Who “Killed” the Economy?

When it comes to forecasting the ebbs and flows of the business cycles, few mainstream economists today bother to look past their models for alternative theories that do a far better job of predicting important turning points in the broad economy. The recent and completely backwards statement by CIBC economist Benjamin Tal is a perfect example of this widespread refusal to abandon such deeply entrenched yet erroneous dogma. On the possibility of future interest rate hikes by the Bank of Canada to a mere three percent, Tal states:

I suggest three per cent may be way too high given where we are in the economy, given the demographic story, given productivity and many other reasons. My fear is that we’re chasing something that’s in the air, and it might actually impact real life. Because every economic recession was helped, if not caused, by monetary policy error in which central bankers were chasing inflation that was not there, took interest rates much too high and killed the economy.

Tal is correct about one thing, of course – the next recession will almost certainly be caused by the Bank of Canada, but not for the reason he thinks. What Keynesian economists often fail to grasp is that the Bank of Canada has in fact already set in motion an inevitable and severe economic contraction through the easy money policies that came about as a consequence of the 2008 financial crisis. Far from being the harbinger of economic crisis, it is not the raising of interest rates that will spell the death knell for the broad economy, but the lowering of interest rates that preceded it.

When interest rates are driven artificially lower by Central Banks such that they no longer represent the actual stock of available savings in the economy, businesses are erroneously led to borrow and invest to expand production based on an economic calculation grounded in unsustainably cheap money. Businesses thus collectively make a rash of poor investment decisions which temporarily leads to a boom in the economy as the newly created money resulting from credit expansion bids up prices for labor, raw material, land, and other factors of production. But this increase in prices is only sustainable through continuous money printing, for once the new money circulates throughout the economy and has at last been spent by the original borrower, other businesses will soon find that the price of their goods have been bid up in an unsustainable manner.

Low interest rates make otherwise unprofitable investment seem profitable, causing widespread mal-investment that can only be sustained through continuously low interest rates. Whether the Bank of Canada chooses to raise rates sooner or later is immaterial to the fact that the mal-investment has already been made based on an incorrect reading of consumer preferences for savings versus consumption. The mal-investment must at some point be liquidated, since it is based on demand that does not exist. Central Bank inflation does not create additional demand for new businesses, it only creates new money.

The presence of continually low interest rates serves only to hide the fact that capital has already been grossly misallocated during the prior economic boom. Holding rates artificially low merely delays the inevitable liquidation event and prevents economic resources from being re-allocated to their proper proportions in a manner where they can be most efficiently employed. It is not the raising of interest rates that “kills the economy”, but the lowering of interest rates that had previously occurred. The economy has in fact already been “killed”, but economists like Tal have simply yet to realize it.

The challenge with debunking economic fallacies such as the one repeated by Tal above is that he is ultimately correct in that the raising of interest rates and the corresponding reduction in money supply growth will stop the unsustainable economic boom dead in its tracks. It is precisely because the painful withdrawal from low interest rates will be acutely felt everywhere and immediately by society at large that mainstream economists are easily able to lay blame at the feet of the Bank of Canada and their increasingly restrictive monetary policies as the ultimate cause of the recession. Government economists will of course fail to trace the origin of the recession back to its root cause of excessive money supply growth via low interest rate stimulus, and they will almost certainly be blind to the fact that the raising of interest rates is merely the removal of artificial government-induced mal-investment incurred during the preceding economic boom.

Interest rates, of course, are meant to represent the cost to individuals and businesses of acquiring accumulated savings for the purpose of investment. The artificial low rates of today send false economic signals to businesses that individuals collectively have accumulated an abundance of savings available for loan when in fact quite the opposite is true. Like any other good or service, a lower price (the interest rate) implies an increasing supply (of savings), and yet no one today would suggest that today’s rock-bottom interest rate denotes a condition of present day under-consumption and savings on the part of society.

So Tal, it turns out, is superficially correct but also hopelessly misguided when he states that recessions are caused by Central Banks moving too early in raising interest rates which irreparably harms the economy. Quite the contrary – by maintaining interest rates below what would otherwise be dictated by the free market, the Bank of Canada has engaged in a form of price-fixing of the worst kind. It is this price-fixing of the cost of capital that has led the economy to its ultimate crisis, not the necessary raising of the interest rate back to a natural state reflecting the actual level of savings available in the broad economy. Allowing interest rates to rise is merely the removal of a price-fixing scheme that has caused a gross misallocation of capital while giving the appearance of an economic boom.

The return to a more rational pricing of savings and capital in accordance with actual consumer preferences of savings and consumption is both necessary and natural. And yet like Tal, not one in a hundred Keynesian economists will recognize this basic fundamental elementary truth. They will continue to spread their fallacies and inaccuracies ad nauseam, inevitably leading to renewed cries for the Bank of Canada to once again reduce interest rates back to rock-bottom levels once the impending economic recession finally takes hold. It is a tragic mistake with systemic consequences, for it continually mistakes the disease for the cure and will over time do exactly what Tal and his ilk have warned so persistently against since the Bank of Canada began its rate-hiking campaign to stamp out perceived inflation. In their attempts to maintain perpetually low interest rates to prevent the Bank of Canada from “killing” the economic patient, they will ironically and tragically have done exactly that.