Rates: When Zero Is Way Too High

Can an interest rate of zero be too high? Unfortunately, yes. A new analysis by Goldman Sachs (GS) concludes that the Federal Reserve's cut in the federal funds rate to a record low of zero to 0.25% on Dec. 16 isn't going to be nearly enough to get the economy going again. The report says the Fed would need to reduce the federal funds rate to negative 6% by the end of 2010 to supply the needed amount of monetary stimulus.

The arrival of the economic recession can be postponed if additional loans unbacked by real saving are granted at an ever-increasing rate, i.e., if credit expansion reaches a speed at which economic agents cannot completely anticipate it. The procedure consists of administering additional doses of bank credit to the companies which have launched new investment projects and have widened and lengthened the stages in the production process. This new credit may defer the six phenomena we explained in chapter 5, which always tend to spontaneously reverse the initial consequences of all credit expansion in the market. However, while this procedure may postpone the depression, and may even do so for relatively long periods of time, this strategy is condemned to inevitable failure and involves a huge additional cost: once the recession hits, it will be much deeper and much more painful and prolonged.The success of this strategy of postponing the crisis through additional loans hinges on a continuously-growing rate of credit expansion. Hayek already revealed this principle in 1934 when he stated: "In order to bring about constant additions to capital, [credit] would have to . . . increase at a constantly increasing rate." The need for this ever-escalating increase in the rate of credit expansion rests on the fact that in each time period the rate must exceed the rise in the price of consumer goods, a rise which results from the greater monetary demand for these goods following the jump in the nominal income of the original factors of production. Therefore given that a large portion of the new income received by owners of the original means of production originates directly from credit expansion, this expansion must progressively intensify so that the price of the factors of production is always ahead of the price of consumer goods. The moment this ceases to be true, the six microeconomic processes which reverse the changes made to the productive structure, shortening and flattening it, are spontaneously set in motion and the crisis and economic recession irrevocably hit.In any case credit expansion must accelerate at a rate which does not permit economic agents to adequately predict it, since if these agents begin to correctly anticipate rate increases, the six phenomena we are familiar with will be triggered. Indeed if expectations of inflation spread, the prices of consumer goods will soon begin to rise even faster than the prices of the factors of production. Moreover market interest rates will soar, even while credit expansion continues to intensify (given that the expectations of inflation and of growth in the interest rate will immediately be reflected in its market value).Hence the strategy of increasing credit expansion in order to postpone the crisis cannot be indefinitely pursued, and sooner or later the crisis will be provoked by any of the following three factors, which will also give rise to the recession:A) The rate at which credit expansion accelerates either slows down or stops, due to the fear, experienced by bankers and economic authorities, that a crisis will erupt and that the subsequent depression may be even more acute if inflation continues to mount. The moment credit expansion ceases to increase at a growing rate, begins to increase at a steady rate, or is completely halted, the six microeconomic processes which lead to the crisis and the readjustment of the productive structure are set in motion. Credit expansion is maintained at a rate of growth which, nevertheless, does not accelerate fast enough to prevent the effects of reversion in each time period. In this case, despite continual increases in the money supply in the shape of loans, the six effects described will inevitably develop. Thus the crisis and economic recession will hit. There will be a sharp rise in the prices of consumer goods; simultaneous inflation and crisis; depression; and hence, high rates of unemployment. To the great surprise of Keynesian theorists, the western world has already experienced such circumstances and did so both in the inflationary depression of the late 1970s and, to a lesser extent, in the economic recession of the early 1990s. The descriptive term used to refer to them is stagflation.Hayek revealed that the increasing speed at which the rise in the monetary income of the factors of production pushes up the demand for consumer goods and services ultimately limits the chances that the inevitable eruption of the crisis can be deferred via the subsequent acceleration of credit expansion. Indeed sooner or later a point will be reached at which growth in the prices of consumer goods will actually start to outstrip the increase in the monetary income of the original factors, even though this may only be due to the emergence of a slowdown in the arrival of consumer goods and services to the market, as a result of the "bottlenecks" caused by the attempt to make society's productive structure more capitalintensive. Beginning at that point, the income generated by the factors of production, specifically wages, will begin to decline in relative terms, and therefore entrepreneurs will find it advantageous to substitute labor (now relatively cheaper) for machinery, and the "Ricardo Effect" will enter into action, hindering the projects of investment in capital-intensive goods, and thus ensuring the outbreak of the recession.C) Finally let us suppose that the banking system at no time reduces the rate at which it accelerates credit expansion, and instead does just the opposite: it constantly and progressively intensifies it, with the purpose of quashing any symptom of an emerging depression. In this case, the moment economic agents begin to realize that the rate of inflation is certain to continue growing, a widespread flight toward real values will commence, along with an astronomical jump in the prices of goods and services, and finally, the collapse of the monetary system, an event which will ensue when the hyperinflation process destroys the purchasing power of the monetary unit and economic agents spontaneously start to use another type of money. At that point the six microeconomic reversion effects we are familiar with will appear in all of their intensity, as will an acute economic depression, which to the painful readjustment of a totally distorted productive system will add the tremendous cost and social harm involved in any general failure of the monetary system.