Monetary policy is about more than just inflation, and as hard as it is to normalise rates it will be worth it.
Most western economies started to raise interest rates about 18 months ago. The effort to bring down inflation is proceeding unevenly and often too slow for many. However, interest rates are more than the premier tool for bringing down inflation, it’s one of the main rules for the economy the state can use to implement economic policy. It’s easy to find reasons to be pessimistic about high interest rates; anyone with a variable rate mortgage will know what I mean. But it is also positive. Capitalism can’t function properly if interest rates are zero.
I wrote about monetary policy often in the early years of the blog and I think it’s time to return to the topic now that things have changed. Since the 1980’s western economies have become increasingly financialised, meaning that finance has become a larger and larger part of the economy. This process has been driven by two factors, first it has been driven by globalisation. In a globalised world where barriers to trade are low, it makes sense to specialise. In richer parts of the world with a lot of capital and a lot of well-educated white collar professionals finance is a high margin niche to specialise in. Finance is also necessary to develop economies as more efficient production requires capital investment, which can be expensive. Secondly, the west has broadly deregulated finance since the supply side revolution of Thatcher and Reagan and their imitators. With less rules financial firms have been able to be more creative in their pursuit of profit and have thus created a bevy of new financial products for speculation and risk management. As new innovations become available on the market firms and individuals have more options, but relying on those options create new dependencies on the financial system.
Private equity is a good case study. After the invention of the junk bond in the 80’s private equity became an increasingly used fund strategy. The most common manoeuvre in private equity is the leveraged buyout, whereby a company is bought using a high share of borrowed money compared to invested money. Often the revenue the acquired company generates is used to pay the costs of the loans used to finance the acquisition until the company can be sold on the stock market or to another buyer. When interest rates are low, a leveraged buyout is a cheap way to take over a company, but when rates are high that strategy becomes increasingly risky. On the level of a single company financialisaton is not a big deal, but on the scale of an entire economy it can result in a drastic increase in exposure to interest rate risk as companies which have been the target of a leveraged buyout is exposed to the risk to its core business higher interest rates could pose, and the risk of not being able to pay their new debts. This exposure spreads through the economy when a company goes under due to high interest rates can’t pay its suppliers and when it has to let its workers go.
I bring all this up to say that very low and negative interest rates encourage what I call the valuation economy, a system where one of the most profitable business models was to chase high valuations on the financial markets. High interest rates kill that business model, and while it can be painful to transition from one economic environment to another it is necessary. It’s important to see that interest hikes are not just a way to combat inflation, but also a necessary reform to how western economies work. Normalisation will mean more productive economies which produce useful products and services and less unprofitable high valuation tech companies. That’s just as important as bringing down inflation.
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I've always been interested in politics, economics, and the interplay between. The blog is a place for me to explore different ideas and concepts relating to economics or politics, be that national or international. The goal for the blog is to make you think; to provide new perspectives.
Written by Karl Johansson
Cover photo by Karolina Grabowska from Pexels, edited by Karl Johansson
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