Interest Rates: Too High, Not Too Low

I have previously referenced my support for the idea, advocated by Keynes and Adam Smith, that low long term interest rates are a desirable stance for monetary policy. The claim about the effect of low rates is two fold:

(1) Low rates reduce the cost of investment and so encourage it.

(2) Low rates reduce the yields required to pay back debt incurred, and hence encourage more sustainable,  less speculative investments. To phrase it conversely: high rates push people into speculation as they attempt to recoup the money they owe.

Commenter Roman P. is not convinced by this argument. I am willing to admit I have, thus far, provided insufficient evidence for this, mostly due to lack of data. However, I have assembled what data I can below, and believe it offers broad – though not definitive – support for this hypothesis.

A few caveats. First, let me establish clear criteria for what I consider to be ‘low rates.’ John Maynard Keynes wanted the long term interest rate to be as low as 2.5%; he even remarked that 3.5% would be too high for full employment:

There is, surely, overwhelming evidence that even the present reduced rate of 3½ per cent on long-term gilt-edged stocks is far above the equilibrium level – meaning by ‘equilibrium’ the rate which is compatible with the full employment of our resources of men and equipment.

For most of the data, the rate is above even the 5% that Adam Smith thought should be the cap, lest the capital of a country be “wasted.” Obviously we shouldn’t believe something simply because Keynes and Smith did, but hopefully the evidence I present below will lend some credibility to their arguments.

Second, what matters will not be just the interest rate; expectations – and the realised trajectory – of the interest rate will also be important. If the rate is rising then it will have a similar impact on investment decisions as an already high rate. If the Central Bank (CB) is committed to a policy of low rates, then it will be far more stabilizing than if rates happen to hit a low point and subsequently bounce back. We do have a test for an explicit low rate policy: the post-WW2 arrangements. It is common knowledge that the stability in that period was unprecedented.*

Third, let me make obligatory correlation =/= causation remarks. Nevertheless, correlation at least gives us a clue about causation. A further clue is if what we think is the causal variable (interest rate) moves first, and the dependent variable (growth) moves second. It is also true that we have a valid theoretical link for our causation. Lastly, it is empirically verified that businesses consider long term rates the most important interest rate in their borrowing decisions.

So what does the evidence look like? Let’s start by taking a look at the ‘Prime Loan Rate’ in the US for the second half of the 20th century. This is the interest rate banks offer to their most stable customers, mostly big businesses:

Every single recession is preceded by an increase in rates. Not every rise in interest rates create a recession – there is one peak without a recession from around 1983-4. However, this may well be explained by movements in the base rate; it dropped from 11% to 8% in that period. By the next recession it had settled at about 6%; that recession seems to have ended when it was reduced down to 3%.

The data for the prime rate only go as far back as 1955, so I’ll use two of Moody’s corporate bond measures for the first half of the 20th century:

Again we observe a similar pattern with rate increases and recessions. Furthermore, the high rate, high volatility period between WW1 and WW2 sits in stark contrast with the low rate, low volatility period post-WW2. It’s interesting to note that rates – though high, relative to our benchmark of 2.5% – were not that high during the stock market boom of the 1920s. Certainly the spike in rates after the first crash is what seemed to bury the economy.

Update: commenter Magpie helpfully pointed out that the Moody’s data could be lagged, which is why it falls inside recessions instead of before them. Indeed, this is what we see when we compare it to the prime rate post-WW2: the spikes are late.

Interest rates in the UK show a similar pattern, as do UK recessions. Unfortunately I do not have access to – or the competence to create – graphs like the above for the UK.

Overall, it seems high or rising rates accompany periods of substantial periods of economic turmoil, else periods where speculation is rampant and bubbles are building up. It is possible the speculation fuels further rises in the interest rate as the perpetrators become overconfident about their potential gains – a positive feedback loop.

Clearly the central bank does not control corporate borrowing rates directly. However, it does control government bond rates, and I would argue that this rate, as a benchmark, has a significant impact on other interest rates in the economy. Indeed this is borne out by the data:

(For a more comprehensive, but uglier, graph of the correlation between government and corporate bond yields, see here).

A central bank committed to low rates could help quell this, as we observe in the data post-WW2. Naturally, such a policy requires a degree of monetary autonomy that central banks have not had since the Bretton Woods system was in place, else rates be disrupted by international flows.

I think the evidence presented here is a blow to the ‘too low for too long‘ meme that pervades discussion of the crisis. There seems to be a belief that low rates are somehow ‘artificial’ (relative to what, exactly?) and we need to ‘get back to reality.’ In fact, it seems that ‘checking’ a bubble may both fuel speculation and needlessly invalidate potential investments, hence creating the situation that the central bank purportedly wanted to prevent.

*Unless you lived in Guatemala or Iran, of course.

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  1. #1 by JW Mason on February 24, 2013 - 2:01 pm

    You will not be surprised that I am in full agreement with this post. You may also find this paper in progress (by Arjun Jayadev and myself) relevant.

    One data caution — the prime rate is not the appropriate thing to look at here. For quite a number of years now, the prime rate has been defined as simply a fixed markup over the Federal Funds rate. It’s not informative about the interest rates actually faced by private borrowers. Better to look at corporate bond rates, mortgage rates, etc. Or perhaps simplest, effective rates for various borrowers, computed as total interest payments divided by total debt stock.

    • #2 by Unlearningecon on February 24, 2013 - 3:03 pm

      Thanks for your comment and paper.

      Fair point about the prime rate, though it does seem to be strongly correlated with other measures such as Moody’s, so the patten I identify still holds.

  2. #3 by Roman P. on February 24, 2013 - 4:37 pm

    I am afraid that for all the merits of this post, it doesn’t resolve our dispute. The core of it, as you remember, was if the high interest rates lead to the higher levels of financial speculation. Your second figure does not really show anything besides the dynamics of bond yields (consistent with debt-deflation theory), and in the third one after about 1983 the upward movements of the interest rate do not even preclude recessions and do not correlate with any asset bubble I could remember. One could of course say that since Keynes wrote that the optimal rate must be below 2.5 percent, it was always too high in the 20th century, but I feel this is an unproductive point of view. What, the speculators on forex, stock markets and real estates would have stopped their activities had the banks been willing to extend credit to them for 2 percent rate of interest? I doubt it.

    To reiterate my position, I like neither ‘too low’ nor ‘too high’ explanations. I think that the shifts in the balance of productive investment and speculation are driven not by the interest rate, but by some underlying social or technological changes. I might be wrong, though – and I’ll certainly read and consider Prof. Mason’s paper.

    • #4 by Unlearningecon on February 25, 2013 - 9:54 am

      I am afraid that for all the merits of this post, it doesn’t resolve our dispute. The core of it, as you remember, was if the high interest rates lead to the higher levels of financial speculation.

      I started to include the Dow Jones but it was just too messy and didn’t seem to tell me anything in either direction.

      and in the third one after about 1983 the upward movements of the interest rate do not even preclude recessions and do not correlate with any asset bubble I could remember

      True, though the high rate period does seem more volatile than the low rate period.

      I have in my mind something along the following lines:

      (a) Rises in the interest rate have something to do with bubbles.

      (b) High rates in general are associated with recessions.

      One could of course say that since Keynes wrote that the optimal rate must be below 2.5 percent, it was always too high in the 20th century, but I feel this is an unproductive point of view.

      I think a period where it was below 3% and the CB was committed to such a policy can be found post-WW2, and I think this is a fair test of the policy – it also seemed to perform very well.

      What, the speculators on forex, stock markets and real estates would have stopped their activities had the banks been willing to extend credit to them for 2 percent rate of interest? I doubt it.

      Perhaps, perhaps not. I don’t think regulatory questions can be avoided at any interest rate. But bear in mind the cumulative effects – for long term rates, there is a fairly big difference between 2 & 4%.

      To reiterate my position, I like neither ‘too low’ nor ‘too high’ explanations. I think that the shifts in the balance of productive investment and speculation are driven not by the interest rate, but by some underlying social or technological changes.

      This seems to explain the internet stock bubble but not really housing bubbles or 1929 (?)

      I think high interest rates can be a major factor in creating volatility and recessions. I don’t think they are the only factor, but monetary policy has to have some objective and to me low rates seems historically the most stable.

      • #5 by Roman P. on February 25, 2013 - 1:31 pm

        Let’s use http://www.ritholtz.com/blog/wp-content/uploads/2010/08/1790-Present.gif as a reference for the moment. Supposedly T-bond yields reflect long-term interest rates, if I understand it all correctly.
        http://research.stlouisfed.org/fred2/series/AAA – For the corporate bonds, though I don’t know how reliable is the data of Moody’s before 1983.

        Then, we could see that your theses are quite weak.
        a) Not really. Pre-GD bubble – lowering trend, Dotcom boom – lowering trend, noughties housing bubble – flat trend? I don’t see rising interest rates in times of asset bubbles.
        b) True, but usually the high rates in times of recessions are but the tiny spikes on the diagrams. One would think that 1980 was the end of the world, but it wasn’t actually that disrupting judging from the interest rates alone. Likewise, GD didn’t significantly drive up interest rates.

        I think there might be some underlying factor that influences the real interest rates, and it is located in the world of real production and reproduction (production of commodities by commodities). Somehow, it interacts with the provision of liquidity and credit by the monetary system in some complicated way to produce the numbers of interest rates and inflation we could actually observe. But I am not even sure how to approach this subject, and I am not very knowledgeable of the theories of it.

      • #6 by Unlearningecon on February 25, 2013 - 6:31 pm

        I don’t think trends as long term as the ones you identify are relevant for those investing on the stock market – I would argue the ‘tiny spikes’ are in fact significant from the PoV of an investor. I don’t think that data contradicts my idea that a very low rate of interest is a desirable from a macroeconomic PoV, both in terms of general stability, depth and length of recessions etc. The history of capitalism has been characterised by many recessions and bubbles, except for the post-WW2 period, the only period where rates were that low for a significant period of time.

        This isn’t to say low interest rates are themselves sufficient to stabilise capitalism completely (obviously I’d say nothing can). Neither is it to say it is the only factor in driving speculation: I would not dispute that technological progress, for instance, plays a role.

        For the corporate bonds, though I don’t know how reliable is the data of Moody’s before 1983.

        Out of interest, why do you say this? For what’s it’s worth, all the major measures are closely correlated which leads me to believe they are reliable, unless they suffer from some common fault.

      • #7 by Roman P. on February 25, 2013 - 7:33 pm

        From the PoV of speculator, everything is significant. The few forex traders I’ve known were heavily into the Elliot waves voodoo bs and considered every little fall and bounce as The Sign of great Things to Come. I doubt people in the times of Wicksell and Keynes were any less stupid. Ultimately, for the yields of corporate bonds to go up, it means there were more pessimists than optimists in some time period. Just that. Were they really that important for the wider economy?

        I find it interesting that you are thinking that causality must run from the low interest rates to the healthy economy. But perhaps it is the other way around? There was a great need for rebuilding all over the world, and the emergence of new technologies provided very profitable ventures for the investors. Plastics, semiconductors, nuclear power… It was really the golden time for the USA, though for the UK and USSR, not so. Vae victis!

        Maybe the interest rates reflect, at some level, the underlying Kondratiev’s supercycle of technological change? Though there are problems with this line of thinking like where in this hypothetical cycle we are now…

        Yeah, the data is well correlated (otherwise I wouldn’t have used it). But when I searched for the yields of the corporate bonds, Moody’s data from their site and a couple of other sources was only from about 1983 to the present day. It is possible that pre-1983 stuff came from some not-so reliable measurements.

      • #8 by Unlearningecon on February 26, 2013 - 9:50 am

        Ultimately, for the yields of corporate bonds to go up, it means there were more pessimists than optimists in some time period. Just that.

        Perhaps. But this doesn’t stop the CB from pushing them down again.

        I find it interesting that you are thinking that causality must run from the low interest rates to the healthy economy. But perhaps it is the other way around?

        Seems to me the causality would go from a good economy to high yields as investors became more confident, which is a corollary to what you say above. No?

        It was really the golden time for the USA, though for the UK and USSR, not so. Vae victis!

        USSR perhaps not, but I’m not sure when everyone got this idea that it was only the US that boomed. Most of Western Europe experienced a boom. Also worth noting that Japan, Korea etc. kept a BW-like system until the 1990s and experienced comparable growth. And look at Japan’s long term bond yields over that period! Obviously we all know what happened when they got rid of it…

        Yeah, the data is well correlated (otherwise I wouldn’t have used it). But when I searched for the yields of the corporate bonds, Moody’s data from their site and a couple of other sources was only from about 1983 to the present day. It is possible that pre-1983 stuff came from some not-so reliable measurements.

        Quite possible. The data are hard to come by which is what makes this so difficult to verify.

      • #9 by Roman P. on February 26, 2013 - 4:38 pm

        > causality would go from a good economy to high yields as investors became more confident

        Ah, but a bond’s yield is inversely related to its price! So when yields are down, it means that prices are up and its relatively cheap for a firm to borrow funds. When yields are up, it means that the interest rate the firms that finance their expenditures through bond market is effectively higher. So the higher pessimism of bond traders is essentially translated into the worse credit conditions for everybody.

        >Most of Western Europe experienced a boom.

        Yeah, sure, but a lot of that was in the form of rebuilding lost wealth. Yes, the economies worked amazingly effectively, but it was a hungry and desolate time for most of Europe. Half-destroyed USSR actually starved in 1946. In Britain people were really close to it, with slashed food rations and government encouraging people to hunt for squirrels.

      • #10 by Unlearningecon on February 28, 2013 - 8:47 pm

        Ah, but a bond’s yield is inversely related to its price! So when yields are down, it means that prices are up and its relatively cheap for a firm to borrow funds. When yields are up, it means that the interest rate the firms that finance their expenditures through bond market is effectively higher. So the higher pessimism of bond traders is essentially translated into the worse credit conditions for everybody.

        I think there are competing effects here. Both yours and mine are valid, but the question is: why do we see a rate rise in bubbles?

        Yeah, sure, but a lot of that was in the form of rebuilding lost wealth. Yes, the economies worked amazingly effectively, but it was a hungry and desolate time for most of Europe. Half-destroyed USSR actually starved in 1946. In Britain people were really close to it, with slashed food rations and government encouraging people to hunt for squirrels.

        Well, rations are standard fare in wars and just after, no? At least the countries recovered relatively quickly.

  3. #11 by Min on February 24, 2013 - 5:21 pm

    My question is this. Since you are talking about nominal rates, inflation must be lower, or who would lend? And the problem with such low inflation is the risk of deflation. One reason that Australia came out relatively well in our current crisis is that they had higher inflation to start with than comparable economies did. So low inflation could be a problem in itself. Hasn’t low inflation been a problem for Japan? Wasn’t it a problem during the Long Depression?

    • #12 by Unlearningecon on February 25, 2013 - 10:15 am

      Real rates in the 1920s were actually higher for the late 20s – and obviously, the early 30s – due to deflation.

      I feel the interest rate is first a nominal phenomenon. Inflation expectations matter, but nominal decisions are what people actually make, which is why we observed high rates of investment post-WW2 despite close to 0 real rates.

      One reason that Australia came out relatively well in our current crisis is that they had higher inflation to start with than comparable economies did. So low inflation could be a problem in itself. Hasn’t low inflation been a problem for Japan?

      I don’t think low inflation is necessarily desirable. Not sure how you got this from the post?

      • #13 by Min on February 25, 2013 - 7:13 pm

        Here’s how I get it.

        If nominal rates are 2.5%, how do you have 4% inflation (for long)?

      • #14 by Unlearningecon on February 26, 2013 - 9:36 am

        Well, inflation would still be controlled under my (sort of) proposed system, with commodity stock buffers and BoP balances. A lot of inflation/deflation is imported.

        If, e.g. you take inflation in the US there was some volatility post WW2 but it settled under 2% until the oil shocks.

  4. #15 by Rob Rawlings on February 24, 2013 - 6:37 pm

    Interest rates have been the main counter-cyclical policy instrument for the past few decades so its very hard to separate interest rates from monetary policy. Also in looking at rates one really needs to distinguish real from nominal (as interest rates increase to reflect expected inflation) and in order to see if money is loose or tight one also needs to see if the prevailing rate of interest is correlated with rising or falling NGDP rather than just looking at the “raw” rate.

    Bearing this in mind I think that rising interest rates just before a recession are not inconsistent with the “too low too long” meme you reference. Interest rates below the market clearing rate lead to an increase in the money supply (and NGDP). This initially generates a boom (increasing RGDP) that increasingly becomes inflationary (NGDP grows faster than RGDP). Inflation and the growing perception of a coming bust (that make lenders more cautious) drives interest rates higher just before the bust actually comes. The CB then lowers interest rates in the bust to prevent deflation and if it keeps them there for too long it will feed the next oscillation of the cycle.

    • #16 by Unlearningecon on February 25, 2013 - 10:20 am

      Interest rates have been the main counter-cyclical policy instrument for the past few decades so its very hard to separate interest rates from monetary policy.

      Mostly the base rate and short term rates, though. Since BW was dismantled (and before then) the CB had less control over long term rates.

      This initially generates a boom (increasing RGDP) that increasingly becomes inflationary (NGDP grows faster than RGDP).

      I don’t think we observe this pattern in, say, 1990 or the 2000s. Inflation was relatively steady for both of these periods.

      • #17 by Rob Rawlings on February 25, 2013 - 7:14 pm

        Since the 1980’s the fed has targeted inflation rates so even when the economy is over-heating inflation has stayed low. I think the fact that interest rates rose just before recessions is still consistent with higher inflation expectations during those periods. And these higher inflation expectations ( for which higher interest rates were a response) could indicate that interest rates had been too low in the build up to the recessions.

      • #18 by Unlearningecon on February 26, 2013 - 9:32 am

        But CBs have primarily used short term and base rates. Long term rates have been largely out of their control since BW was dismantled.

      • #19 by Rob Rawlings on February 27, 2013 - 3:40 pm

        I think whats important here is not short v long rates of interest but the money supply v NGDP (interest rates are just a way of increasing/decreasing the money supply which in turn affects spending which in turn affects NGDP/RGDP).

        So recessions typically occur (or are defined as occurring when) RGDP drops. It could be these drops are just random or caused by external things. But the fact that rates always rise just before seems to make that unlikely. One theory that could explain this is one where the CB systematically increases the money supply too much (via lower interest rate) during good times , which generates high inflation expectations as RGDP fails to match the increase in the money supply, followed by a bust where the economy sorts itself out (and where rates stay low).

      • #20 by Unlearningecon on February 28, 2013 - 8:37 pm

        The problem here (I think) is two competing explanations of the money supply. For me the interest rate is the independent variable which sets the money supply, which contracts and expands due to actions by the private banking system. It is what we can control. For you, it seems that the important thing is keeping the money supply under control.

      • #21 by Rob Rawlings on March 1, 2013 - 6:26 pm

        In think you are correct about 2 different theories.

        The key question is: Does the money supply change “due to actions by the private banking system” or does the private banking system lend more because the CB has created more money , some of which become available for them to lend out?

        I think the mechanism of the banking system indicate that it is clearly the latter, though some of the implementation details ( the part where the CB will “create” whatever money the banks ask for at the current target interest rate) make it look a bit like the former.

        In any case I think that at any given level of expectations about the future there will be a very close correlation between the money supply and the market-clearing interest-rate . It seems a little odd to me to talk about interest rates driving a certain level of money supply rather than the other way around – but I agree that is because we are using different models.

        BTW: I just want to say what a great blog this is. – Interesting topics and a desire (both by the blogger and commenters) to engage on the issues even when there people hold different views.

      • #22 by Unlearningecon on March 2, 2013 - 8:23 pm

        I think the mechanism of the banking system indicate that it is clearly the latter, though some of the implementation details ( the part where the CB will “create” whatever money the banks ask for at the current target interest rate) make it look a bit like the former.

        I disagree, simply because evidence suggests that broad money moves first, followed by base money:

        There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly.

        In any case I think that at any given level of expectations about the future there will be a very close correlation between the money supply and the market-clearing interest-rate.

        Agree.

        It seems a little odd to me to talk about interest rates driving a certain level of money supply rather than the other way around – but I agree that is because we are using different models.

        If credit expansion and contraction (lending and being paid back) increase and increase M1, it seems to make sense to me. The bank knows that it can buy reserves at a certain cost: the interest rate. From this it makes its lending decisions. If the rate is lower then it can invest in more conservative endeavours; if it is high then the only way for any borrower to recoup their interest payments is through speculation.

        BTW: I just want to say what a great blog this is. – Interesting topics and a desire (both by the blogger and commenters) to engage on the issues even when there people hold different views.

        Thanks a lot.

      • #23 by Rob Rawlings on March 3, 2013 - 1:14 am

        “There is no evidence that either the monetary base or M1 leads the cycle,”

        I think the reason for this is because that is the way the fed has chosen to implement its monetary policy. It sets a target rate, Banks find new lenders to lend to, then if they need additional reserves to back up the loan they get them from the fed who if necessary buys assets with new money that will then end up as bank reserves.

        This is a bit of an optical illusion in my opinion – if the fed implemented policy differently (say targeting the money supply directly and not interest rates) then this effect would dis-appear as banks would need reserves before they could lend.

      • #24 by Unlearningecon on March 3, 2013 - 6:09 pm

        This is a bit of an optical illusion in my opinion – if the fed implemented policy differently (say targeting the money supply directly and not interest rates) then this effect would dis-appear as banks would need reserves before they could lend.

        I disagree – the fed tried this in the 1980s and it didn’t work. Maybe you will be interested in these posts:

        That the central bank could say no means some might interpret endogenous money as a policy issue, but it isn’t – as I explained in my previous post, it reflects the reality of capitalism: banks must make lending decisions based on endogenous activity, and the central bank must accommodate this. If it does not, the credit markets will simply not work, and credit crunches will ensue.

  5. #25 by Cameron Murray (@Rumplestatskin) on February 25, 2013 - 12:18 am

    I’m glad you’ve opened this can of worms. Let me start with a couple of points.
    1. There is no natural rate of interest. Regulations surrounding lending, banking, security, and importantly, social norms, all lead to a general kind of ‘market rate’ of interest. We can basically choose this nominal rate, as central banks have demonstrated. We an monitor inflation and also roughly choose real rates – either positive or negative.
    2. This market rate of interest, coupled with regulations about lending etc, generate asset values. Land values are the capitalisation of rents, so lower rates will generally increase land values unless some other regulatory constraint exists (such as rent controls).

    Therefore, for low interest rates to generate high levels of investment, there must be a way to provide incentives for new investment in capital equipment, rather than in existing fixed assets such as land.

    So for me, the recipe for higher rates of capital investment has two ingredients – low interest rates, and regulatory incentives that make speculation on land and fixed assets (and various traded second hand markets like stocks) difficult, and investment in new capital (buildings, equipment, machines etc) much more attractive.

    Which of course goes back to the problems of aggregating different types of capital in your models!

    • #26 by Unlearningecon on February 25, 2013 - 6:51 pm

      Yeah, a land tax and regulation on loans to speculators are certainly required for overall stability.

      However I don’t necessarily see why low rates would inflate land prices. Seems to me those speculating are more likely to receive capital at higher rates, while those with modest investments are more likely to receive it at lower rates. A bank would prefer the latter, but at high rates the only option would be the former.

  6. #27 by JW Mason on February 25, 2013 - 3:21 am

    Another article you might find useful is http://scholarworks.umass.edu/cgi/viewcontent.cgi?article=1148&context=peri_workingpapers.

    While I agree with you that it’s mistake to describe recent market rates as unusually or excessively low, there is a serious question as to how effective central bank policy is in controlling longer rates. I also recommend the work of Leijonhufvud on this.

    • #28 by Unlearningecon on February 25, 2013 - 9:44 am

      Well, it seems that they had success immediately post-WW2, but as I commented this might also have had to do with the capital controls and regulatory regime at the time, which are perhaps necessary conditions for such control to be established. The paper you linked seems to deal with exactly that issue.

  7. #29 by Magpie on February 25, 2013 - 8:40 am

    Congratulations, very interesting article. Good work.

    The relationship, however, looks much clearer in the first chart (post 1955, prime) than in the second (pre 1955, Moody’s corporate bonds): in the first chart spikes precede slumps; in the second, they don’t. Any idea why this should be so?

    • #30 by Unlearningecon on February 25, 2013 - 10:17 am

      As I said to Roman P, I’m starting to think along the lines of increases are associated with bubbles, while recessions themselves are associated with high rates. If you look at the recessions in the first half of the 20th century, only one of them can be said to be a bubble.

      • #31 by Magpie on February 25, 2013 - 6:05 pm

        I see what you mean and it is possible.

        However, it still doesn’t explain why before 1955 the increases trigger busts but after 1955 it is the rates themselves.

        If you ask me, I’d guess it has to do with Moody’s data.

      • #32 by Unlearningecon on February 26, 2013 - 9:42 am

        A couple of people have commented on the data. Ia there something I’m missing? Is Moody’s not reliable?

  8. #33 by lyonwiss on February 25, 2013 - 11:11 am

    Sorry. Economists have no ideas about interest rates. There is no such thing as the “right” rate, or just one rate. There are many rates. The concept of something going wrong does not exist among academics with their smooth running mechanical model of the economy. What about credit defaults? It is easy to see real-world interest rate (pa) must be greater than probability of default (pa). Different borrowers have different default probabilities, which set lower bounds on interest rates, regardless of inflation.

    • #34 by Unlearningecon on February 25, 2013 - 6:34 pm

      If you look at the data, though, it’s clear the government bond rate acts as a benchmark for others, so the CB can influence the whole spectrum of rates.

      • #35 by lyonwiss on February 25, 2013 - 7:53 pm

        This means official rates are only lower bounds and hence they can make interest rates too high generally, choking off activities. But they may not make interest rates low enough, which must be greater than default probabilities, to stimulate activities (as is the case now). This asymmetry makes monetary policy ineffective.

      • #36 by Unlearningecon on February 26, 2013 - 9:42 am

        This is quite possible. But capital controls and regulation give an extra degree of control.

      • #37 by lyonwiss on February 26, 2013 - 10:03 am

        Capital control and regulation generally means restriction. Even if they are relaxed, it does not necessarily lead to more lending and economic activity. You have really grasped my point.

      • #38 by Unlearningecon on February 26, 2013 - 12:43 pm

        Sure, there will be a floor under rates to compensate lenders for the risk – that’s why it’s 2.5%, not 0. Getting it even as low as 2% is incredibly difficult except by historical fluke.

        What I meant about regulation is that it can reduce risk e.g. regulation of loans to speculators.

      • #39 by lyonwiss on February 26, 2013 - 10:04 am

        Sorry I meant you have NOT really grasped mu point.

  9. #40 by Xavier on February 26, 2013 - 4:16 pm

    Low interest rates in the years 2000 were certainly a blessing for the PIIGS…

    • #41 by Unlearningecon on February 26, 2013 - 5:18 pm

      That’s a superficial comment. The PIIGS have the problem of no monetary (and, by extension, fiscal) autonomy.

      • #42 by Xavier on February 26, 2013 - 9:26 pm

        What about the low real interest rates in the United states in the same period? A lot of risky investment took place. But because of the Chinese exchange rate policy, monetary autonomy of the US was also quite limited.
        But why would you say that fiscal autonomy of the PIIGS was limited?

      • #43 by Unlearningecon on February 27, 2013 - 8:58 am

        Well as you can see from the graph, they weren’t low enough in the US and were also rising.

        But why would you say that fiscal autonomy of the PIIGS was limited?

        Because the CB will not finance their deficits.

  10. #44 by Magpie on February 26, 2013 - 6:29 pm

    @Unlearning (#25)

    Is Moody’s data unreliable?

    You are using Moody’s data as a proxy for the prime rate. But it wasn’t your first choice: you only used it because the prime rate series starts in 1955. Right?

    My suggestion (but it’s up to you to take it or not) compare the whole Moody’s series (pre- and post-1955) with **both** the recession dates and the prime rate.

    My guess is that post-1955 Moody’s data peaks should still fall inside recession periods (after all it did that before 1955). This would mean that Moody’s data is a lagged indicator: in other words, it is recessions that predict Moody’s data.

    But this is not so bad as it may sound at first. My other guess is that Moody’s post-1955 data should also be a lagged indicator for prime rate. And that the lag in this case is longer: if you had pre-1955 prime rate, it would most likely have also predicted recessions.

    • #45 by Unlearningecon on February 27, 2013 - 8:54 am

    • #46 by Xavier on February 27, 2013 - 9:46 am

      “Because the CB will not finance their deficits.”

      That´s a problem now. But it wasn´t a problem in the 2000´s. Spain and Ireland didn´t have deficits and the other ones didn´t have any trouble financing them, interest rates being low.

      • #47 by Xavier on February 27, 2013 - 9:47 am

        Somehow my comment ended up in the wrong place. :)

      • #48 by Unlearningecon on February 28, 2013 - 8:38 pm

        Somehow my comment ended up in the wrong place.

        I think that happens sometimes. Unfortunately I don’t know how to move it.

        That´s a problem now. But it wasn´t a problem in the 2000´s. Spain and Ireland didn´t have deficits and the other ones didn´t have any trouble financing them, interest rates being low.

        But it is the reason things got so bad so fast. Had monetary autonomy been the case, those countries would surely be in better shape.

  11. #49 by Blue Aurora on February 27, 2013 - 7:51 am

    Thank you Unlearningecon, for taking the time to defend Dr. Michael Emmett Brady’s thesis that Smith and Keynes would have agreed on the potentially destabilizing role of speculators.

    For those of you that haven’t heard of Dr. Michael Emmett Brady or seen the article where he makes this argument, please see the following link…a link I believe Unlearningecon should have clearly cited:

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1728225

    However Unlearningecon, *HAVE* you gone back to the primary sources (the most authoritative scholarly versions are the Glasgow Edition of the Works and Correspondence of Adam Smith…I think that one should especially read carefully The Theory of Moral Sentiments and The Wealth of Nations) to see if Dr. Michael Emmett Brady’s thesis holds water?

    Yes, you cite Gavin Kennedy, and Gavin Kennedy has positively reviewed that paper by Dr. Michael Emmett Brady before.

    http://adamsmithslostlegacy.blogspot.com/2011/10/adam-smith-jeremy-bentham-and-keynes.html

    But have you read through Adam Smith’s works yet to determine for yourself if Dr. Michael Emmett Brady is correct?

    • #50 by Unlearningecon on February 28, 2013 - 8:43 pm

      I have not read the original texts fully, though I do possess them. I have gone over Smith’s sections on speculation and am convinced he did not approve. I have to say I’m not fully grasping Dr. Brady’s position on inflation stemming from M2 expansions being used for speculation in any of Smith’s or Keynes’ writing.

      • #51 by Blue Aurora on March 1, 2013 - 8:05 am

        What versions of Adam Smith’s texts do you have?

        I own the Penguin Classics two-volume paperback edition of The Wealth of Nations and the Penguin Classics 250th Anniversary Edition of The Theory of Moral Sentiments.

        I need to check the sources more properly, but having read Dr. Brady’s paper on Adam Smith, Jeremy Bentham, and John Maynard Keynes (linked earlier on), it seems that Dr. Brady’s thesis does hold water.

        (Also, I don’t want to detract from the conversation or the theme of your blog, but you still need to respond to our correspondence…)

  12. #52 by Jan on March 1, 2013 - 2:04 pm

    In Fixing global finance, Martin Wolf makes the argument that Chinese economic policy forced the FED to lower interest rates to keep GDP growth in line with potential output. Inflows of capital from current account surplus economies, especially China, pushed down long term real interest rates, which according to Wolf (If I correctly understand his argument) was one factor that led to the housing bubble. There was a shortage of save dollar assets with high enough yields, the market then proved AAA rated high yielding mortage-backed securities in response, that were not so safe after all.
    Do you reject Wolf’s thesis that the Chinese current account surplus and the housing boom in the US are linked to each other?

    • #53 by Unlearningecon on March 2, 2013 - 8:17 pm

      The “global savings glut” wasn’t particularly big in historical context:

      It seems to me that interest rates were getting higher and higher in the worst of the bubble (2006ish). Overall, I don’t find the glut a satisfactory explanation.

      • #54 by Jan on March 2, 2013 - 11:54 pm

        Wolf uses the same graph as you did and argues that ‘…we find that the notion of a savings glut is not right. It might be better thought of as an investment dearth’. (p. 65) His focus is not on the global level of savings but on imbalances between savings and investment within separate countries and how imbalances in one country relate to imbalances in the other. I think it also important to add that he argues that American business was running a surplus in the wake of the Dot-com bubble, the public sector didn’t run very big deficits, so the counter part of the current account deficit turned out to be a big deficit in the financial balance of households. I think this is important if you accept his thesis that the US could not shrink the CA without going into recession (as China would continue to target a certain real exchange rate). So his picture is much wider than just low interest rates and it does show that the housing bubble is related to China’s policy, among other factors.

      • #55 by Unlearningecon on March 3, 2013 - 6:41 pm

        Yeah, I don’t necessarily disagree that the picture is bigger than low interest rates. I would be all for an international system that tried to keep financial and BoP surpluses/deficits at a minimum and hence prevent that kind of thing.

  13. #56 by Dan on March 2, 2013 - 7:07 pm

    Ok, this is a slightly different take that other posts. But if we were to keep interest rates as low as you reccomend, what would the effect be on the finance industry as a whole? I know we have seen many smaller/local banks fail and/or get bought out since the 2008 crisis. The neoliberal and conservative types are quick to blame Dodd-Frank, though this doesn’t seem likely because most of the provisions of Dodd-Frank haven’t even been enforced at all since the bill was so voluminous and some would say poorly written. My personal belief is that the failures of smaller financial institutions is a direct result of lower interest rates, which undoubtedly would put enormous strain on their income if commercial loans and mortgages are their main areas of focus. As such they cannot compete with the economy of scale of the larger banks. If interest rates were to stay low for an extended period of time, we should expect to see exactly what we have seen the past few years- consolidation of the financial industry into a virtual oligopoly of a few too big to fail banks. Now this isn’t necessarily a bad thing, too many for profit lenders and overcompetition in the banking industry is probably a bad thing. And perhaps it actually increases opportunities for new non-profit style banking practices to emerge and flourish (like credit unions and the like). And lastly, if you have most of the for-profit banking industry wrapped up in a few institutions it probably is easier for regulators to keep an eye on them. But I am curious, in writing this post, did you take into consideration the effect of low interest rates on the for-profit banking industry and whether this would be a positive development for the rest of us or not?

    • #57 by Unlearningecon on March 2, 2013 - 8:47 pm

      That’s an interesting point and I don’t really disagree. But my response would be that high interest rates would not do wonders for small banks, either. It’s a double edged sword, and the question is not whether low interest rates in particular cause concentration of finance, but whether concentration of finance is inevitable in any case.

      • #58 by Dan on March 2, 2013 - 11:02 pm

        “the question is not whether low interest rates in particular cause concentration of finance, but whether concentration of finance is inevitable in any case”

        Thats true, most of history shows (and especially those instances where banking has been deregulated) that the banking industry tends to consolidate, and it is more or less inevitable.

        But as far as interest rates are concerned, if interest rates become lower and the margin of profitability per loan decreases, what effect would that have on risk premium for those higher risk borrowers? It would seem that if the yields from low risk lending decrease, it just mean that rates for high risk borrowers go up because the overall lower profit margin from “low risk” loans would be less able to swallow up the losses from the higher rate of defaults among high risk borrowers. You may see more collaterized loans too for those deemed higher risk. And since high risk borrowers tend be the young and downtrodden it means that this scheme could have a regressive effect.

  14. #59 by freedomthistime on March 24, 2013 - 9:34 pm

    Here’s an interesting question – what if interest rates are actually a massive red herring within the economics profession, and all but irrelevant to determining economic outcomes? This is what Prof. Richard Werner suggests (amongst many other things…) in his book New Paradigm in Macroeconomics. See chapter 6 in particular.

    Economic theory would suggest:

    – low interest rates are correlated with high GDP growth, high interest rates are correlated with low GDP growth.
    – changes in GDP follow changes in interest rates

    Werner looks at the data for Japan and USA and finds that:

    – high interest rates are correlated with high GDP growth, low interest rates are correlated with low GDP growth.
    – changes in GDP lead changes in interest rates

    Werner concludes with:

    “Given how central the inverse and leading relationships between interest rates and economic growth is to modern economics, and given how frequently we hear assertions in the leading financial press and by central banks that lower interest rates will stimulate growth and higher interest rates will slow growth, it must come as a surprise to many, especially theoretical economists, that there is no empirical evidence for this relationship.

    “There is another, related enigma. And again, it is not unique to Japan: mainstream economic theory holds that interest rates should be in negative correlation with money supply aggregates (low interest rates and high money growth going together on the one hand, and high interest rates and low growth on the other). Concerning timing, interest rates are considered the driving force of broad money aggregates. This negative and leading relationship between interest rates and money growth is referred to as the ‘liquidity effect’. In a detailed empirical study, Leeper and Gordon (1992) have sought to establish this liquidity effect empirically, as it has hitherto only been ‘demonstrated’ in theoretical models. What they found was that both causation and correlation appeared *the exact opposite* of what standard theory proclaims.

    “Despite these devastating findings, none of the above facts are pointed out to students of economics, nor to journalists or the general public. Apparantly oblivious to the facts of this world, central bankers and theoretical economists keep repeating the mantra of the importance of interest rates, derived from their theoretical models, like monks spinning a prayer mill. Those who do not have the time to check the facts are easily misled by the so-called experts who are supposed to know better.”

    I’ve just finish reading this book and encourage you to give it a go, Unlearning – I think you will like it. Really, really good book – it DESTROYS neoclassical economics, blow by beautiful empirical blow. Werner’s main point – don’t look at interest rates, look at *credit creation* in the private banking sector. That is the key economic variable.

    • #60 by Unlearningecon on March 25, 2013 - 7:41 pm

      I don’t see that in the data I presented. Was Werner looking at short term rates? They behave very differently to long term rates.

      Perhaps I am misreading, but it seems to me that standard monetarist theory predicts that money growth will lead changes in rates, so high interest rates will be associated with (caused by) high growth. That seems quite mainstream to me!

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