For recovery, raise rates

Even before there was an Obama administration, there was the hue and cry for the government to "do something" to stimulate the economy reeling from the Chris Dodd Bear Market and Recession. But there also were voices warning that stimulating the economy the way Barack Obama and congressional Democrats intended — massive government borrowing to fund massive spending on government employees and infrastructure; government interference in commerce; microscopic interest rates — was failure waiting to happen.

Those voices recalled how Japan stimulated its economy 10 times after the credit bubble burst in 1990. Each time, Japan ramped up government spending and borrowing; interest rates were reduced to almost zero. Investment, consumption and economic growth never rose above anemic, however. Government debt got so out of control that the Bank of Japan couldn't raise interest rates because it might have collapsed the government buried under a mountain of debt. Japan's "Lost Decade" is now in its third decade because it has been unable to escape the economic doldrums.

The lesson lost on the Obama administration is government can't produce prosperity. After trillions in deficit spending, its economic program has failed. Look around: All signs point now to stagnation or worse, yet the push is for further Keynesian pump-priming, only this time with recession-fanning tax increases on entrepreneurs.

The Fed pledges to keep short-term rates near zero. But as John C. Michaelson of Imperium Partners Group of New York City detailed recently in an excellent Wall Street Journal op-ed, the Fed's strategy has "pernicious consequences," as recent history proves. Low rates depress investment returns, so companies must divert money for operating expenses to meet their pension obligations; that leads to job losses and pay cuts that reduce consumer spending. Governments that increase payments to their pension funds to make up for lost investment income exacerbate their budget crises; those that carry these losses as unfunded liabilities worsen future crises.

Banks are discouraged from lending to job-producing companies because they can invest their near-zero-interest loans in zero-risk government bonds. Low rates also failed to produce the promised spike in consumer spending because shell-shocked Americans are deathly afraid the recession may deepen and the government's response will make things even worse. This same fear and loathing has companies, even those making record profits, sitting on their cash reserves, now estimated at nearly $2 trillion.

Mr. Michaelson says it's obvious the United States is near the jaws of the Japan trap. His counterintuitive way out is to raise short-term rates so "more funds will flow to borrowers who will invest them in job-creating activities and increase consumption. And from a recovery perspective, increased returns on cash will cause Americans to feel more confident about their economic future." This would begin a spiral of business expansion, job creation, and higher consumer confidence and consumption that would draw the bulk of that $2 trillion off the sidelines and generate trillions in economic activity.

He is not alone in believing the Obama administration has not put America on the road to recovery. But it appears the only way to get the government to follow his road map is to change the government. That's why America has elections and why elections are important.

“It the Fed raises rates, we will instantly be in an inflationary spiral as businesses try to spend the trillion dollars in cash reserves they have on their books right now.”

You have it somewhat backwards. Raising real interest rates makes holding cash balances more attractive because you get a return on your savings. People spend cash reserves as fast as they can in response to inflation, for example during the late 70s, when the real interest rate offered on savings was often less than the inflation rate.

Some might argue that the current real rate of interest is positive even while it is nominally zero, due to deflation.

That would depend on what you mean by Keynesian economics. Animal spirits, consumer confidence, are ideas used by almost everyone now. And it was a recent Republican administration that went far beyond Keynes’ modest prescription by claiming that “deficits don’t matter”.

We don’t have inflation though. There is no penalty to holding cash now. Increase the interest rate and there will be.

A higher interest rate is an incentive to hold cash. You earn more on your savings the higher the real interest rate is.

A low rate, especially a zero interest rate policy like we now have, is a disincentive for holding cash balances because you earn little or nothing on your savings. There is no penalty incurred for spending your money because you are earning nothing on it.

This is a very elementary economic concept. Raising rates does not cause inflation, it is in fact the first tool that the Fed uses to combat inflation. You have the process backwards.

They don’t pay interest on cash. I will grant you that my logic is counter to conventional wisdom but I am saying conventional wisdom is wrong in this instance. We had a story a few weeks ago that businesses are sitting on more than a trillion dollars in cash. Why? Because there is no penalty in doing so. You can’t invest it in stocks and bonds and generate any kind of meaningful positive return anyway right now so why not hold cash? If you push up the interest rate just a little though, then there is a penalty for holding casha nd it would quickly either be spent or invested.

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