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For example, in the UK, after the Brexit vote, the Bank of England decided to lower reserve interest rates to 0.25%. This, as I understand it, has the knock on effect of lowering the interest rates of loans. If a government wants to borrow to fund particular investments, such as renewable energy, a new bridge, trains, etc, it would cost them less under the new, lower interest rate. So my question is, why aren't low interest rates the standard strategy for a government? Surely they would always want to borrow at cheaper prices?

I can think of a few reasons but I'm not really sure if they're correct.

  1. Savers would get annoyed and move their money to another currency.
  2. Ideological positions (neoliberalism/austerity instead of Keynesian economics)

Seems like I'm missing something obvious here..

Cheers!

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What stops governments from partnering with their central banks to lower interest rates? Central banks in most countries are independent. It means that the governor of the central bank decides the monetary policy according to his/her mandate. This mandate is usually to keep a check on inflation and in some countries to lower unemployment rate. If the central bank lowers interest rates then due to the "knock on" effect you mentioned credit becomes available at lower rates which exerts inflationary pressure on the economy. If the mandate of the central bank is to keep inflation low then the central bank ensures that interest rates are not lower than what is required to keep inflation in check.

However, in some countries central banks are not independent. In those cases, the government can partner with the central bank to lower interest rate and borrow from the central bank at low rates to fund government spending. This is usually a bad idea because it can cause hyperinflation. When the government wants to borrow big amounts (which is mostly the case) from the central bank it usually means that the central bank will have to generate more currency and then lend it to the government. This is expansionary monetary policy, which increases the cash flow in the economy and exerts inflationary pressure. Secondly, when the government spends the money that it borrowed it increases aggregate demand. This is expansionary fiscal policy, which is inflationary too. Both of these in conjunction can cause hyperinflation (like it happened in Zimbabwe).

When it comes to government borrowing, borrowing from foreign entities or issuing short- or long-term government bonds are better strategies than borrowing from the central bank.

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  • $\begingroup$ But many central banks already increase the money supply through quantitative easing. The difference is that instead of the money going to fund government projects, it goes into private bank reserves. So the money is still in the system either way but in one case it is more efficiently used and in the other it goes towards speculation. So I'm not sure I understand why speculation is preferable to inflation? $\endgroup$ – Durand Sep 8 '16 at 1:59
  • $\begingroup$ Printing money for quantitative easing and printing money to fund government projects are two different things. They have different effects on the economy. I will leave it to you to figure out why they have different effects since it is not directly relevant to the original question. One important implication, however, is that printing money to fund government projects undermines the independent relationship between the central bank and the government. This is not desirable for the reasons discussed above. $\endgroup$ – The Kaykay Sep 8 '16 at 4:27
  • $\begingroup$ So ultimately, the reason is the scare of hyperinflation... okay. I did not mean to imply that QE and printing to fund government projects are the same thing but anyway. Thanks for the answer. $\endgroup$ – Durand Sep 8 '16 at 14:24
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Bank of England decided to lower reserve interest rates to 0.25%.

This means the central bank wants to reduce the interest paid on reserved stash, discourage bankers parking too much money in central bank.

With smaller return from central bank interest rate, this is just a policies that central bank hope the bank will use the money to invest or buy bonds.

In short, this has nothing to do with borrowing rates.


Long story Most country central bank enact rules that require banker to deposit some reserved, which the stash can be used when one of the banker face a sudden surge of withdrawal,etc. It is just a measurement to prevent banker gone rogue, loan too much money to borrower than a safety threshold. But money in this reserved are "unproductive", thus most central bank will give some interest return.

However, in high risk condition or common rent seeking situation , bankers might do the opposite, they park more money in central bank to earn some dime, when the bond or other money making tools just too expensive or risky to them.


The speculation follow by the question are mostly flaw, perhaps IMHO, those are fallacy impost by media.

In real life. 1. i. Moving money is costly ii. it is difficult to find a safe haven that is cheap. 2. In fact, the move is just pragmatic (Beware that pragmatic doesn't mean it is logical or good decision)


And to OP question title : What stops a government in partnership with its central bank from lowering interest rates and then borrowing at this lower rate to fund investments?

  1. Interest rates DOESN'T SOLVE the problem of money supplies.
  2. Central bank only control money supplies, it doesn't do the "borrowing"
  3. Government borrow money by printing bonds. HOWEVER, if too much bonds are printed and too much money are used to buy the bonds, it will affect liquadation of money. So there is always some "money printing" (AKA inflation) action follows.
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  • $\begingroup$ Thanks for your answer. Over time, I think I discovered the answer I was looking for, which is that if the interest rates are too low when inflation is high, people will end up investing in things like housing, which creates a housing bubble that will eventually burst. $\endgroup$ – Durand Nov 25 '16 at 5:05
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The Bank of England lowering interest rates was a signal that the UK economic outlook over the next few years is weaker because of Brexit - the deflationary pressures have increased.

That also indicates that there's less yield to be had from Sterling investments.

Those same forces that led the Bank to lower its interest rate, and restart its programme of quantitative easing, have increased the value of any ultra-low risk Sterling yield. Such as gilts.

So it's not the case that lowering the Central Bank rate has directly made government borrowing cheaper. But rather, the same forces that led to the rate reduction, have also increased the value of gilts, and thus reduced their yield. Their yield is the rate the government can borrow at, to fund investments.

The government isn't borrowing from the Central Bank to fund investments.

And the infrastructure investment outlook in the UK has got worse, not better, because Brexit means the UK will (probably) no longer have access to cheap loans from the European Investment Bank, nor other EU infrastructure funds.

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  • $\begingroup$ Yes, I do understand that it is an indirect effect but the effect is still there and it makes sense in my mind for the government to take advantage of it to help the country. "The government isn't borrowing from the Central Bank to fund investments." Is this not true? I thought that post-Brexit, the central bank would green light public infrastructure investments by writing off government debt of those projects. That is effectively the government borrowing from the central bank. $\endgroup$ – Durand Sep 8 '16 at 2:03
  • $\begingroup$ No, that's not true. $\endgroup$ – EnergyNumbers Sep 8 '16 at 9:02

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