Economic Growth Requires More Than Low Interest Rates

Many commentators and economic experts are of the view that the Federal Reserve is running out of tools to keep the economy going given the very low level of interest rates. It is also argued that despite a steep downtrend in the policy rate since 1980, the underlying growth of the US economy has been following a down trend.

This must be contrasted with the previous period when the underlying trend in the federal funds rate was heading up while the underlying growth of economic activity followed a rising trend.

Why Is Economic Growth Slowing?

Many experts are of the view that the key reason behind subdued economic growth notwithstanding low interest rates is a decline in the population growth and the lack of sufficient technological innovations. It is held that slower population growth coupled with a lower speed of technological progress undermines economic expansion.

A slower pace of new inventions weakens investment in the infrastructure, which in turn also undermines economic growth, so it is held. In addition to slower population growth, experts also attribute the decline in the trend growth of economic activity to subdued productivity.

This decline in turn is explained by the slowdown in innovations and investment in the infrastructure.

The main question which has puzzled all economists is why has there been a downtrend in investment growth given the decline in interest rates? Most experts are silent on this. Some of them have argued that the downtrend in interest rates is on account of subdued economic growth, which prompted the central bank to lower interest rates.

Other experts have embraced the view that the downtrend in economic growth is on account of long-term factors that pushes the economy onto a declining path of economic growth.

The problem here is not of a cyclical nature but rather of a secular trend, which cannot be handled by monetary policy, so it is held. Hence it is advocated that the solution should come from a more aggressive fiscal policy, which could lift the underlying economic growth trend by boosting investment in the infrastructure, which in turn will give boost to more innovations etc.

Given the seemingly positive correlation between low interest rates and low economic growth some commentators have also questioned the validity of the Austrian Business Cycle Theory.

After all why hasn’t the low interest rate policy of the Federal Reserve succeeded in reviving economic activity as the Austrian school implies? Furthermore, during 1960-1979 when interest rates were in an uptrend, investment trend growth was also heading up, i.e. contrary to what the Austrian theory would suggest, so it is held.

Economic Growth Requires more Than Just Low Interest Rates

Even if we were to ignore the measurement problems of various macro economic data that popular economics is employing, the Austrian business cycle theory is not only about the mechanical manipulation of rates by the central bank that cause boom–bust economic cycles.

It is about the overall monetary policy of the central bank and its effect on money supply growth and interest rates. Furthermore, the theory pays attention to the damage that loose monetary policy does to the process of wealth formation and to the pool of real wealth.

A keyconcept in wealth formation is that production must precede consumption. It is necessary to produce useful goods that can be exchanged for other useful goods.

When a baker produces bread, he doesn’t produce everything for his own consumption. Most of the bread he produces is exchanged for the goods and services of other producers, implying that through the production of bread the baker exercises his demand for other goods.

To put it differently, his demand is fully covered (i.e., funded by the bread that he has produced).

Demand Depends on Production

Demand therefore, cannot stand by itself and be independent; it is limited by prior production, which serves as a means of securing various goods and services.

What thwarts individuals’ demand for goods and services, is the availability of means at their disposal to appropriate all the goods and services individuals want. These means however do not spring “out of thin air.” They have to be produced.

The production of goods and services is constrained by the real pool of wealth: the final goods available to provide sustenance to the economic process. The pool of wealth is the quantity of final goods available in an economy to support future production. If it requires one year of work for a man to build a tool, but he has only enough apples saved to sustain him for one month, then the tool will not be built-and the man will not be able to increase his productivity.1

The Role of Money in the Market Economy

In a market economy, money has just one role — to provide the services of a medium of exchange. Money permits the product of one specialist to be exchanged for the product of another specialist.

The exchange of something for something also means that consumption doesn’t precede production. That is, we first have to produce a useful product before it can be exchanged for money and only then we could exchange money for goods we desire. Consumption is fully funded by preceding production.

The Effects of Easy Money

On account of loose monetary policy and the subsequent increase in the money supply, the process of wealth transferring from wealth generators to the holders of the newly created money is set in motion. Since this new money was generated