TJP

It appears that the Federal Reserve chairman, Mr. Bernanke, does not understand interest rates or how to revive the economy. Mr. Bernanke argued, erroneously, that super low interest rates leads to economic growth by sparking investment and hence creating jobs. As a result, he kept interest rates low for approximately three years.

His hypothesis, like many of his policies, has adversely affected the economy. Super low interest rates have not led to any meaningful economic recovery. Yet, he continues to depress interest rates to the detriment of savers and borrowers.

Super low interest rates restrict credit and choke off economic growth. Like any other commodity, when the price (interest rate) of money falls less of it will be supplied.

Therefore, when the price of money is low, money owners, as well as banks, are reluctant to lend to the public. Without a vibrant credit market, the middle class will remain excluded from any monetary expansion and jobs.

The recession was not caused by high interest rate. Rather, it was a result of diminishing consumer purchasing power (real income), due, in part, to inadequate growth of the money supply (M1) between 2003 and the fourth quarter of 2008, and war induced high-energy prices (speculation). Thus, the economic problem stems from loss of consumers’ real income.

Prior to the recession, the Fed inflation targeting (IT) policy used interest rates to manipulate the supply of real money balances and restrict demand. However, when the demand for real money balances exceeds the supply of real money balances, asset prices fall, due to lack of demand. Apparently, Mr. Bernanke believes that reversing his disastrous IT policy can increase consumers’ real money balances and hence aggregate demand.

Unfortunately, it is income, and not interest rate, that is preventing demand. Hence, any viable solution has to restore consumers’ purchasing power (income).

Some steps that should be considered as compensating mechanisms to restore consumers' income are: reducing personal tax rates at the state and federal levels; raising interest rates to restore income stream to savers and provide credit incentives to banks; suspending trading on the NYMEX to reduce energy speculation and provide savings to motorists and the transportation industry; establish a moratorium on foreclosures and provide government backing for distressed mortgagees to restore homeowners savings.

Additionally, Congress should rescind payment of interest on bank reserves. The level of bank reserves is a function of interest rates. When interest rates are high, it is costly for banks to hold excess reserves, because they would forgo profits. Likewise, when the Fed pays interest on banks reserves, it dampens banks incentives to provide credit to the public.

Policy makers should not to raise revenues by hiking tax rates. Rather, economic expansion should drive government revenues. The following steps should be implemented without delay: suspension of NYMEX energy trading, rescinding payment on excess bank reserve and providing real and tangible foreclosure support to homeowners through government backed refinancing program.

Contrary to the common argument, the economy is a credit economy. Credit is essential for economic growth and hence job creation. Without credit, entrepreneurs, merchants and consumers cannot bring their ideas and dreams to the market.

Rebalancing the housing sector will restore wealth to homeowners. It will also benefit renters, since rental demand and prices would decrease. These steps will help restore consumers’ income and aggregate demand close to pre-recession levels.

Post Comment