Why it’s time for higher interest rates

May 11, 2012, 6:07 PM UTC

FORTUNE — In the late 1800’s, coal mine barons found no shortage of ways to maximize profits at the expense of their workers. Miners were paid subsistence wages then required to shop at the notorious “company stores” where they were sold over-priced goods on abusive credit terms. As time passed, coal-mining families would find themselves “another day older and deeper in debt” as Tennessee Ernie Ford lamented in the popular 1950’s song “Sixteen Tons.”

Much attention has been paid to rising income inequality in the U.S. over the past several decades. Less attention has been paid to rising disparities in debt between the haves and have-nots. According to a recent IMF report, debt to income ratios for the bottom 95% of income earners in the U.S. skyrocketed from 60% in 1983 to a whopping 140% in 2007. For the top 5%, the debt load actually decreased from 80% in 1983 to 65% in 2007. At the same time, real wages for the working classes stagnated. Our economy followed a business model akin to the company store. American workers experienced little real wage growth, but instead were given ready access to credit to buy over-priced houses, imported goods, and other things they could not otherwise afford.

Now comes a group of progressives, led by Nobel Laureate economist Paul Krugman, who propose, you guessed it, more consumer borrowing and spending as the main solution to our economic woes. They advocate aggressive action by the Fed to keep interest rates near zero, as well as to raise the inflation target to 4%-5%. They argue that consumers, enticed by low interest rates, will borrow and spend more while those of us who have built up savings will start spending those savings rather than let higher inflation erode their value. All of this new consumer spending will create jobs and get us out of our economic doldrums, or so their theory goes.

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Here is my question: Once we’ve all borrowed as much as we can and spent down our savings, then what? Their arguments assume that our problems are cyclical, not structural, and that we can somehow successfully return to the pre-crisis good times if we can just stimulate enough consumer demand. But if we learned anything in 2008, it is that credit-infused consumer spending based on accommodative monetary policy is not a sustainable model. The Fed can print lots of money, but it cannot control what is done with it. Instead of supporting new lending for healthy, sustainable economic growth, those newly minted trillions can just as easily support asset bubbles and irresponsible lending and risk taking by yield hungry financial institutions and investors. Near zero interest rates discourage savings and weaken pension funds. At the same time, they encourage highly leveraged speculative investments based on short-term price fluctuations, not long term economic fundamentals.

Given the millions of baby boomers at or near the cusp of retirement, and the dwindling resources of Social Security and Medicare to support them, the last thing we should be doing is pursuing policies to erode private savings. And with overburdened consumers only midway through the process of de-leveraging, now is hardly the time to try to entice them to take on new debt. To be sure, the ability to refinance mortgages into much lower rates has been a positive outcome of the Fed’s near zero interest rate policies. But mortgage refinancings will eventually run their course.

Krugman and his allies want to increase the target inflation rate as a way to manipulate consumers into spending more with today’s higher-valued dollars. They downplay inflation’s harmful effects on those whose incomes do not keep pace with the cost of living. History has shown that once inflation starts to accelerate, it can be hard to control.  Moreover, it is unclear whether even the mighty Fed can keep rates low while explicitly raising target inflation. This may simply lead bond investors to demand higher interest on their investments to compensate for inflation risk. In addition, it is unlikely that the Fed could generate inflation in the one area where it might be helpful – housing – given the huge amounts of inventory projected to come on the market over the next several years which will put countervailing downward pressure on home prices.

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The harsh reality is that the solution to our problems lies with fiscal policy, not monetary policy. Unfortunately, it is easier to call on the Fed to keep printing money than it is to convince our political leaders to start doing their jobs. The major road blocks to America’s economic future lie with inefficiencies in the tax code, unsustainable defense and entitlement spending, and most importantly, massive uncertainty on the part of both businesses and households over how or even whether these core issues will be resolved. Progressives would be better served by focusing on how we can get more bang out of our social spending bucks, given our high per capita expenditures on health care and education and subpar results. Similarly, conservatives need to face up to the fact that we need more tax revenues, with the real question being whether we do so by raising rates, imposing new consumption taxes, or, dramatically cutting back on tax loopholes (my preference).

Those who favor fiscal responsibility over lax monetary policy should not be branded with the scarlet A of austerity. Unlike many European countries which have tightened too rapidly (though some have little choice, given their dire fiscal situations), we can and should phase-in tax and spending reforms over time. What’s more, in some areas, additional spending makes sense. I agree with Krugman that even with current budget constraints, we should undertake well-designed and administered programs to repair infrastructure. That type of “stimulus” will create construction jobs while providing long-term benefits to our economy through more efficient transportation systems, uninterrupted water supplies, and safer buildings for our kids’ schools.

Structural fiscal reforms will give our economy real, lasting benefits. On the other hand, too much easy money from the Fed, while well-intentioned, contributed to asset bubbles, excessive risk taking, and a populace over-burdened by debt who, like the coal miners of yore, will be taking years to dig out.

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