An economic idea

Full disclosure: I'm not an economist.

So, with that out of the way, I have an idea (its not really my idea but it doesn't seem to be one that you hear much in the public discourse and this is my effort to promote the discussion) for helping improve the economy.

The idea?

Raise interest rates.

"What?!" I hear you ask. "How could you possibly suggest the government raise interest rates during such a slow economy? Doing so will put a huge break on what little credit flow currently exists, thereby killing the economy!"

On the surface that would indeed seem to be the case, but I ask you: why do people lend others money?

Is it altruism or are they motivated by a desire to make money?

I think we can all agree that the vast majority of institutions that lend money (banks for instance) do so as a way of making money through interest payments. The higher the interest rate the more money they can make on the money lent. The lower the interest rate the less money they can make on the money lent.

So if interest rates are kept below 1% (the currently reported prime interest rate [US] is 0.25%) where is the incentive for people to lend money?

If you were to borrow $100,000 at a rate of 0.5% with interest compounded annually over a life time of 5 years would only earn the bank $1,275.80 over the life of the loan. Less than $1,300 over five years? Why bother?

Currently the 15 year fixed rate for a home mortgage is 3.13% (the 15 year fixed rate during the boom of 1997 was averaging more than 7% by comparison). If you were to try and buy a $250,000 home with 10% down you would need to borrow $225,000. This would earn the bank $57,225.60 over 15 years (or 3,815.04 a year). Hardly a great return on the investment given the current economic climate of mass foreclosures, high unemployment and massive credit contraction on both the home owner and financial sector markets.

There is simply no incentive for people to lend money unless its to the most secure of creditors due to the lack of return given the dramatically low interest rates. The end result is that credit shrinks.

Money is lent in order to make money. Its not done in the name of altruism or a sense of fair play. Its a means of making money and the way that that is done is through interest rates. If the interest rate was raised it would give an incentive for those hoarding money to lend it out to others knowing that they could make a decent return on their investment.

The current interest rates are artificial method being implemented by the government to try and lure people into borrowing money. Great idea, but if one is to borrow money it usually requires that they have a job or enough equity to warrant an investment through debt. The current jobless rate is officially over 9% but more realistically more than 20%. The housing market has crashed and there are hundreds of thousands of home foreclosures still being processed. So the government is trying to lure people into borrowing money that they can't afford regardless of the interest rate, and simultaneously giving creditors no reason to extend credit.

People talk about supply and demand. Okay so lets look at it that way.

If the supply of borrowers exceeds the supply of lenders, then credit is harder to come by and one would expect that they would have to pay a price to gain access to credit: a higher interest rate.

If the supply of lenders exceeds the supply of borrowers, then there would be more credit available and therefore it would be easier to access credit and one would pay a lower price to gain credit: a lower interest rate.

So the low interest rate would suggest that there is massive amounts of credit available but people aren't borrowing. Funny given the massive credit contraction that has taken place over the previous two years. Reality is that credit is shrinking which would suggest that interest rates should rise reflecting the nature of supply and demand and giving creditors an incentive to lend what they do have. But no, the government is keeping the prime rate too low which offers creditors no incentive to lend what they have which furthers the credit contraction.

So, why not raise the interest rates? Give creditors an incentive to put their money out there thereby allowing those with the ability to obtain credit (even at higher rates - say 4%) get it and move the economy forward.

It can't hurt any more than the credit stagnation that the US is currently experiencing.