Friday, March 26, 2010

Interest rates: low does not always mean better

There is something about low interest rates. That they are a "good thing" is deeply ingrained into the psyche. To homeowners they promise cheaper mortgages and higher house prices and to businesses cheaper borrowing and more cash in their customers' pockets. Politicians look to low interest rates as a general economic cure-all.

Indeed a few years back when Labour was trying to persuade Britain that the Euro was a good idea, the main argument was that joining would keep interest rates low. The Conservatives today are arguing for a tough approach to the public sector deficit partly because they say that will keep interest rates down.

But are low interest rates such a great thing? If the government suddenly decreed that it was illegal to charge any interest would that be a good thing? No because it would take away the incentive to save and lend money to people who want to borrow. After all, interest rates are a pricing mechanism designed to balance the plans of savers and borrowers, consumers and investors. Surely what we really need is "correct" interest rates that ensure enough money is saved to finance investment in the economy.

Living in Spain I can visibly see the effects of an extended periods of low interest rates just by looking out of the window. Spain had the low interest rates that Tony Blair tried to sell the Euro using and it stoked a huge boom on the back of consumer and corporate borrowing. Now we see the stalled building projects, shutdown shops and businesses and unsold property that resulted. Spain shows no sign of recovering.

I know a lot of people will say raising interest rates now would be a recipe for "double dip", a slide back into recession particularly if public spending is cut and tax raised at the same time. All I am saying is that let's rebuild the economies of Spain and Britain on sound principles this time. Instead of trying to stoke demand via dollops of public spending, massaging down interest rates and house price booms, let's try and improve the supply side: the workforce, productivity, competitiveness. Meanwhile allow interest rates to settle at a rate that rewards savings to fund investment and stops people taking on debt they can't afford.

My latest column at the Alrroya website covers this topic in more detail Time to Raise Interest Rates

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