Would higher interest rates help the economy?

Since 2009 central banks around the world have been pursuing a near zero interest rate policy.  The idea being that low interest rates will entice borrowers to take out loans, which they will use to invest, and the result will be business growth and new jobs.

That’s a good theory, but we know theories don’t always prove true.  The effect of low interest rates has not been as expected.  Companies have taken low interest rate loans or bond offerings and bought back their own shares.  Young couples and others wanting to own a home have not rushed out to buy houses.  Even though these low interest rates make borrowing the cheapest it has been since 1900.

I suggest the idea that higher interest rates would actually be better.

There are two elements that in reality are important to making an investment and to the economy in general that are not being taken into account by the central banks lowering interest rates repeatedly.  The first is banks are in the business of lending money to make money.  At 0.25% interest rate levels, there is no motivation for them to make loans.  There were stories in the news a couple of years ago about the difficulties of getting loans, but I believe the same concern still exists.

Furthermore, lowering interest rates brings a lack of confidence.  A major element of someone taking the risk of getting a loan and investing in a business is that person must be confident they will do well with the investment.  Think back to the years 2006-2007 for a lesson on confidence.  When the real estate bubble was pumping up, everyone was confident they would make money by buying a house.  The interest rate didn’t matter.  People here in California were able to buy a house and flip it a month later for a profit without doing any improvements to the house!  Everyone was thinking they had to get in on the action.  That is confidence.

Until a bit of confidence is restored, lowering interest rates is not going to help the economy.  Raising interest rates however would cause people to take out mortgages again.  They might start thinking they should buy now before rates go up again.  Higher rates would get the banks to make loans because they will make more money.  By continuing to increase interest rates, people will begin to believe the economy is doing okay, and they will begin to get back the confidence they need to make large investments in businesses and capital improvements.

Without higher interest rates things are bound to continue the way they are now.

Thanks for reading.  You can reach me on twitter @iammrmarshall.

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Would higher interest rates help the economy?