MYTH #8: Government spending increases interest rates and ‘crowds out' valuable private sector investment.
Reality: Banks can lend essentially without limit, and the Fed can hit any interest rate target it chooses.
Reality: Banks can lend essentially without limit, and the Fed can hit any interest rate target it chooses.
Ask an economist what determines the interest rate, and she'll probably mutter something about supply and demand or "market forces." Ask the same economist what determines the level of saving and investment, and the answer probably won't change very much. This is because most economists were trained using textbooks that have not been rewritten since the United States went off the gold standard after WWII.
Back then, we had a monetary system that really did limit the growth of the money supply, and too much government spending really could force rates higher and crowd out other forms of spending. It is all based on something economists know as Loanable Funds Theory, which describes a market in which there is some limited pool of savings available to satisfy the demand for credit. Thus, deficit spending required the government to compete (with private borrowers) for a portion of these limited resources. Because the capacity to lend was constrained under the gold standard, the added competition could drive borrowing costs (i.e. the interest rate) higher.
Decades later, the monetary system looks completely different. But economists continue to treat governments as if they are the users of the currency (as opposed to the issuers) and to treat banks as passive money lenders -- there simply to broker deals between savers and borrowers. In truth, banks can lend essentially without limit, regardless of what the federal government is doing, and the Federal Reserve can hit any interest rate target it chooses.
~Stephanie Kelton, Associate Professor, University of Missouri-Kansas City, Missouri
