Will Further Interest Rates Reductions Boost The Economy?

Well, our survey has different views included, as usually. The answers tend to be pretty structured though, so let’s see the results.

The theory, as previously explained by doitinvest.com in a previous investing blog, says that the interest rate cut executed by the FED should boost the US economy. By reducing the refference interest rate, FED actually reduces the borrowing costs of the US banks. This is because the banks attract an important portion of their cash through loans from FED at the official interest rates. obviously, the lower the refference rate is, the lower the costs for the banks, which in turn are encouraged to lend money at smaller costs. The ultimate beneficiaries in this lending chain are the final consumers/companies, which should benefit from borrowing facilities available at lower costs.

More cash pumped like this into economy should encourage the consumption and the investments from the private sector. Simply because borrowers have cheaper cash available should encourage them to consume and to re-start the economic cycle. New jobs are created, salaries increase and everybody sells more. This is how the theory, more than 70 years old, functions. As early as the ’30’s the economist John Maynard Keynes put the basis of the interest rates theory…

But the opinions on our expert survey shows that the cycle of restarting the US economy through lower interest rates is broken. Some people look at what happened in Japan in the last decades, where even at negative interest rates (meaning that you will actually have to pay money to keep your savings into a bank!) did not manage to fight stagflation (=inflation + stagnation). These people, most of them adept of the Austrian school of economics, point at the centralised character of the current economy,  showing that this central reduction of interest rates propagates hardly through the economy and has very late effects on what is going on…

Others point out that making cheap money available to the banks does not mean that they will get to the consumers. Most of the banks are still reluctant to lend cheaply further, despite their very low costs (historically some of the most advantageous costs). They preffer to use the government money to cover their huge losses or even to propel the Ponzi schemes, such as the Madoff one. Estimates suggest that saver’s holding in cash and fixed income are around $ 9 Trillion. Hedge funds (size $ 1.9 Trillion) are torn apart with the fall in oil and commodity prices. Squeezed down to now $1.3 Billion, these hedging funds are staying away from those markets, where they were previously very active.

Some opinions say that whilst borrowers are now encouraged to spend at the future taxpayer’s expenses, the savings are punished – and all of this in the name of a nice spending atmosphere. The god of these days is of course the consumer spending index, which is continuously falling – and who could blame the consumers who now have to pay the bills and the mortgage rates at non-reduced rates?

In January 2009, Bank of England cuts interest rates to 1.5%, the lowest since its foundation in 1694. Some signs are already showing that the recovery is on the way, since the pound bounced back from 1 to 1,12 euros in just a matter of weeks, but the UK economy still looks battered. But some of the surveyed experts rightly point to the fact that most of the current crisis is due to the lack of liquidity. Interest rates cuts should actually boost up the vanquishing liquidity and return the markets to their normal state of trading. This is indeed a method of proping up the economy, with the only exception that due to banks’ state the liquidity gets very hard into the real economy…

As Business Week mentioned a few days ago,  “We have not closed down banks ruthlessly. That’s the big problem,” says Harvard University’s Kenneth Rogoff, who delivered a paper at the San Francisco meeting. “We railed at Japan for not giving tough love to its financial institutions, but we’ve had a lot of trouble doing that ourselves.”  Therefore, the bad assets seem to be still among us and the interest rate cuts do nothing to clear them out, therefore the crisis is not solved by this panacea. This opinion current has its merits – at least it acknowledges that the problem itself is not only the current liquidity crisis but the state of the investing assets themselves. Being worthy almost anything, people are afraid to invest and thus keep the investments markets frozen…

At last (but not at least), investment banking professionals point out that the recessions are not efficiently battled with by the interest rate cuts only. These investment friendly measures should be accompanied by other economic policies, such as fiscal stimulation policies, massive gvernment investments and changing the banks regulatory environment. Furthermore, these experts point out that the investment crisis is easily propagated by the globalisation of the markets. Central banks around the world are responsible for price stability (inflation) with few exceptions for broader mandates which may include direct influences on the real economy. The current period is not an inflation crisis but a  demand one, and therefore the Keynesian theory seems appropriate to the problem.

Therefore, the bulk of our doitinvest.com survey seems to indicate that the interest rate cuts are not really efficient – at least not in alone. And their effect on the investing activity will anyhow be delayed by a couple of months…
Article originally published by doitinvest.com

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