Incentives For Lowering Interest Rates

Economics Economics Questions
1

This is going to be vastly oversimplified, but can someone help me understand what incentive these banks have in keeping interest rates low? It seems like they could make more money, and have a more sustainable business model even with their monopoly status, in keeping interest rates reasonably connected to the market.

One would think that these major investment banks would have a lower time preference and want a more sustainable long term business model.

It just doesn’t seem to make any sense unless you view them as perfectly insulated from competition, making them sluggish and perfectly uncompetitive. It’s hard for me to think that anyone could be so stupid though. I don’t know, I just have never thought about it like that before though.

I know that the addition of new dollars will earn interest no matter how small, but is that really the only reason? Is it only new sales that is driving them? Making them just a sluggish inefficient monopoly at the end of the day?

2

Two banks. Trust and Honesty.

Current interest rate is 3%. Fed targets 2%. Trust lowers to 2%, Honesty remains at 3. As a business looking for money, I see the rate difference and I go to Trust for a loan instead. Honesty loses customers.

3

So, are you saying the Fed is attempting to eliminate competition by lowering rates? When I say ‘banks’ in my original post, Im talking about the banks that control the Fed. I might be confused here though.

4

What incentive does the Fed have in lowering interest rates?

5

The banks that control the Fed… hm… you mean The Power That Be? I am not well-versed in that subject.

As to what incentive the Fed has - Keynesian economic theory teaches that lowering interest rates can boost the economy. This works by stimulating investment, which in turn boost both GDP and the employment rate (in the short run).

If we are to assume that the Fed is an independent body that truly looks out for our interests, then that is the explanation.

I suggest you pick up a standard Econ textbook and give it a read to see where they are coming from. I’m using Principles of Economics by Mankiw.

6

Well, this is my predicament. Please do not hesitate in point out any misperceptions. My view on the motives previously were informed by the standard Keynesians canon. In a theoretical (economic textbook) sense, the Fed is acting upon what it percieves as good economics and what will benefit the economy.

However, after reading Rothbards Wall Street, Banks and American Foreign Policy, I have begun to see the situation a bit differently. Underwriting municipal and state bonds is seemingly the exact same process as underwriting treasury bonds on the Federal level. However, on the federal level this activity is hidden behind the ominous facade called the ‘Federal Reserve.’ The same institutions involved with the creation of the Fed still appear to some form of monopoly power underwriting muni and state bonds. (Bank of America, Bear Stearns, Citigroup, Goldman Sachs, J. P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, RBC Dain Rauscher , UBS etc…)

This does not require alot of theoretical background to understand. This is why Hillary Clinton may become the next chairperson of the World Bank. When bond yeild becomes the lens you see this situation through, you can understand the vested interest these banks have in all sorts of government policies. It goes from all the activities from IMF structural adjustments, Drug policy (filling up and building more prisons), education (building more schools), to all the oblivously worthless federal programs.

Getting back to my original question - when you see public, personal, corporate debt as (interest bearing) profit to bankers, and therefore the real motivation to increase the supply of money and public debt, what incentive is there to lower rates?

It seems like bad business.

7

It’s not that they want lower interest rates, it’s that they want the newly printed money. The Fed prints money and loans it to the banks at very low interest rates, who then loan it out for more and pocket the difference. Because of the increase in the supply of loans, the interest rate goes down. But even if they could make more money with a higher interest rate than a lower one, all else equal, they can make more money with a low interest rate and a money printing machine than a high rate and no free money.

This lecture by Hoppe explains the system pretty well: http://vimeo.com/24507042

8

You’re confusing two things: Why banks would want to lower interest rates, and why the FED wants to control interest rates.

With the FED it’s very simple.

A basic Keynesian model of the macroeconomy:

Now what happens if Aggregate Demand, AD, shifts to the left? This means that fewer things in the all around economy are demanded. This is fine within the microeconomic sphere, where the inputs are involved are simply used for other purposes, but if less is demanded all around then this means that inputs, namely labor, are no longer demanded to the same extent, and unemployment rises. Thusly, we see the Keynesian solution of raising aggregate demand as a solution for economic recessions. The traditional ways to do this are

  1. Increasing consumer spending by lowering taxes and allowing the other two steps to work through the multiplier effect
  2. Increasing demand for inputs through government spending
  3. Increasing business investment by lowering the interest rate

In our case we only care about the third method, but I believe it answers your question about the federal reserve. By decreasing the interest rate business spending rises because now they have more money to invest, picking up the slack in aggregate demand, moving the demand curve to the right, and regaining normal employment and a non-recession state of affairs. That is why the Federal Reserve would want to lower interest rates, as an anti-recessionary measure.

As for individual banks, they are partly required to decrease the interest rate due to competition, but also because of the fact that the new money has realistically cost them nothing, they can probably gain higher profit margins by lending out more money. However, all banks also have an incentive to keep a boom going and prevent the economy from going into a recession.

Did that answer your question?

9

You’ll pass your APs.

Meanwhile, I sort of floated on through the macro second semester. I need to reread half the book :stuck_out_tongue:

Edit: Ok, jk, yeah, I know the same stuff. I just want to be very thorough in my knowledge if I am then going to go on and challenge the standard model.

10

In addition to what nbome said, I think a part of the reason is that if you use the new money first, the prices have not adjusted to it. Those that use the money last are hurt the most and those that use it first benefit most.

To help illustrate this, imagine five classes of people, ranked by their order in getting their hands on new money: A, B, C, D, E.

A gets the money first and buys things from B. B notices a lower demand for cash in A and adjusts prices accordingly. B buys things from C and C notices B’s lower demand for cash and adjusts prices accordingly. It goes on like that, down until the last recipients. Obviously society is not divided up into A B C D E but you get the idea. This is the essential non-neutrality of money. It’s behavior can only be informed by the purchases it facilitated, subject to the changes of market data.

Basically, JPM gets to buy stocks at 36$/share or gold at 1600$/oz and you get to buy it at 39$/share or 1650$/oz.

EDIT: This is in regards to Fed asset purchasing, not their discount window: the Fed buys bonds from banks. The effect of this may be to lower interest rates from increased money in the loan market, but it’s also nice solid business for the banks. After all, “a little bit of inflation is good for the economy”.

EDIT: Bear with me here, I but I think another plausible explanation for low interest rates is actually a bust as a means to dirty cheap stocks. I think that many in the upper-echelon of finance realize that, in a boom, the options are acceleration of credit expansion or bust. With this knowledge it is possible to become really wealthy: store wealth in more solid areas (like metals), maybe ride the boom and sell off a bit, wait for the crash, and buy the heck out of the dip and wait for the glorious QE action to roll in.

There is a myth, which I cannot verify but find plausible, that a certain english finance family made their fortune doing just this in the Napoleonic War (and in other catastrophic periods for that matter).