Really, Raising Interest Rates Won't Spur Economic Growth

Every once in a while you read a news story about economic theory that simply confounds. One such article can be found in today's Guardian. It says that the Bank of International Settlements is urging central banks to raise interest rates in order to, and here's the crazy part, avoid a double-dip recession. Huh?

Here's the argument:

Record-low interest rates, aimed at spurring economic growth, are keeping households and banks from reducing the huge debts that led to the credit crunch, the bank said. "Keeping interest rates near zero for too long, with abundant liquidity, leads to distortions and creates risks for the financial and monetary stability," it said.

First, this argument makes no sense in regard to households. Does anyone really believe that, if central banks keep short-term rates lower, consumers are going to run a higher credit card balance or suddenly re-inflate a housing bubble in a market still trying to find the bottom? That's absurd. On the contrary, if savings rates are low, people should feel more encouraged to pay down higher-interest debt because the net return will be better than if they put extra income in a savings account or CD.

But let's say you accept this bizarre logic, and believe that households won't pay down as much debt if interest rates are low. So it's better if households are encouraged to save during a severe economic contraction than if they used disposable income to make more purchases, stimulating the economy and creating jobs?

Low rates might encourage debt pay-down, but certainly encourage spending. They would also lead to more equity investment. But again, in the short-term, that's a positive for a struggling economy. Businesses need more equity for investment, which will lead to growth and hiring. This argument can be cross-applied to banks. It's preferable that they're investing in businesses and providing low-interest loans during a severe economic contraction.

The article then provides the quick counter-argument:

Some economists oppose this view, claiming that tighter monetary policy and fierce budget cuts may cause a double-dip recession.

Yes! Because higher rates encourage saving, discourage investment in businesses, and make debt more expensive. This is precisely what those European nations struggling with sovereign crises don't need. If interest rates are higher, they'll have even more trouble turning over their debt and regaining their footing.

Clearly, ultra-low interest rates shouldn't last forever. The BIS is right that if left too low for too long, they can cause distortions in the market. They can bring about bubbles. They often lead to inflation. But when asset prices and inflation appear to be under control, raising rates too soon could lead to a much worse consequence: a double-dip.

It's not time in the U.S. to raise rates just yet, and it's certainly not time in Europe, where the economic turmoil is even worse. Central banks should have their finger on the trigger to tighten monetary policy once we're sure that the market is stable and inflation begins creeping up. But to advocate any sort of tightening at this time would cause far more harm than good.