articles claim that reduced interest rates will increase consumer borrowing and consumer spending, in turn raising the "aggregate demand" for products available for sale. This strategy is supposed to spur economic growth by enabling producers to liquidate unsold production and begin new production. As a result of the recent high-tech meltdown, many manufacturers of big-ticket items are still operating well below capacity while having some unsold inventory on their premises. Lowered bank lending rates is claimed to indirectly alleviate the problem of excess production (glut), while also either increasing the pace of economic growth or stimulating new such growth.
tried and true method
Traditionally, producers who seek to profit from their production use the tried and true method of accurately determining market demand by adjusting prices. Let's suppose a hobby farmer who cultivates a seasonal speciality food crop for private consumption. He also sells a small excess produce to a speciality food retailer, whose sales reveal some market for the product. In a subsequent year, the hobby farmer improves production efficiency and product quality while increasing yields (over-production). Since speciality products usually operate free from state market regulation such as price controls, the retailer adjusts prices to profitably liquidate the farmer's excess production with minimal waste and spoilage. If the excess production is sold at a loss, the farmer curtails future production for the market. Selling the excess production at a profit reveals a greater market demand, signalling the farmer to increase future production.
In short, lowered prices increase sales (demand) and this without the need for the central bank to print extra paper money to increase "aggregate demand." The same approach may be applied to all other products and services offered for sale in an economy where interest rates are determined by the market itself. Under this condition, the freedom to rapidly adjust prices in response to changing market demand assures that in the long term, there could never be an over-supply (glut) or under-supply (scarcity) of any product or service. This also assumes that any producer or provider located anywhere in the world may sell to any customer located anywhere else, at agreed upon prices. The problem of matching supply to demand is always resolved by the freedom to adjust prices, that is, until governments step in to regulate markets through such mechanisms as market entry restriction, production quotas, licencing requirements, price regulation, sales restrictions and even through subsidies to inefficient producers.
Canadian market regulation of agricultural produce (dairy, wheat, poultry, etc.) has inflicted hardship on a segment of the Canadian population known as the working poor, who often cannot afford to buy food at the state-regulated market prices. This segment regularly supplement their grocery supplies with donated food from food banks. State price controls and regulation on rental accommodation have resulted in a virtual nationwide shortage of affordable housing. Television news reports have shown working poor people in some regions of Canada actually having to sleep at shelters for the homeless, a direct result of state economic regulation having prevented these market sectors from accurately matching supply to demand. Indirect state participation in the economy as a partner to business can also result in mismatching supply to demand.
Central banks in both Canada and the USA lowered interest rates to well below market rates when the high technology sector began growing fast. Direct and indirect government participation in that sector subsequently set off the high-tech boom, which then generated malinvestments which culminated in the high-tech meltdown (see STATE MEDDLING CREATED THE HIGH-TECH BUST, le QL, no 116). During the boom period, manufacturers of more traditional big-ticket items received misleading market signals from an over-heated market, that a high demand for their products existed. They responded to these misleading signals. Following the high-tech meltdown, manufacturers of big-ticket items had higher production capacities and large unsold inventories, that is, an over-supply (glut) of high-priced goods. Under a regime of interest rates set by market forces, they would have received more reliable market signals and been able to more accurately establish demand.
Those calling for lower Canadian interest rates believe that such a remedy could liquidate unsold inventory and increase economic growth. Their call comes at a time when personal debt is at an all-time high, as are personal and business bankruptcies, also while personal savings is near an all-time low and declining. Writing in America's Greatest Depression, author and economist Murray Rothbard suggested that due to a high default rate on bank loans during the early 1930's, banks were often reluctant to make new loans despite the then record low interest rates. A similar situation exists again. Despite American interest rates having been lowered to near the minimum limit, comparable to Japanese rates, the American economy still remains essentially stalled, their present "economic recovery" notwithstanding. This mini-boom has resulted from the near zero interest rates and government spending related to the Iraq situation. For example, the US government has been making large purchases of lumber intended for reconstruction in Iraq and bidding up domestic lumber prices in the process. This economic "recovery" is being sustained by government spending and related malinvestment that will propagate through the American economy. Despite the increased government spending, it will inevitably lead to another economic slowdown, one followed by a long period of economic stagnation similar to the ongoing one that began in Japan a decade ago. The Japanese government has being trying to spend Japan's way out of their long-term recession through public works projects, with little avail.
Due to American interest rates being near their minimum possible levels, there is very little room for the Federal Reserve to lower much further. A period of price deflation (dropping prices) may be unavoidable within the next year. At this point in time, lowered Canadian interest rates could lead to an increase in Canadian purchases of lower-priced American-made goods, while having little effect on stimulating new Canadian economic growth. If the Fed keeps interest rates at the low Japanese levels, America's economic growth could stagnate, dragging the Canadian economy into a slowdown and similar period of price deflation. Those who call for lower Canadian interest rates could, within the next year, be calling for increased government spending on public works projects, that is, to copy Japan's failing economic strategy. Again, the call would be based on a theoretical construct that has no relation to real world economic events.
Building pyramids and digging holes
The US presently has a major public works project underway, in Iraq, the total cost of which may exceed US$1-trillion. Due to their record low interest rates and feebleness of "aggregate demand," the only agency able and willing to spend large sums of newly printed money is the American government itself. In his General Theory, Lord Keynes suggested that government spend money building pyramids or fund wars to create new wealth (p. 129), or even spend money to dig holes (p. 220). Over the next 2 to 3 years, it is highly unlikely that this kind of state spending strategy would achieve very much, let alone lift the American economy out of its present slowdown. Economic developments in America will invariably impact on the Canadian economy in the long term, given the extent of the interconnectedness between the two economies.
During the expected period of American economic stagnation, various levels of government in Canada will likely resort to Keynesian-style spending in trying to stimulate new growth in a slow economy. One method involves spending heavily on public works projects, while another method involves increasing the role of government as a partner to business. While the former method is failing in Japan, the latter method was a contributing factor in the high-tech malinvestment boom and the resulting melt-down. The federal government may find itself tempted to play a partnership role in the economy during a slowdown, perhaps contributing grant funding to various politically favoured business sectors. But government playing the role of a partner incurs a high risk of generating distorted market signals that invariably can lead to business malinvestment (as happened in the high-tech sector) and result in another economic slowdown.
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