Negative interest rates? Negative!

Keynesian economists have an enduring disposition to spend their way out of trouble. This is so even when overspending has caused the trouble. Gone are the days when expenditure and taxation were varied by a ‘touch on the tiller’ (James Callaghan) to steer aggregate demand. With disillusionment over the timing and efficacy of fiscal policy, the preferred instrument for intervention became short-term interest rates; and, when they are pushed to the floor, attention turns to long-term rates (aka ‘quantitative easing’). And with that having fallen flat, negative interest rates are now proposed as a possible route to recovery.

From the Austrian School, the indictment is that Keynesian economists are blind to the relevance of capital theory. They have no understanding that interest rates are inter-temporal prices, which are as relevant to microeconomic resources allocation as are prices at any point of time. Mercifully, governments have accepted the wisdom of allowing the price mechanism to work; but, they remain blind to the microeconomic price-distortions that are caused by meddling with interest rates for dubious macroeconomic outcomes. The general ignorance to the implications of capital theory of the proponents of Keynesian panaceas is exemplified by the opening statement of Lord Skidelsky in the LSE debate of 2011 and, more recently, by the writing of Nicholas Wapshott.

Mark Twain is attributed with the notion that, while history doesn’t repeat itself, it sometimes rhymes. So it is that, with every repeat of a low-interest rate credit boom and bust, governments are always more likely to grasp a Keynesian panacea than to allow necessary liquidations to occur.

Friedrich Hayek spent a large proportion of his professional life to refuting policy panaceas. For the USA in the 1920s, only a mild recession would have followed growth to 1927, had an easy-money policy not succeeded: ‘in prolonging the boom for two years .. [postponing] .. the normal process of liquidation’ (Hayek, 1935). The Great Depression followed. In the 1970s, Hayek examined monetary distortions in the context of labour markets, trade unions and unemployment, being careful to engage a readership that had become well-versed in monetarism and Phillips curves. He then focused upon misallocations of labour and consequential unemployment caused by distortions to the structure of investments. In the 1990s, information communication technology sectors were the primary feature of unwarranted longer-term investments that become viable (but are always unsustainable) during a bank credit upswing. In the vernacular, the dotcom bubble burst. In the 2000s, domestic property developments were the primary feature of unwarranted longer-term investments that were made to appear viable by loose credit.

Friedrich Hayek’s remarks from 1975 are relevant to the latest panacea of negative interest rates:

 ‘For forty years I have preached that the time to prevent a depression is during the preceding boom; and that, once a depression has started, there is little one can do about it. My advice was completely disregarded as long as the boom lasted. Now suddenly, when my prediction has come true and we have reached the stage where ... little can be done about the inevitable reaction which has set in, people suddenly turn to me and ask for my opinion.’

Why do Austrian inclined economists tend to be dead against negative interest rates? Austrian economic theory is able to explain them in a very parsimonious way, almost uniquely. If interest rates are simply inter temporal prices, then a negative interest rate suggests that consumption is expected to be more expensive in the future than it is right now. This could be because of predicted future resource shortages, demographic shifts (fewer workers, more pensioners) or technological stagnation. It is probably also due to supply-side problems in the current economy. In any case, market participants are currently sufficiently pessimistic about the future that they are prepared to pay money now to save some of it more securely (by buying German bonds for example). By failing to lower interest rates to the current natural rate, the Government could be artificially subsidising savers, probably to the detriment of future wealth generators. There is a lot that should be done to raise the real interest rate (supply side reforms that reward capital investment) but keeping the nominal interest rate high is not one of them. Negative real interest rates are a signal, like any other price. They should not be suppressed.
Negative interest rates may well be required to get back to our trend rate of money/ngdp growth which had been way, way under any desirable level since 2009. Banks have increased their demand for base money, causing a money supply contraction, negative interest rates could reverse this trend. Hayek's quote is baseless with no evidence to support it. Friedman & Schwarz show rather well that booms don't have to result in busts, that what goes up doesn't have to come down or that downs are caused by preceding ups. More importantly they show that a lack of stable money growth causes macro instability. Don't get me wrong, Hayek is one of my favourite economists, but his macro isn't on par with his other work.

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