The Fallacy That Rate Cuts Can Save the Economy

-Just as price controls disrupt the balance of supply and demand

-Artificial interest rate cuts lead to investment errors

-The proper path to growth is tax cuts and deregulation

In the third quarter of this year, Korea’s gross domestic product (GDP) growth rate was 0.1% quarter-on-quarter, far below the Bank of Korea’s forecast. It now appears difficult to achieve the government’s projected growth rate of 2.6% for this year. Next year’s economic growth rate is expected to be even lower than this year’s. As a result, many experts and politicians are calling on the Bank of Korea to cut interest rates to spur economic growth, with some even arguing that the Bank of Korea missed the proper timing for a rate cut. This seems to stem from the belief that, since the central bank is the source of interest rate decisions, it can revive the economy by manipulating rates.

However, the fundamental determinant of interest rates is not the central bank, but people’s time preference, which is inherent in human nature. Time preference refers to the tendency to prefer consumption in the present rather than in the distant future, assuming the same good is involved. Therefore, for the same good, its future value must be greater than its present value. Only then will people postpone present consumption for the sake of future consumption. This is precisely where interest arises. In other words, interest is the difference between the value of future goods and the value of present goods.

Time preference, however, differs from person to person. Some people have relatively high time preference, placing greater value on present consumption, while others have relatively low time preference, placing greater value on future consumption. Those with relatively weak time preference save, that is, supply loanable funds, for future consumption, while those with relatively strong time preference borrow, that is, demand loanable funds, for present consumption. Interest rates are determined through the interaction of these groups.

When people’s time preference changes and savings increase, interest rates fall. A decline in interest rates of this kind signals to entrepreneurs that consumers intend to consume more in the future rather than in the present. In response, entrepreneurs increase investment in more capital goods or new capital goods in order to produce more goods for future consumption. Through this process, savings and investment, as well as present goods and future goods, come into balance, and the increase in goods and services available for future consumption raises welfare and enables the economy to grow steadily.

A central bank’s interest rate cut distorts the signals that interest rates send to entrepreneurs and consumers. Because of the central bank’s policy of supplying cheap credit, investments previously judged unprofitable suddenly appear capable of generating profits, leading entrepreneurs to make mistaken investment decisions. Meanwhile, lower interest rates reduce people’s incentive to save, causing consumption to rise. Investment and consumption both increase, and the economy enters a boom. But such a boom is only temporary. As time passes and the future arrives, production rises because of increased investment, but because savings have not increased, demand for those goods proves insufficient, and unsold goods pile up. In addition, the increase in the money supply released through rate cuts pushes up prices. As prices rise, the central bank raises interest rates to contain inflation. With produced goods going unsold and financing costs rising, firms that made mistaken investments go bankrupt, and a downturn follows.

Artificial interest rate cuts are no different from price controls on goods. Just as price controls disrupt the balance between the supply of and demand for goods and create market distortions, artificial interest rate cuts disrupt the balance between present goods and future goods, bringing about a temporary boom followed by a bust. That is why the 2008 global financial crisis, the stagflation of the 1970s, and the Great Depression of the 1930s all occurred.

Moreover, a prolonged low-interest-rate policy does not revive the economy; rather, it hinders economic growth. That is because it induces mistaken investments and continually wastes valuable resources. Japan’s case clearly shows that cutting interest rates cannot rescue an economy. Japan has adhered to a low-interest-rate policy for more than 30 years. Yet it still has not escaped low growth and has experienced its “lost 30 years.”

The economy can continue to grow only when real savings increase and firms and entrepreneurs produce more and better goods and services. If the government truly wants to grow the economy and improve people’s lives, it is important to encourage greater saving and create an environment in which firms and entrepreneurs can operate dynamically. It should lower income taxes, corporate taxes, inheritance taxes, and the like, and ease regulations on firms and entrepreneurs. Only then will people’s real income rise, savings increase, and firms’ investment and innovation become more active, allowing the economy to continue growing. This is also the path for weathering the turbulence that a “second Trump administration” may bring. The idea that central bank rate cuts can revive the economy is an illusion.

Jaewook Ahn, Chairman, Center for Free Enterprise (CFE)

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Original title: 금리인하로 경제를 살릴 수 있다는 ‘착각의 경제학’

Author: Jae-wook Ahn

Date: 2024-11-24

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=press&idx=27115