The unseen side effects

There is a war going on against savers. The business press is questioning Raghuram Rajan for not cutting rates further. Arun Jaitley is claiming interest rates are too high and this will hamper economic growth. Let's examine the relationship between interest rates and economic growth and determine for ourselves if this is indeed the case.

Anil borrows ₹50,000 from Brijesh for three years and agrees to pay 10% interest. Anil uses this money to buy an autorickshaw, pays Brijesh his interest of ₹5000 each year and returns the entire amount in 3 years. While the loan enabled Anil to buy the autorickshaw, it did not produce the autorickshaw. Anil driving the autorickshaw benefited his passengers, contributing to economic growth. Brijesh enjoyed the fruits of his interest income, contributing to economic growth.

Now, suppose the government mandates that the interest rate should be 8% instead of 10%. Anil ends up paying ₹3000 less in interest overall and is quite happy. Brijesh, on the other hand, has lost ₹3000 of income, leaving him worse off.

At the lower rate, there is a greater demand for loans. Companies borrow more money, spend on new capital equipment, hire more workers and increase production. It appears that the lowering of interest rates worked, since the economy is booming. That is all that is seen.

But there is something that we don't see. The reduced income of savers means they change their spending habits. The companies which would have benefited from the savers having higher income are now worse off. They halt their expansion plans, lay off workers, decrease production. Furthermore, some savers, unhappy with the lower interest rate, decide to take their capital elsewhere.

Hence, while it appears that lowering interest rates creates economic growth, all it does is favour some companies at the expense of others. This makes intuitive sense, since loans don't create new machinery or new autorickshaws; they merely facilitate their purchase. Money is not capital, it is just the means used to make transactions possible in an advanced economy.

Takeaway #1: Lowering interest rates transfers wealth from savers to debtors
Takeaway #2: Lowering interest rates benefits some companies at the expense of others
Takeaway #3: Lowering interest rates leads to capital flight

If lending more money at lower interest rates were all it took to create economic growth, Venezuela and Zimbabwe wouldn't have had their economic crises.

Parting thought
"The bad economist sees only what immediately strikes the eye; the good economist also looks beyond. The bad economist sees only the direct consequences of a proposed course; the good economist looks also at the longer and indirect consequences. The bad economist sees only what the effect of a given policy has been or will be on one particular group; the good economist inquires also what the effect of the policy will be on all groups." - Henry Hazlitt, Economics in One Lesson.