If you have been following the news on TV, then you know that the Fed increased the Fed discount rate by about 0.25% recently, but it appears that they are going to hold at this level for a while. I bet that 99% of voters have no idea what all this means and I would also bet that most people who have taken University economics don't either. That is the point of this blog.
It is accepted by, so called, economists that if you reduce the discount rate that the Fed charges banks that it will stimulate the economy. This is like the holy grail of modern economics, but how many of the believers ever really thought thru the idea themselves? My guess is zero!
Think of it this way. The discount rate is like the steering wheel on a car. You can turn it to the right or the left, but you can't just turn it one way if you ever expect to do anything but turn in a circle. If you turn it one way, sooner or later you are going to have to turn it back the other way.
Years ago, I administered a multimillion dollar capital budget for a major corporation. We had a lot of money to invest, but it was not unlimited. For that reason, it was my job to see that only the "best" projects were funded. Believe it or not, but it was not that difficult to do. These capital projects were actually simple investments. I started by giving the OK to those that had the highest rate of return and then went down the list to those with lower rates of return until I was out of money. Simple right?
Here is how the Fed thing works. When the discount rate is high, the banks have to charge more for a loan. When the rate is low, they charge less interest. With me so far? Lets say that we have been in a period where the discount rate and the bank interest rates were high. If you were to look around at where the money was being invested, it would be in high quality projects that yielded a good pay back. If we get personal, if the interest rates were high, you would buy a cheaper car or home, but if the interest rates were low, you would be more inclined to buy a more expensive car or home. Are you following that?
Now, if the Fed wants you to buy more and more expensive homes, what do you think they would do? They would lower interest rates! The problem is that some day, the interest rate have to get back to normal and how do they do that and what impact will that have. It is a little like riding your bike down hill. Going down is great, but getting back up the hill is hell. Why is it that you never hear an economist explaining how they are going to get interest rates back up to normal?
Here is what happens. When interest rates were going down, we added all kind of poor or worthless projects which people thought were great, but on the way back up with interest rates, these project had to be scrapped or bankrupt. Isn't this exactly what happened with the big economic bust 10 years ago? The government bailed out businesses who made bad investments when money was cheap and when money got more expensive, these investments failed. What else would you have expected.
The lesson here is, "if you chose to dig a hole, you had better think about how you are going to get out of that hole". It is a lot harder to go up hill than it is to go down. Think about it!
PS---There are at least two basic kinds of businesses. First, ones that are limited by capital and ones that is limited by intellect or skill. An example of the first is a Frosty Stand. The cheaper the Frosty equipment the easier it is to get into the business and make money selling frostys. As interest rates approach zero, the cost of the Frosty machine also approaches zero. The other side is that the more expensive the Frosty machine is the fewer people there are who will be able to enter the Frosty business. In the intellect or skill category, singing a song would be a good example. You don't need any money to write or sing a great song, but you do need the intellect or skill "which are limited " by Darwin. Our problem is that we have run out of business that just need funding. Now, most new businesses are based on intellect or skill and that is limited and to get more of those kinds of businesses, we have to pay more. That is why ;people with intellect and skill are earning much more than people who run Frosty stands.
It is accepted by, so called, economists that if you reduce the discount rate that the Fed charges banks that it will stimulate the economy. This is like the holy grail of modern economics, but how many of the believers ever really thought thru the idea themselves? My guess is zero!
Think of it this way. The discount rate is like the steering wheel on a car. You can turn it to the right or the left, but you can't just turn it one way if you ever expect to do anything but turn in a circle. If you turn it one way, sooner or later you are going to have to turn it back the other way.
Years ago, I administered a multimillion dollar capital budget for a major corporation. We had a lot of money to invest, but it was not unlimited. For that reason, it was my job to see that only the "best" projects were funded. Believe it or not, but it was not that difficult to do. These capital projects were actually simple investments. I started by giving the OK to those that had the highest rate of return and then went down the list to those with lower rates of return until I was out of money. Simple right?
Here is how the Fed thing works. When the discount rate is high, the banks have to charge more for a loan. When the rate is low, they charge less interest. With me so far? Lets say that we have been in a period where the discount rate and the bank interest rates were high. If you were to look around at where the money was being invested, it would be in high quality projects that yielded a good pay back. If we get personal, if the interest rates were high, you would buy a cheaper car or home, but if the interest rates were low, you would be more inclined to buy a more expensive car or home. Are you following that?
Now, if the Fed wants you to buy more and more expensive homes, what do you think they would do? They would lower interest rates! The problem is that some day, the interest rate have to get back to normal and how do they do that and what impact will that have. It is a little like riding your bike down hill. Going down is great, but getting back up the hill is hell. Why is it that you never hear an economist explaining how they are going to get interest rates back up to normal?
Here is what happens. When interest rates were going down, we added all kind of poor or worthless projects which people thought were great, but on the way back up with interest rates, these project had to be scrapped or bankrupt. Isn't this exactly what happened with the big economic bust 10 years ago? The government bailed out businesses who made bad investments when money was cheap and when money got more expensive, these investments failed. What else would you have expected.
The lesson here is, "if you chose to dig a hole, you had better think about how you are going to get out of that hole". It is a lot harder to go up hill than it is to go down. Think about it!
PS---There are at least two basic kinds of businesses. First, ones that are limited by capital and ones that is limited by intellect or skill. An example of the first is a Frosty Stand. The cheaper the Frosty equipment the easier it is to get into the business and make money selling frostys. As interest rates approach zero, the cost of the Frosty machine also approaches zero. The other side is that the more expensive the Frosty machine is the fewer people there are who will be able to enter the Frosty business. In the intellect or skill category, singing a song would be a good example. You don't need any money to write or sing a great song, but you do need the intellect or skill "which are limited " by Darwin. Our problem is that we have run out of business that just need funding. Now, most new businesses are based on intellect or skill and that is limited and to get more of those kinds of businesses, we have to pay more. That is why ;people with intellect and skill are earning much more than people who run Frosty stands.
