05 June 2011
In other words, artificially raising the price of something to a level higher than it otherwise would have been reduces the demand for it.
The obverse of this is that artificially lowering the price of something to a level lower than it otherwise would have been diminishes its supply.
A good example is rent control. Nearly all economists agree that fixing a ceiling on rents lowers the quantity and quality of housing brought to the rental market.
Yet, when it comes to money, economists seem to forget the basic laws of supply and demand. For nearly three years now the Federal Reserve has artificially pegged interest rates at a level close to zero. First it operated on short-term rates and then on long-term rates. The result is that it has successfully engineered an economic slow-down.
Now why should this be so? It is rent control all over again. When rents are fixed low it is unprofitable for the owner of an apartment to rent it out. Far more profitable to lock up the apartment or employ it as a brothel.
That roughly is what happened with banks. With interest rates at levels close to zero they found it unprofitable to lend money to firms. It was far more profitable to use the money to speculate on various financial assets. Now it is likely that at least some of them have lost money in speculation and discovered that they are on the way to going bust all over again. They have therefore curbed their already low-level of lending which has led to the current slowdown.
For a highly leveraged bank or financial institution even a small fall in the prices of financial assets is sufficient to wipe out its equity. If you leverage yourself 19 times and use the money to invest in a financial asset, then even a 5% fall in the price of that asset is sufficient to wipe out your equity. I am pretty sure that has already happened to several banks. Expect them to be soon crawling to the Fed on their knees.
Even ordinary investors, stuck with interest rates close to zero, and with no alternative safe havens would have decided to have a go at speculation and thus contributed to the growth of financial bubbles.
Most economists seem to think that when Walter Bagehot asked central banks to "lend freely at a high rate, on good collateral" he intended the high rate to serve as some sort of punishment meted out to recalcitrant schoolboys. The real reason of course was not to prevent moral hazard but to discourage speculation and prevent the banks from doing all over again what got them into trouble in the first place.
But how can one expect the Fed to understand this when it has forgotten the basic laws of demand and supply?
When the Fed rediscovers the basics it will realise that low interest rates are a recipe not for ending a recession but for causing the next one.