There is a FQ here, I think, but possibly a subsequent GD. I defer to the mods on where this belongs.
What I’m wondering is if the effect of raising taxes would be the same as raising interest rates, but less damaging to the health of the budget.
So, we raise rates and that increases costs to buy things, but that money (I think?) ends up in banks’ pockets, ultimately, and increases the cost of the debt to the government.
Wouldn’t raising tax rates do the same thing, but then the money could be used for something more beneficial, like reducing the debt? Obviously spending it on infrastructure or military kit would be self-defeating.
I know it would be unpalatable to the electorate, but strictly speaking, would it be better? Please feel free to disabuse me of my notions.
These are very different things with very different effects on very different groups of people. One significant question when you talk about raising “taxes” and “interest rates” are which taxes and which interest rates? The question is unanswerable without knowing those things. When we talk about the Federal Reserve raising interest rates, we are usually talking about the Federal Funds rate or we are talking about their using open market operations to raise rates on Treasury securities. These actions have different effects than banks raising credit card interest rates.
Higher interest rates on mortgages raises the cost to buy houses. Higher rates on Treasuries raises the cost to fund government operations. But banks don’t necessarily profit from higher interest rates. Banks profit off the spread between their borrowing costs and their lending costs. That spread tends to be higher in times of higher interest rates but the correlation is not perfect. Their profits are also affected by losses, which tend to be higher during times of higher interest rates, which often lead to recessions that affect borrowers’ ability to repay.
Interest rates as defined by the central bank of a country (Federal Reserve for the USA) set the rate at which banks borrow money from that central bank. Banks pass this rate rise onto customers, and may sometimes pass on a bit more. The gap between the central rate (which goes by different names depending upon country) and the rate charged to bank customers is in some sense the place where the banks make their money. But they need to pay interest on money deposited with them (which is the source of most of the money they then lend out), and those interest rates also rise. To a first approximation, this is a zero sum game for banks. The Fed rate is essentially the benchmark rate against which other rates are pegged. It defines the cost of money in the market, and is used to control the market, raising and lowering liquidity. Higher base interest rates don’t put money into the pockets of banks. They do slow markets down, which is why they are used. If the economy is slowing, interest rates are dropped in an attempt to reduce the cost of money and stimulate things. It doesn’t always work.
If you have lots of money, higher rates mean you get more interest. Which can be great for some. Only if you are cash short and need to borrow does the higher interest bite. Higher interest rates mean that leveraged investments become much less attractive. If you have borrowed lots of money with the hope of making even more money with it, higher interest rates tends to put a dampener on risky behaviour. For instance borrowing money to invest in stocks or real estate with the expectation that a rising market will make you money faster than the interest charged is great when interest rates are low, and so the markets rise. If you want to dampen down the markets, the Fed raises interest rates. The effect is disproportionate.
You can of course slow a market down by taxing it. Putting a tax on properties, unearned income (aka dividends) etc, will slow the market as well. But it is a blunt hammer and politically unpalatable. And hard to stimulate the economy messing with taxes. No matter what rhetoric is used. Governments have a habit of not removing taxes again. The federal base rate is a much more subtle tool. And most importantly, most western countries have acted to disconnect the setting of rates from political control (with varying but mostly good success.) This is hugely important. Political influence has almost always resulted in politicians not being able to resist meddling for political gain, and bad outcomes.
Thanks. I have sooo many questions. This is something that fascinates me, but I must confess is way outside my expertise.
For several years I have been reading that banks are sitting on piles of cash, without enough lending to put it all to work (banks are sitting on cash - Google Search )
Does that mean that if rates rise, and the banks don’t need to borrow that money to make loans, it’s a windfall for them?
I do want to be clear- this thread was never meant to be advocacy for tax hikes, nor is it meant to become an indictment of banks. I’m just interested in exploring the workings of these things.
Banks are essentially always borrowing to get assets. When rates rise, their cost to borrow also rises. They get money from depositors for CDs but, since Treasury rates are higher and savers could choose those instead, banks need to pay higher rates on CDs, increasing their borrowing costs. Or they pay higher interest rates to sell bonds, since those bond investors could also just elect to buy Treasuries instead of buying the banks’ bonds.
But since interest rates are higher, fewer people are going to want to borrow money. I might decide I have to buy a cheaper car with a smaller loan in order to keep the payment manageable. Or I might decide not to upgrade my house (which, indeed, I have done in the last six months) because mortgage rates are too high. As a business owner, that new machine I wanted might only return 10% each year on the invested capital. If I can borrow at 3%, the 7% margin I will make is worth the risk of increasing my leverage. If I have to borrow at 8%, I might decide that the 2% I would net isn’t worth the risk. Banks will have a harder time lending out the money they have accumulated.
In fact, one of the problems I am dealing with at work is tied to the general unwillingness of banks to take deposits because they don’t have enough productive uses for the cash they get.
Don’t forget that humans are not algorithms. Whether it’s rising taxes or rising interest rates, they respond not only to current numbers, but what the trends seem to indicate for the future. Yes banks charge a spread above the central bank rate, but they also figure in what they think the rate will be in future if you are asking for a fixed interest rate. If rates appear to be continuing to rise, longer term fixed loans will be higher rates. A bank can lose money (that’ll be the day!) if they overcommit to long term fixed rate loans and the fed rate goes higher than they anticipated. Timing is important.
(There’s the old Argentinian joke about hyperinflation - what’s cheaper, the bus or the taxi? The taxi, because you don’t pay until the end of the ride.)
I presume the goal in reigning in inflation, or pumping up the economy, is to encourage productive spending but reign in frivolous spending. Taxes can do that too, but tend to hit a different demographic. You could, for example, cool a heated real estate market with a tax on houses - but one man’s more reasonable house price is another’s overspending on a house depending on income levels. Do you tax only houses over a certain price? This brings on the joke about - this house is below the tax threshold without the flooring installed - so buy it with bare plywood floors, avoid the tax, and then install the expensive flooring after purchase. Sometimes taxes drive unintended results. Canada has the classic “one donut, GST. Six donuts, no GST”. (GST - Goods and Service Tax. Snacks are taxed, bulk groceries not.)
Plus, as mentioned - when governments are perpetually spending more than they take in, once a source of revenue is created like a new tax, it’s difficult to turn that tap off. (Unless it’s income tax on rich people)
Raising interest rates hits all spending, personal and business. It quickly reduces the tendency to borrow and spend. It has an immediate impact. Raising income tax only targets individuals, who vote and resent higher taxes. Raising corporate taxes stifles legitimate reinvestment, plus can drive away businesses that can move some of their activity out of country.
Raising rates happens immediately, with the message that more could follow any time. Raising taxes - usually - is set to happen in the next fiscal year, unless it’s an emergency, so is a longer delay to affect economic activity. (Would you want to have to fill out a tax return where you have to figure out how much income was earned before date X of this year, and how much after? Are payroll programs designed to give you the tax form with that breakdown on it? Or would you rather pay a retroactive tax for the whole current year - that has to be popular?)
They make money by lending money. It doesn’t really matter where the money comes from. Not lending is losing them money. So no.
The question about banks sitting on cash is interesting, and something of a modern malady. When we talk of banks, we are usually talking about the major banks, those with a government guarantee. Most western countries have adopted this model in essentially the same form. In the past banks were not safe. You deposited money with them, and they then lent it out. They paid you interest, and charged interest, making money on the margin between those interest rates. Money could go around in a circle multiple times. (Fractional reserve banking, a whole new subject.) Banks could end up squeezed, lots of outstanding loans, little actual money on hand, and if there was a run on a bank by worried depositors, the cupboard would be bare. And so the bank would fail. Such failures can be catastrophic for the economy, so governments stepped in.
What matters is that there is confidence. With confidence nobody is worried that their money will be lost, and so they don’t engage in a run on the bank. Confidence is built by the government guaranteeing deposits. No matter what, even if there is a run on the bank, the money will be there, even if the government has to provide it. Which works great, as since there is confidence, this guarantee is never actually needed. But the guarantee comes with a price. If a bank is guaranteed they cannot engage in risky behaviour, for some prescribed value of risky. This means that their lending profile is limited. For instance, you won’t be able to get a loan to buy Bitcoin, or even become heavily leveraged in the share market. Banks that don’t have a government guarantee are less limited. Such as the Savings and Loans banks. Queue the sub-prime disaster of 2008. S&Ls, free of the strict restrictions applied to guaranteed banks, made more risky loans. And they failed. And around we go again.
Now add superannuation and mutual funds filled filled with money by your average Joe. Funds also looking for places to invest money. These funds are even more restricted by law than banks. They really had better not fail, otherwise lots of people will retire into penury. So these funds have a huge amount of money also looking for a safe place to invest.
The world is awash in money looking for reasonably safe places to go. Major banks, super and mutual funds, are all competing for safe investing. Banks are looking for companies to lend to, and super funds are looking for safe shares to buy in these same companies. So both ways a company might look at to raise capital are oversubscribed. That is, if they want to raise more, which is also key.
What loses out is easier money for risky investment. Venture capital is one route, but that is a limited in what it can do, and the VCs usually have a pretty clear idea about how and when they want to be able to cash out, one that is not compatible with many ventures or entrepreneurs.
The history of money seems to be a matter of lurching from one side to the other with risky liquidity versus risk averse tight money. Where things can get unstuck is when economies stagnate, and no amount of easing of access to money will get people enthused. When nobody wants to engage in expanding it doesn’t matter how much or how cheap money is, nothing happens. Japan is the poster child for this. More than a few people are worried that this same spectre looms for the rest of us. All IMHO, and YMMV.
No. Nor will it be the last. Economies need access to money, and there will always be pressure to to provide easier money. And there will always be people that overreach, and imagine that “this time for sure”, they have a fail safe way of making money leveraging in a rising market. The story is as old as banking.
The S&L crisis, and the mortgage crisis of 2008 all feature the same thing; the returns from interest were low, so people whose job it was to take wads of cash (such as retirement savings funds) and make more money, were willing to try anything and apparently they blindly ignored the risks because at the start it seemed a good idea. Lend money to those who otherwise were too risky for banks (“sub-prime”) but probably could pay a mortgage. Glom these loans together to spread the risk, and even with a few failures, the net result would be very positive. Unfortunately this flipped due to the hot market - “find anyone who would want to buy a house, and twist their ARM to make it happen, so we can sell still more of these investments”.
The history of the world (and especially America’s) economy is this jump from investment to investment as people with money try to find ways to make more than the going interest rate. There’s venture capital - try to get in on the ground floor for the next Microsoft or Google. Leveraged buyout, or trying to guess who’s going to get bought out a premium. There’s hedge funds - try to leverage the current stock price vs. the guess as to future. There’s stocks, the recent favourite. There was mortgages. Tesla, for example has been valued higher than any other car company - not because it makes more cars - not even close - but because its tech is a head of the others and it looks poised to grow much bigger. Same with many tech stocks. Gold mining is a perennial favourite. And the ultimate “need for returns” leads to Bernie Madoff’s fund.
The job of the central banks is to smooth out the ups and downs of the economy. Stability is the goal. The old joke goes: “A recession is when my neighbour is unemployed. A depression is when I’m unemployed.”
the current inflation is probably different to the extent that the problem is not a flood of money, but rather a backlog shortage of the goods that money is chasing; Between COVID supply chain issues, and energy commodity shortages from the war in Ukraine. The solution however is the same - raise interest rates to make it harder to borrow, thus choking off demand and lowering prices. However, rectifying the supply issues would be a preferrable solution - but that would require Russia to see reality.
Taxes one has to pay, but interest can be avoided if you don’t buy a house or car or whatever. In fact, slowing things down is the point of raising the interest rate.
Should also point to the carbon tax, a much debating thing here in Canada. It is specifically designed to tax - hence raise the price - of CO2 producing products, thus discouraging their use and making clean alternatives more desirable.
This is an example of a targeted tax. Unlike interest rates, it specifically goes after only certain items. By setting the rate, the government can manipulate the desirability of the products without as great an impact as the rest of the economy. It can quickly adjust the rate - effect will be immediate. By giving rebates to poorer households, it can also more easily target those able to pay, so the driver with the big expensive gas guzzler feels the impact more than the person with a small economy car and can plan to drive less or buy a more carbon-friendly alternative. (Or lower their thermostat in their house).
Without a cost associated to pollution, people will not as easily stop producing CO2 or as in the old days, emptying their chamber pots into the street.