I found the point on higher interest rates getting executives to think about the merits of projects particularly vital. From what I’ve seen in the popular press, there has not been enough focus on how much of our recent economic woes were the product of business people pursuing irrational projects because the financing for them was so cheap and easy. Perhaps with more realistic interest rates, decision makers will stress the economic merits and not pursue things for the sake of doing them.

Concerning point 1: I wonder what longer-term interest rates would have been without the Fed’s QEII. I guess we will only have academic research on this within a few years...

Thank you for a very interesting and frank analysis of the drivers and effects of interest rate levels, and the great discussion it has generated.

One effect of the extremely low interest rates has clearly been to inflate the stock market: with near zero returns from retail fixed income investment, many individual investors see equities as the only means of growing their retirement savings.

Regarding the very interesting discussion of how government debt drives interest rates and the role of the mortgage deduction, the mortgage deduction could be eliminated without raising taxes over all. The question of how much revenue the state should collect is separate from how the burden is shared.

In the US, we appear to have a situation where the voters demand for services exceeds the taxpayers (also voters) willingness to pay for them. Until this situation is resolved, an impending debt crisis will hang over the future of the country. It is not enough to symbolically cut waste. It will take cuts to large, popular programs such as Medicare and Social Security or large increases in revenue to balance the budget, unless (least likely of all) a compromise is found.

The longer that serious attempts to deal with this issue are avoided, the more drastic the solutions will need to be.

Interesting article, and even more interesting discussion! Most of the US-based participants seem to share a view that any tax is an infringement of their natural right, and that all adjustment in the US economy should come from the public sector.

As an outside investor in the US, it seems to me that the biggest problem is excessive leverage by both business and personal sectors. American levels of spending cannot be sustained.

Greenspan’s magic recipe was to keep interest rates low but growth high to attract external investment. This bought a solution to the 2001-02 recession but at the cost of importing more and more capital—the future was mortgaged to the present.

Now, the inevitable bubble has burst, but the debt remains. As a side effect, it significantly increased inequality which destabilizes society in the longer term. It is not possible to go back to the halcyon days of the mid-2000s—they were an illusion.

An excellent overview. My concern is that econometric projections rely on historical data, but we are now faced with a new paradigm: It is an anomaly when short-term interest rates for the currency of the largest national economy and the de facto world reserve currency are near zero. The world economy cannot function normally in this situation. It is time for the Fed to start talking about the inevitability of a return to normal ST rates, i.e. not lower than 3.5%. The shock to the system by such a shift would be great, but very short lived. And then we can return to a normal situation.

The interest rate (short, long, etc.) is a function of demand and supply—just like all prices are. The question whether the level of interest rates is good or bad is like asking whether the price of bread is too high/low or good/bad. Any subsidy or tax influencing the demand and supply will distort the “real” price or interest rate (actually the mortgage interest tax deduction increases the demand for capital and without intervention by Government—like Fanny, Freddy, or the Fed—would increase interest rates. The subsidies by the government actually increased and lengthened the financial/housing bubble).

The fiscal policy of the government—with its enormous deficits—should normally increase interest rates. QE2 tries to prevent this rise by intervening at the longer side of the supply curve for capital. However, the market is not fooled by this action. Actually, it could be argued that just the contrary should be done by the Fed, because higher interest rates, in principle, should increase the savings rate and reduce consumption (time preference theory). Somehow, the Fed and the government believe that continung the imbalance in the economy (i.e. savings rate lower than the investment rate, including the government budget deficit) will increase GDP faster and hopefully also tax revenues and employment. This is, however, not certain at all. Economic growth is a marvelous objective but the actual policy may lead to stagflation and, in the end, higher interest rates. The most important objective should be to try to get a better fiscal balance. A higher savings rate (thanks to higher interest rates) and a lower GDP growth rate (maybe for some time) may be preferable for future generations. Implicitly, it seems that the government prefers retired people over the younger generation. Present-day consumption is favored by the Fed and the government (subsidized and taxed lower), and savings and investments for the future are discounted.

The US is helped out by the reserve status of the dollar which makes the rest of the world save for the US (to finance its budget and balance of payments deficits). This already keeps interest rates lower than they normally would be. The rest of the world is hostage to this situation for the time being. Let’s hope the US straigtens out its imbalances before the rest of the world demands to be payed back for the trillions of dollars the US owes.

Interest rate is a function of demand and available money supply in the short term and for the longer term it is a decider of demand. The servicing of long-term debt is directly related to macroeconomic factors that are driven by known and unknown variables.

Intervention by the state (the Fed in the case of US) in a free market economy, except in extremely rocky situations, is frowned upon. A state is invariably the largest borrower, mostly for extra long-term needs to fund its requirement cost effectively, and so dictates the short-term rates for its lending to get mirrored in the long-term funding. The market as such keeps these rates as a platform to work on and decides the rates based on credibility of the borrower and other associated risks. When one talks of debts, these must include personal and national as well. In other words, if the economy is excessively in debt, personal debt will become expensive.

A state’s role in moderating the rates cannot be understated. However, the adopted methods need to be supportive of and facilitating the final target of lower interest rates and therefore lower inflation. If the supply of money exceeds the possible demand, or vice versa, the problems are not corresponding.

The situation in the US is not ideal with the economy getting driven by spending. It may be the present savings that get spent or future savings (like credit card binging). When this happens in the next couple of years, and a new avatar of derivatives get accepted as safe and fitting in a framework, history might repeat itself and more public funds will go down the drain.

Unless there are real economic pluses like the bouncing back of exports and higher local consumption from better income, there is no likelihood of any change in the picture. Doom sayers as they are called the cautious analysts might prove right again if too much tinkering happens with interest rates.

A responsible way of handling is required with over 60 percent of the trade and business of the world happening in the still trusted mighty dollar.

The debate and commentary about various fiscal and monetary instruments have been rife throughout economic history. If a clear answer was possible, humanity would have got it by now and economic cycles would have ceased. These instruments in essence work to hinder or assist the flow of money in the economy, assuming there are transactions in the pipeline. They fall short when it comes to building or recovering the economy. That is becasue, they cannot create the underlying transactions. New transactions are the result of new value being created in the economy. Recovery will depend on value creation and long-term recovery will depend on long term value creation—those with life-cycles longer than a mood. Value creation does not sit happily with either the central bank or the government. The role of these two institutions in building economies have been overstated for too long. Creative energies, unfettered by compulsive three-monthly launch plans, would to come to rescue.

Consumption spending matters in economics because, based on what neoclassical macroeconomic theory tells us, saving is a leakage from the economic system, so higher interest rates may spur savings, a leakage to an open economy. However, increased savings could lead to more investments, and increases in productivity and jobs to raise living standards in the US.

Your observations are worth noting. Myths 1, 2, 3 are certainly very valid. However, the conclusion that mortgage deductions are not good is very misleading. These deductions have created a very positive impact on the overall economy of US. The impact on deduction on tax revenue is nothing compared to subsidies that businesses get. It seems like in the culture or corporate controlled government, anytime there is benefit to the common person, businesses and consultants cry. Analysis should be more balanced and should not be biased to business only.

Your comment that the mortgage-interest deduction increases the federal deficit presumes that the government has a right to that money. Based on that presumption, having money in your pocket contributes to the deficit. The federal deficit is not due to your having money in your pocket that the government can’t take—it is due to the federal government over spending its means. It simply spends too much money. Increasing taxes in whatever form—by eliminating deductions or simply raising taxes—is taking more money from the citizens under the premise that the government has the right to the money. This notion is rejected by the majority of taxpayers who must manage their spending within their means. Cut spending—that is the only way to reign in this out-of-control deficit and generate sustained growth in the economy.

On point 3, I’m not sure where the government will get the funding for additional investing to compensate for falling consumer spending. It either comes from the consumer (through taxes) or through borrowing (from the bond markets, which are just future taxes). Only business spending can replace consumer spending without the crowding out effect, which happens which ever way the government raises finance.

Finally! Some nuts and bolts reflection on the value of personal savings, increased interest rates, and the non (business)-biased truth about the mortgage interest deduction. Thank you for a reality check regarding these key facts: savings is good; a healthy interest rate paid on personal savings would be a positive fiscal incentive for middle America; and the dirty little secret about the mortgage interest deduction is that it is a disincentive for homeowners to pay off their mortgages and secure fiscal freedom. Sometimes back to fiscal basics for the masses is a good thing!

There is no substitute for hard and productive work for creating wealth. Distortionary policies like mortagage interest deduction (at least in “excessive” measures) must be shunned.

Good points. You would be doing your readers (not to mention policy-makers) a great service by calculating the net benefit (or cost) of artificially low rates. The Fed’s policies appear to be a massive tax on savers with little ostensible benefit other than permitting banks to rebuild their balance sheets.

#4, Interest rates —- I strongly disagree with your comments that fewer deductions (mortgage interest) are good. It is not that government needs more money, it is that government needs to stop giving away so much money.

Let people spend the money they work for, that will build the economy.

While I have supported increased interest rates for some time (one only needs to look at Japan to see that low interest rates do not necessarily spur economic growth), the cost to the US federal and state governments is substantial for every 1 percent increase in rates. This in effect will need to be paid by the consumer. The dog (US Government) will continue to chase his tail (low interest rate policy) until he falls. It might be hard to get up. Discussion on the effects of higher interest rates on government spending should have been included in your presentation.

I guess that this article would have been useful 6 years ago. Today it is so obvious that even people who doubtfully understand economics are saying so. If you’re interested in giving us some value in the next article, please write something about national debts and how they are going to affect business around the world.

This is an evergreen issue but your article is timely. Modest interest rates of say, 6 or 7% at the 30-year range combined with a positive slope in the interest rate curve will encourage longer-term savings and generate the capital needed to fund the capital requirements of the nation. A robust regulatory climate is also needed to require bankers to keep the risk of their lending and investment portfolios within reasonable levels (reasonable as determined by the regulators—not the derivative wizards of the market).

Encourage the study of history. Those who fail to learn from history are destined to repeat it.

The Fed is obsessed with keeping interest rates low for one very strong reason: the US national debt service rises approximately $180B for each 1% rise in the interest rate.

Raising interest rates whilst the economy is still relatively weak and deleveraging is continuing is widely regarded by neo-Keynesian economists as tantamount to heresy. I disagree; it is precisely the super-low interest-rate environment which is sending distorting signals to the markets. Central Banks’ control over interest rates via open market operations (supposedly altering the supply of money in the system) has already been compromised by the ability of banks to create credit or withhold it in a fractional reserve system. It also informs markets that we continue in crisis mode and, besides choking off personal saving, does not instill confidence—the key element which is lacking to drive growth.

I agree that the demand for capital is enormous—at troubled sovereign as well as financial and non-financial corporates. Last figure I heard on this was approx $100 trillion over the next 20 years and even that maybe a low estimate.

The deductibility of mortgage interest on homes was an issue we had to face in the UK in the 1980s—the MIRAS system. This was a clear market distortion and was phased out, successfully. If the mortgage market is made to operate efficiently and not as a global merry-go-round, there is no need for this tax break.

Central Banks’ timings on interest-rate policy is uniformly dreadful, it usually fails to respond fast enough on the upswing and emerging inflationary pressures and regularly clonks the economy on the head in downturns.

The “bad” justification for current policy is that of weakening the dollar against currency intransigence elsewhere—we know where! Time to change gears.

You did not look far enough on your point about deductible mortgage interest. First of all, eliminating the deduction is nothing but a straight-out tax increase. Yes, the government will get more revenue from that single action but not necessarily in total. Second, there will be other consequences. The incentive to own a home will be partially removed because the ability to leverage a down payment against the appreciation of the entire value of the property will be lost. This is the only remaining opportunity for individuals to leverage anything other than high-risk investments such as options and shorting stocks. Fewer homes will be sold and the price that is paid for homes will decrease from increased downward pressure on the value of owning a home. The losses in value will take away from the subsequent capital gains taxes the government eventually collects, in some cases. These factors will result in a proportional decrease in home ownership, shifting the consumer spend to rental properties. Rental property income is highly offset by all the expenses involved which, I believe if you run the numbers, will generate less income and hence less tax revenue for the federal government, offsetting some if not more than what was saved by eliminating the deduction.

The only sound tax policy, according to Thomas Jefferson, is not to change taxes! This is because when left alone, the economy adjusts to taxes. Leave taxes alone or lower them—only these two actions will help the economy, which is the issue, not giving more revenue to our already bloated government.