When higher interest rates are actually good

A lot of people are freaking out about interest rates, particularly after the Federal Reserve hiked its benchmark rate to 1.5 to 1.75 percent this week — the sixth increase in three years, and the highest interest rate in a decade.

Unemployment is low, Republicans and the Trump administration just passed a massive tax cut, and they're also planning significant increases to the federal deficit. That's led to a slew of warnings that government borrowing will crowd out private investment and jack up interest rates even more. "If you borrow money — through a credit card, a mortgage, or an auto loan — you could end up paying the price," The New York Times ominously warned.

This is wrong — as is the recent hysteria over interest rates. In fact, higher interest rates might well be a good thing.

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Simply put, interest rates measure the price we pay to borrow. High interest rates make borrowing more expensive, which discourages investment. Low interest rates make borrowing and investment cheaper, encouraging more of it.

Some people think there's only so much money out there to borrow at a given time, and that by taking out big new deficits to fund tax cuts, "the government is competing with individuals and companies to borrow money from a limited source of lenders," as the Times puts it. When demand for credit outstrips supply, the price (i.e. interest rates) goes up.

This is a very common idea called "loanable funds theory." It's also wrong.

There's actually no ceiling on how much credit individual private banks can create. When you think about it, this is what made the bank runs of history possible. They had more deposits outstanding than money in the vault. Banks can take on too much risk, overextend themselves relative to their reserves, and collapse. But there's no finite pool of credit they can deplete.

As for the federal government, it's the issuer of the currency. It's literally the source for all U.S. dollars in the economy. Uncle Sam isn't in competition with anyone over a limited supply of funds. He can just make more.

The bottom line ought to be clear: If there's hunger out in the economy for more borrowing, that credit can always be created.

Then why do interest rates go up and down?

Well, higher interest rates allow banks to increase their profit margin. They charge higher rates because they can. If the economy is booming — if there's lots of market demand to tap, and lots of businesses looking to tap it — then banks know people can and will pay the higher price to borrow money. But if the economy is tepid, demand for borrowing will be tepid, too. And banks will lower their interest rates to avoid scaring off customers.

At the macroeconomic level, the interest rate that's profitable for banks is determined by the Federal Reserve. Nationally, interest rates go up and down because the central bank adjusts them. Again, if the economy is booming — if wages are rising and employers are running out of jobless people to employ — that might bleed into inflation. Then the Fed will hike its interest rate target to tap the brakes. Conversely, if the economy is sluggish or in recession, the Fed will cut interest rates to encourage investment and job creation.

The common thread is this: Higher interest rates are a sign of a booming economy. They rise when there's business to be done, and when businesses want to do it. They rise when lots of people are getting jobs, and when wages are increasing across the economy. If President Trump's new deficits drive up interest rates, it would be because the tax cuts succeeded in stimulating investment and employment.

Like a bodybuilder gradually taking on heavier weights, the economy can shoulder higher interest rates the stronger it becomes. Think about it at the individual level: Higher interest rates on home loans and credit cards worry us because wages have been stagnant for decades; because good jobs are scarce, financial insecurity is widespread, and inequality is soaring. That scares individuals and families, but it also scares businesses. They need confident consumers out there with money to burn. That way, when businesses borrow to expand storefronts and hiring, they know the investment will pay off. In a world where wage growth was high (especially for the lowest earners), where good jobs were abundant, and where wealth and incomes were broadly shared across the economy, what counted as "affordable" interest rates would be much different.

In fact, during the famous job and wage boom of the late 1990s, interest rates ranged between 5 and 6 percent. During the economic recoveries of the Reagan years, they got over 8 percent.

Today, interest rates are around 1.8 percent. We've got lots of room to grow.

Now, is it possible for interest rates to get too high, and choke off the very economic boom that drove them up?

Maybe. Sort of.

When inflation ramped up in the late 1970s, the Fed eventually jacked interest rates up to 16 percent or so to squash it. That set off a massive recession. But that's the point: It was a policy choice by the central bank. And a highly questionable one at that. In fact, when interest rates went high enough over the last few decades to spark downturns, it was because the Fed got trigger-happy about inflation. If you load a burgeoning bodybuilder up with too much weight too soon, you'll just injure them. But it doesn't follow that they should never lift that much.

When economists and journalists say higher interest rates are bad, they might as well be saying a strong and healthy economy is bad. When they worry that fiscal policies will drive interest rates up, they're basically worrying that those policies will deliver more jobs, higher wages, and stronger growth. This simply couldn't be more backwards.