The conventional wisdom is that aggregate demand (AD) is best regulated by adjusting interest rates - or at least that interest rates should be one of the main tools used to regulate demand.
I set out numerous criticisms of this policy here. And Prof.R.A.Werner and others set out yet more reasons and evidence here.
Prior to the crunch, people were betting big time on house price increases, and borrowing big time so as to fund those bets.
In a genuine free market, that increased demand for borrowed funds would have caused a significant rise in interest rates. But we don’t have a free market: interest rates are rigged because the conventional wisdom is that central banks know better than the market (ho ho).
And prior to the crunch, demand and inflation were not going thru the roof, so central banks did not raise interest rates to any significant extent.
So what was the result of this “central banks know best” policy? Well borrowing continued unabated because private banks can and will create money out of thin air and lend it out, just as long as they see what looks like good collateral (like rising property prices).
The Werner regime.
In contrast, Werner & Co advocate a regime in which private banks CANNOT create money out of thin air and lend it out, and in which the government / central bank machine DOES NOT use interest rates to control demand. Instead, demand is controlled in a much more obvious, simple and straightforward way: the government / central bank machine (in a recession) just prints new money and spends it. Conversely, if inflation looms, taxes are raised and money is “unprinted”.
Incidentally Modern Monetary Theory also advocates the latter sort of policy. Great minds think alike.
Thus under a “Werner regime”, market forces prior the crunch would have raised interest rates, which would have choked off house price increases. Incidentally the “choking off” would probably have come from a QUANTITATIVE effect as well as a PRICE effect. That is, the sheer unavailability of funds to borrow might have played as big a role as interest rate increases.
Another incidental point here is that my use of the phrase “Werner regime” should not be taken to suggest that Werner himself would agree with everything in this article – though I hope he would.
The false logic behind using interest rates to adjust demand is a beautiful illustration of failure to abide by the Tinbergen principle.
This principle (or at least my interpretation of it) is thus.
1. For each policy objective, one policy instrument, and one only is needed.
2. The policy instrument chosen for each objective should be the one that most effectively influences that objective.
To illustrate, trying to pitch demand at a level that maximises employment without exacerbating inflation too much is an “objective” which no one can object to.
In the case of adjusting demand, there are basically two sources of demand in any economy. First, the public sector (demand for personnel and equipment for the state education system, the police and armed services, etc). And the second basic source of demand is the consumer.
Thus if it looks like demand needs a boost, the logical and simplest course of action is to boost public spending and put more spending power into the hands of the consumer.
AS TO INTEREST RATES, the optimum level of interest is the level at which the marginal benefit from borrowing equals the marginal “dis-benefit” or pain derived from forgoing consumption required to make funds available for borrowing. And there is NO PRIMA FACIE REASON for thinking that the optimum interest rate varies as between a boom and a recession (though there may be minor technical reasons for a small variation). That is, there is no prima facie reason to cut interest rates in a recession.
Tinbergen, car engines and brakes.
When it comes to cars, a valid objective is making the car move. The best policy instrument there is an engine. Another valid objective is slowing the car down in a hurry. The best policy instrument is brakes.
You could of course control a car’s speed by having the engine working constantly at full power while using the brakes to control the car’s speed: not a brilliant use of policy instruments.
Put another way, using interest rates to adjust demand leads to the absurdity spelled out in blue at the top right above.