Is Greenspan leading us to financial disaster?

Factual Questions
1

Alright. Everytime I turn around Alan Greenspan, the head of the Federal Reserve, is lowering interest rates to boost our sagging economy. OK, I get it. Interest rates lower, more people borrow money, economy improves.

My question is, who is LOSING money when the fed lowers interest rates? Aren’t these people infuriated? What do the lenders have to say about this?

And finally, if no one is angry about the fed cutting interest rates, and it helps the economy so much, why not make them as ridiculously low as possible ALL THE TIME?

What is going on here?

2

It’s not so much about people losing and gaining money as it is about money moving around. Lower interest rates cause lenders to get less return on their investments, but it also causes them to lend more money in the first place, possibly generating more interest in the end.

3

Welcome Acco40. Well, as you think, (unhedged) lenders lose when interest rates fall and other things being equal (that’s how you can tell I’m an economist) they are unhappy. Of course they may think the firm they’ve invested in are less likely to go broke.

Why not reduce interest rates to nothing (now or all the time)? Well, because there’s a demand side and a supply side. On the demand side the interest rate tells you how profitable a project has to be expected to be to be worth investing in. Cet. par. (other things being equal) the lower the interest rate the more you will invest.

On the supply side the interest rate is your reward for not consuming stuff now. The lower this is (cet par) the less you will save. Lowering interest rates boosts current consumption at the expense of saving (ignoring foreign capital flows).

4

So picmr let me see how this works in practice-

So, in Japan, where the interest rate is essentialy zero, the saving rate should be very low. But their saving rate is extremely high.(Of course, I forgot-they can invest here, rather than in the homeland at zero percent).

In the US, where our interest rate is rather high, we should be saving like mad. But our saving rate is incredibly low.

Or did I not understand your statement?

5

Those who have their money in a savings account or money market fund get lower returns.

The savvy have a diversified portfolios. Lower interest rates cause their long term bonds and their stocks to appreciate, all other things equal. The nonsavvy don’t know what hit them. Lenders make their money by borrowing short and lending long: although they can charge less for loans, their costs for borrowing also go down.

Lower interest rates cause more investments to become profitable. At 4% interest rates (say), some investment projects (purchases of plant and equipment) become profitable that would not be at (say) 6%. Alternatively, more people purchase houses or cars as the required monthly payments decline. These purchases add to the total demand for goods and services in the economy.

If the economy has excess capacity (as ours does) this is a good thing. If it has very little excess capacity (as it did about a year ago) then higher demand tends to lead to higher prices -or inflation- rather than higher output.

The savings bit is misleading. While higher interest rates tend to cause people to substitute into future consumption (that is, save more) it also increases their income, which tends to cause higher consumption. (Furthermore, those who are saving for a particular purpose, such as a downpayment, find that they have to save less when interest rates are higher). The point is that different effects work in opposite directions, so the responsiveness of savings to interest rates tends to be pretty mild.

6

The effect of all those qualifiers was to keep it nice and simple. Let me expand a little.

First the basic story I told about the market for loanable funds is right, but there are other important determinants of behaviour which are held constant in this crude diagram:


[sub]interest rate

!*                    **S**
!   *                  /
!      *              /
!        *            /
!           *        /
!              *     /
r-------------------*/
!                   / *
!                   /      *
!                  /.           *
!                 / .                 * **I**
0 ------------------I-------------------             savings, investment[/sub]

In the picture demand for funds for investment purposes varies negatively with the interest rate and supply of funds varies positively with the interest rate. The equilibrium interest rate is r and the quantity saved and invested is I. Note that the curves could be steeper or flatter. The savings function is drawn pretty steep, indicating that saving is not very responsive to changes in interest rates. Empirical evidence supports this view.

Other effects will shift these curves - a reduction in income for example will generally shift the savings curve leftwards, an expectation of good times ahead will shift the investment curve rightwards. Very crudely, the idea of expansionary monetary policy is that lowering interest rates/ expanding the money supply shifts the savings function rightwards* (because saving is a function of - amongst other things - income) and investment increases. Depending on supply conditions in goods and factor markets, this can bring you out of a slump or be a temporary effect which will be reversed by an increase in the general price level (ie inflation).

Now to address your questions, although you probably won’t find it very satisfactory: First, what’s happening in the US? Well as mentioned above, domestic saving is not very responsive to interest rates and Americans (at present) are not very thrifty. But, relaxing another of things I ignored before, the US can finance investment with foreign savings. And markets seem to think that US investments will generate returns high enough that they are willing to make up the shortfall in domestic saving at the current exchange rate.

Now Japan. First off, the Japanese are very thrifty. So thrifty in fact as to be weird. They keep on putting money in their post-office accounts despite the fact that it looks like much better returns are available elsewhere. Note - contrary to your reasonable assumption they are not investing much outside Japan (you can tell this by the fact that the Yen has not depreciated all that much in the last 5 years or so). Why they do this is beyond economists’ understanding at the moment, but it is a huge problem for the BoJ: they keep on flooding the place with liquidity and people just won’t spend it. And no-one is investing because no one is spending, so investments aren’t expected to be profitable. Also because the financial system is riddled with incompetence and corruption which the government seems incapable of addressing because (a) The LDP are deeply involved in the incompetence and corruption and (b) the fear that the whole financial system could collapse like a house of cards.

In some economists’ opinion, Japan is caught in a modern version of Keynes’ liquidity trap: below a certain interest rate monetary policy becomes ineffective because people think asset prices are too high and must fall and that therefore yields must rise, so it is best to hold money rather than buy assets. In this circumstance trying to stimulate the economy is like pushing on a string. Krugman for example thinks that the BoJ must commit itself to causing substantial inflation to get the economy going.
*This would be the end effect of what starts in the money market, which would require at least 3 more pictures in the IS/ LM framework. Anyone who wants to follow this through themselves:

  1. the monetary expansion shifts the supply of real money balances rightwards (M increases, P is constant, so M/P increases), which requires
  2. an increase in liquidity demand. This shows up as
  3. a downward shift in the LM curve, resulting in
  4. a movement down the IS curve, which is itself a summary of what is going on in the market for loanable funds.

If the economy is operating at or above the non-inflation accelerating level of output, real money balances adjust back to where they came from as the general price level rises. If there is no pressure on goods or factor prices, voila, we have stimulated the economy.

7

Beautiful, picmr, you got ceteris paribus and a graph in one thread!