If interest rates rise………….

For almost ten years, interest rates have been remarkably low and even on occasion negative (in Japan). Central banks have deliberately kept them low, while expanding the supply of money (quantitative easing), as a means of allowing the global economy to recover from the 2008 financial shock.

But the era of “cheap money” (remember to consider interest rates as being both the cost of borrowing and the price of money) will probably end this year. The US economy, in particular, seems to be in an inflationary gap with an unemployment rate of only 4.1%, which could be below its natural rate of unemployment.  And, in countries such as Britain, inflation is already above the Bank of England’s target of 2%.

Consequently, the Federal Reserve (the US central bank) and some other central banks (but not the European Central Bank nor the Bank of Japan),  will want to raise interest rates soon and significantly in order to deter borrowing for investment and consumer expenditure for large-ticket items (such as cars) which are bought on credit. This would shift aggregate demand to the left.

Without low interest rates, speculators and dealers in shares and property cannot borrow cheaply to continue purchasing these assets whose prices have risen faster than wages in recent years.  More seriously, for the real economy, some firms which have relied on low borrowing costs to keep going may go bust should their bank raise loan rates.

These forebodings are the main reason for the volatility of share prices in the last week. The large drops are also partly due to the inevitable and necessary correction to a speculative bubble,  which has also been observed in bitcoin dealings. It is however unfortunate that the side-effects of such gambling in assets impact the real economy, in terms of investment in capital and employment rates.

JM Keynes observed that stock markets are just casinos but “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done”.

 

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