Let interest rates on housing rise

Sep 25, 2012

This is a repost of a forum post I made today in response to a comment that raising mortgage interest rates to, say, 10% or 15% would be crazy. I'm no economic guru, and I don't pretend to know all the facts, but since being introduced to the whole Austrian school perspective, a lot of confusing things about world economies just make sense to me now. Since then, I've done a lot of reading and still have more information to consume, but here is my response.

Fellow Austrian schoolers, please correct my logic if it is in any way flawed :)

For a century now we have lived within a system driven by the threat of inflation to always be growing and have home prices always increasing. Inflation as we have it today is actually a relatively recent phenomenon in human history, but having lived our entire lives within it, we find it difficult to consider the economy working in any other fashion.

A short history:

Interest rates used to be set by banks individually, and they could charge any rate they wanted. The threshold for opening a bank was low, anyone with some seed money to lend could start one. The existence of many small banks didn't guarantee your money was safe, but the existence of competition kept banks from charging usury. There were still bank panics, and each time many small banks would go out of business, and people would lose their investments. As people rushed to remove currency from the system, interest rates would spike causing a decrease in risky lending and a corresponding increased incentive to save money. In time the economy would pick up again, and the remaining banks would readjust their rates downward to stay competitive and profitable, and cause people to start spending again.

The biggest banks did not like all of these panics. They wanted the government to step in and create steady growth by preventing the wild fluctuations in interest rates which would happen during each panic. If all banks were forced to use one inter-bank lending rate, we would no longer have bank runs. In reality, what these banks really wanted was to peg interest rates at a set value, thus reducing the threat of competition from smaller banks.

The central banks of the world ascribe to a philosophy of economics called Keynesianism, after John Maynard Keynes. In this philosophy, the part of the economy considered most important is consumer spending. As long as consumers are spending, that is creating demand and the economy will be growing. In looking at the panics of years gone by, the central banks noticed that in the recovery phase, interest rates and consumer savings are going down, while consumer spending is going up. Thus, they proposed that lowering interest rates is an incentive for increased consumer spending.

However, their mistake is that they ignored the fact that in the past the lowering of interest rates was a response to an improving economy, not the cause. Essentially they are putting the economy on overdrive by manipulating the interest rate, "fooling" consumers into believing the economy is perpetually improving, causing them to spend more and save less. Without market-driven interest rates, the behaviour of consumers will always be irrational with respect to current economic conditions, because whether the stock market is shooting up, or we are in the middle of the biggest recession since the Great Depression, artificially low interest rates keep signaling us to spend spend spend. Spend on goods, spend on housing, spend on investments. Eventually the distortion can only go on for so long. When people no longer trust that the value of a tangible asset is an accurate representation of the value of their money, then there will be a crash.

What we have is a catch-22. Raising interest rates would put serious brakes on the housing bubble, but because artificially low interest rates have snared people into buying more home than they can afford, we can't raise rates because thousands of people will default. OTOH, maintaining artificially low interest rates will allow current owners to pay off their mortgages successfully, but it remains an incentive for new owners to buy homes far beyond what they normally would be able to afford. An artificially fertilized market will cause prices to rise, which will inevitably cause a housing crash in the future when the ridiculousness of these prices becomes apparent, and when even tiny rises in rates trigger defaults like dominoes.

So yeah, holy crows. Allow banks to set their own rates and they'll rise, which will upset a lot of consumers. Many will lose their homes. However many people who would have bought a lot more home than they could afford will suddenly consider more sensible options. The reduction in demand will lower prices naturally rather than by bubble and crash. It will finally accurately represent the state of the economy we are actually in.

Sticking to the status quo just puts off the pain until a later date, it won't prevent it, and will actually make the eventual correction worse than it needs to be.

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