Increase Interest Rates to Stimulate US Economy

The typical recession is the result of demand exceeding supply which leads to price inflation and is addressed by raising interest rates to reduce demand. However, in the case of a deflating bubble resulting in a financial bust, the resulting situation is too little demand yet the same remedy of lowering interest rates is prescribed. Is it possible that this is the incorrect policy to correct the weak economy resulting from a burst bubble and that the correct policy might be the counter-intuitive policy of raising interest rates? Is it possible that reduced interest rates to stimulate demand might be appropriate for an economy with a large manufacturing sector with a low savings rate but might not be appropriate for a mature service based economy with a significant savings rate such as the US or Japan?

A significant reduction in interest rates by the FOMC might in fact cause demand and GDP to contract while increased interest rates might cause demand and GDP to expand. Although this may seem counter-intuitive, consider the following;

- In 2008, $223.3 billion of interest income was reported to the IRS. As a result of FOMC rate cuts, interest rates paid to savers have declined by at least 80% which, in general terms, has lowered interest income by about $179b and, assuming a 25% federal and state marginal tax rate, has lowered tax receipts by about $44b. The result is that the savers spend less which reduces demand and the state and local governments tax more, cancel projects and/or reduce staff which reduces demand further.
- Insurance companies make a significant amount of money on their float (investing premiums collected until a loss payout is required). When their investment income declines for a given projected actuarial loss, the appropriate response is to increase premiums which reduces the demand of policyholders for other goods and services. Deutsche Bank alone which is the 3rd largest 3rd party insurance asset manager has $150b in US insurance company assets under management.
- US university income comes from tuition and fees and investment income from their endowment funds. In 2008, 4-year not-for-profit colleges and universities collectively held more than $400 billion in endowments with Harvard University alone having an endowment fund of $37b in 6/2008. Typically, a university uses 5-6% of the endowment fund each year to pay for expenses. When earnings from endowment funds decline, the university will either increase tuition, claim additional state tax dollars and/or reduce staff.
- US employers who offer pensions use pension funds to pay for the pensions. Generally, the pension fund calculates how much they need to pay their future obligations, subtract expected investment income and collect the remainder from the employer. Given that the total value of US pension funds at the end of 2007 was $17.3 trillion, a 1% decline in investment income would require that employers contribute an additional $173b which would reduce money available to firms and government for projects and staffing. It should be noted that pension funds are already assuming a much higher rate of return on investments than they can reasonably expect.
- Higher interest rates typically lead to higher prices (inflation) although in a post-financial bubble it isn’t clear that this generalization would hold in the short term. There are certain sources of income such as social security retirement and disability benefits that are indexed to the Consumer Price Index (CPI). Given that social security retirement payments in 2009 totaled $564b and disability payments in 2009 totaled $121b, a 1% increase in the CPI would increase annual benefit payments by about $6.9 billion. Keep in mind that although there are other income sources contractually tied to the CPI such as union contracts, many employers base annual wage increase on the CPI. Given that total 2008 wages and salaries reported to the IRS was $5.95 trillion, even if just 25% of this income was increased by 1% due to a higher CPI this would lead to an annual increase of $14.9b.
- A higher interest rate would typically lead to a higher exchange rate. The net impact of a higher exchange rate on the balance of trade (net imports/exports) is difficult to estimate. However, some imports such as oil are priced in US dollars and as the dollar weakens the US oil cost increases while the cost of oil imports to other countries such as the EU declines. Higher US energy costs reduces consumer demand while lower energy costs to international competitors such as Germany reduces their costs which could reduce US exports.

Note that the above is a general analysis and that there are offsets to increased interest rates. For instance, increased interest rates might increase credit card interest which would reduce demand but can credit card companies really increase above the current 30%?

Of course, when faced with lower investment returns from safe investments, the investor could chase higher returns by investing in riskier assets such as mortgage backed securities but this might just result in a new crisis. Keep in mind that Greenspan intentionally kept interest rates low following the busting of the tech bubble due to anemic job growth but this made the financial bubble possible if not inevitable.