The economy is to a car as interest rates are to the suspension

Cutting interest rates is the traditional method of fighting deflation and stimulating an economy. Just as increasing interest rates was the way to go with overheated economies with high inflation. But as Japan found out, and now much of the industrialised world is finding out, when interest rates are already very low, they are no longer a tool to fight deflation with. In fact going to even negative interest rates dampens all economic activity.

The physical analogy I like is of the economy being a vehicle on tensioned springs. I prefer the suspension analogy to that of interest rates acting as either accelerator or brake. As long as the springs are in tension the suspension can be tightened (hard springs) or loosened (soft springs) to suit the bumps and type of bumps on the road. Take this simple description from a suspension tuning blog:

The purpose of the springs are to control wheel movement and keep the tyre in contact with the road over bumps and undulations. Stiffening the springs front and rear will reduce body roll and make handling more responsive, but cause a loss of traction over bumpy surfaces. Likewise, softening all of the springs will give more grip on bumpy tracks, but increase roll and reduce responsiveness.

Paraphrasing in terms of the economy I get:

The purpose of the interest rate is to control movement in the economy and keep the entire economy steady despite the bumps and undulations in different sectors. Increasing interest rates will restrict overspeeding in economies growing fast, but will cause a loss of control when growth is low or sectors are growing at uneven rates. Likewise, reducing interest rates will give more traction in low speed economies to sectors with low growth, but can give rise to uncontrolled expansion (bubbles) in other sectors.

Of course, it is only an analogy, but taking it just a little further, the low-interest rate regimes that are prevailing are akin to having no tension at all in the suspension. Trying to tune a floppy, tension-less suspension on a very bumpy road is futile. Taking interest rates negative is equally futile. My take-away is that the floppy springs have to be changed-out or you have to go off-road or get onto another road. Right now the springs are broken – not just floppy. We are in interest-rate territory where they no longer function. If this analogy holds, then it is not messing about with very low interest rates which can help. It needs a fundamental change in the way taxes are raised to change the economic road being travelled.

So my recipe for stimulating economies now stuck in the doldrums, would leave interest rates alone for the time being, but provide tax-cuts or tax-credits to real activity that increased turnover or jobs – but only after the increased turnover or jobs had been delivered. The benefits should be for growth delivered. Increasing profit while turnover is reducing should be a sin. So should be increasing spending when there is no growth. Changes to public expenditure should then be made contingent upon – but lagging – actual growth. Wages and salaries ought then to be in line with growth achieved and not with inflation. The same job in a successful business should pay more than in a failing business. How not?

Nothing is as simple as it seems but the idea that public expenditure can lead growth is totally flawed. Equally, just cutting public expenditure (austerity), without also providing for economic stimulation – in the form of judicious tax benefits (after the event), is a cul-de-sac. Going back to a horse-and-cart might sound idyllic but resolves nothing and only increases misery.

Don’t mess with negative interest rates. Instead, stimulate jobs. Cut the cost and long-term liabilities of employing people and more people will inevitably be employed. A too high entry wage and long-term employment commitments when the future is uncertain, are the biggest barriers to creating new jobs. Profits are for the shareholders but the turnover is for the economy. Focus then on turnover as the deliverable from any business to the economy at large and provide real tax benefits for generating such turnover.  Cut the crippling costs for establishing or expanding turnover and both growth and employment will benefit.



Tags: ,

%d bloggers like this: