Busted: Bankers and The Global Economy

May 17, 2008

The Truth About Interest Rates

Most economists, like most Americans, have cheered the rate cuts as medicine that hopefully will work and a reaction that might not do much harm. Interest-rate cuts do have a dark side.

It’s generally assumed that all things being equal, lower short-term interest rates are better. But this view is simplistic and arguably wrong. Lower rates are a help to people with credit card and margin debt, as long as the savings are passed along and don’t end up in banker’s pockets to help fund their adventurous position. Thanks to Mr. Bernanke and a reasonably cooperative Congress, many people facing resets on adjustable-rate mortgages will see less severe rate hikes. Lower rates are not an blessing for everyone. People with money in the bank or investments in Treasury bills and other short-term securities will see incomes reduced. Retirees and others on fixed incomes, such as pensions, lose out every day.

In general, lower rates are a help to borrowers, but an affliction to lenders. When people “lend” money, they usually see this as an investment. The lower rates go, the more the financial system discourages hard-working Americans from investing and saving dollars, and the more Americans are rewarded for borrowing and living beyond their means.

When Americans are discouraged from saving, they have two alternatives. The first is to start spending. This is why lower rates lead to higher prices. You can think of each rate cut as sending an electrical jolt to every American: Live better! Spend more! If you max out your credit cards and your home-equity credit, who cares?

The other option is for people to convert their dollars to another currency. When the Fed cuts rates, it is also saying, “Dollars are a poor investment; try the euro on for size.”

The dollar has plunged to an all-time low against the euro and to the lowest level in years against the Japanese yen. Commodity producers around the world are boosting prices to compensate for what they perceive to be the dollar’s shrinking value. Prices are up. Value is down. Hyperinflation is in the mix.

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