Why Free Money Prevents Recovery 1

Low interest rates are keeping wages from rising.

Over the past four years of the Obama Depression, we've extensively discussed the reason his policies are keeping our economy at a standstill.  No business or wealthy person will invest when they don't know what new regulation might suddenly make their investment unprofitable, or even illegal.  No company wants to hire any more employees than they absolutely need when they've got no clue what they'll be required to pay out in benefits.

Even if a company sees a good opportunity to grow, the ever-increasing pile of red tape and paperwork makes it more and more uneconomical to do so.  And even if, by some miracle, an entrepreneur manages to make a fortune... there stands our greedy government, insisting "you didn't build that" and arguing the money rightfully belongs to the bureaucracy.

Until we have a government that shows it's committed to growth, that demonstrates it understands that entrepreneurs did in fact build their businesses and do in fact deserve to keep most of their profits, we'll have no growth and no hiring.

This is all obvious except to our journalists, but there's another reason why we're in a stagnant economy, where even those who still have jobs are suffering from increasing prices and decreasing wages: In a failed attempt to jumpstart the economy, the Fed is holding interest rates near zero.

The Problem with Zero

For those of us caught in the whirlpool, zero interest rates seem like a good thing.  If you've lost your job, a 0% credit card can make the different between keeping the ship afloat a while longer versus going under now.  It's a way to buy time and hope things will turn around before you finally hit the wall.

Unfortunately, zero interest rates have a pernicious effect on the economy as a whole and free loans to desperate people show us why: Is a loan like that a good investment for whoever has the money to loan?

Of course not!  When you loan money, you want to loan it to somebody who'll likely pay it back.  The more risky the borrower, the more interest you must charge to make up for the risk of not getting the money back at all.  It was the government's misguided policy of forcing banks to loan money to anybody with a pulse that caused the housing bubble, collapse, and foreclosure crisis we're now in.

An economy and modern banking system are supposed to be able to price risk and reward through the use of varying interest rates.  When the government shovels out free money so that interest rates are next to nothing, that destroys the pricing mechanism and obscures the risks involved.

What's the end result?  Banks and investors make foolish investments since pricing discipline has been shut off.

The Cost of Money

Let's do a thought experiment.  Suppose that, instead of near zero, interest rates were 25% as they were during the Jimmy Carter stagflation of the 1970s.  There wouldn't be much investment, obviously, because in order to be profitable, any investment would have to give a return significantly greater than 25%, which is a lot.

Investments that actually happen, though, would be of the very highest quality and would be those most certain to massively pay off.  Nobody would be investing in bridges to nowhere or useless degrees because nobody could afford to.  There'd be a lot fewer bad investments that wasted or destroyed value.

A few weeks back we lambasted Paul Krugman for blind faith in government spending when he argued that government should borrow all the free money and spend it on doing, well, basically everything, just to put people back to work.  If we had the slightest faith that the government would invest the money wisely, his plan would make sense, but we know it won't.

Why don't government employees spend money wisely?  Because it's not their money - it's our money.  From the point of view of the bureaucrat, it's manna from heaven.

If you're a government bureaucrat, money really does grow on trees - when was the last time you heard of a bureaucrat fired for wasting money on foolishness?  Never.

In the private sector, people get fired for wasting money.  It's even harsher than that: people lose their jobs for no fault of their own because somebody else in the company wasted money and the whole place went under.  It's obvious why most private businesses are vastly more efficient and effective than any government entity: it's in the owners' and employees' direct personal interest to be so, in a way that simply doesn't apply to bureaucrats who spend other people's money.

What if the money is free for a company?  If the interest rate is 25% you'd better get at least 35% back on your investment or you'll be sacked.  If the interest rate is 1%, though, 10% is plenty, or even 5%.  Companies are making investments one-fifth as worthwhile as they'd otherwise be willing to do.

Why is this a problem?  Because workers' wages can only rise when their productivity increases, and productivity increases only from profitable investments.

More Stuff for Less Work

Even the most ignorant American understands that our individual lifestyles today are enormously better than those of people 100 years ago.  Think: no iPhones!  No TVs!  Probably not even a radio or a car!  The poorest American today is richer by far than all except the Rockefellers of those days, and in ways like antibiotics or air conditioning, we're far richer even than they.

How has this been possible?  Human ingenuity and capital invested in productivity increases.

Obviously somebody had to invent TV before anyone could have one.  After it was invented, though, TVs were a fantastically complex and heavy piece of equipment that was difficult to manufacture and transport.  Remember those big lumbering console units from years ago, filled to the brim with clunky electronic components?

What's inside a modern TV?  One simple-looking circuit board and a handful of connections - oh, and the TV quality is immeasurably better too.  This came about because of investment in better manufacturing technology, a whole bunch of little incremental inventions, and a great deal of engineering.

A single worker in a modern TV factory can produce ten times as many TVs in the same amount of time, all of which are better and cheaper than the old ones.  That worker's absolute productivity has increased 100 times over a factory worker of the 1950s.  The worker doesn't get 100 times the wages, because there's 100 times as much capital invested in each factory job, but she certainly gets more, and lives better, than a 1950s worker.

How about when a company is forced to invest in compliance, red tape, and bureaucracy?  None of that makes the goods better or cheaper; economically speaking, it's money down the drain.  Red tape lowers productivity and makes it harder to pay employees more, which is why successful companies avoid it where possible.

Bureaucracy isn't the only wasteful practice.  Anything that doesn't lead to innovation wastes money: research that duplicates existing work, dead ends, products that flop.  Every company will have some of these, but again, a good company avoids them where possible.

When the money is free, though, the incentive to be efficient is less.  With lower incentives comes less effort, a lower return, and lower productivity.

In other words, what's important is not that companies are making investments.  We need wise investments.  When we reduce the incentives and the rewards, investments will be less wise.  This shows up in our paychecks, which have stagnated for nearly three decades now.

In the second half of this article, we'll talk about other wasteful investments that aren't paying off and are holding down wages.

Petrarch is a contributing editor for Scragged.  Read other Scragged.com articles by Petrarch or other articles on Economics.
Reader Comments

I think a missing point to the article on interest rates was the stealth tax that lower rates inflict on retirees and savers. With rates so low these people have to dip into their savings in order to meet the cost of living. It's a shame taht no one can explain this to the Joe and Jane Six Pack. They would be hopping mad if it were explained.

September 29, 2012 1:08 AM

@Bassboat - they'd be even madder if they realized how the coming inflation will take away everything they've worked for.

September 29, 2012 4:18 PM

@Bassboat - they'd be even madder if they realized how the coming inflation will take away everything they've worked for.

September 29, 2012 4:18 PM
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