Monday, June 14, 2010

Negative Real Interest Rates and Recovery

The debate over a Keynesian response (or lack thereof) to the nation's unemployment problem continues, sometimes in the comments section of this blog.

I am not certain that the AD story pushed by Krugman & others is absolutely wrong, but I'm definitely skeptical. There are alternative views out there from mainstream respected economists. Disagreeing with Paul Krugman does not automatically qualify one as mentally unfit, though the reactions of his supporters to criticism of Professor Krugman may, at times, make it seem like that is the case.

Here's Professor Raghu Rajan:
Some commentators argue that demand is too low now, that we need a negative real interest rate. Another way of saying this, though, is that the profitability of investment is really low, and households’ desire to save is really high. A strongly negative real interest rate “works” by subsidizing investment (when you borrow to invest, savers pay you for taking their money) and by encouraging consumption and penalizing savings (you have to pay others for the pleasure for borrowing from you)....

So why are so many Americans unemployed ? How do we return the economy to sustained growth? Are strongly negative short term real rates part of the cure? Perhaps we should recognize that the recoveries from the last two recessions (1991 and 2001) have been jobless, despite substantial monetary stimulus. Indeed, the negative real rates during the recovery in 2002-2004 did not prompt substantially more corporate hiring, but created a debt-fueled real estate boom and consumption orgy that we have yet to recover from. The rates were not low enough to prompt corporations to invest (they had just been through an investment boom), but low enough to trigger off a housing boom and a consumption boom. The remedy this time around cannot lie in creating unsustainable growth again.

Why have recoveries been so slow in creating jobs? I don’t think we really
know. But given our limited knowledge and our recent experience, I think we have to be more cautious about advocating negative real rates as a cure-all.

Go read the whole thing for a discussion of why business is hesitant to invest and consumers are reluctant to spend. It includes a sobering ending last two paragraphs concerning the possibility that low rates can form the basis for another asset price bubble.

As with so much in economics, this is far from a settled question.


D said...

The Prof raises excellent points. "Demand" is too low where? Demand for wild consumption during a recession is certainly low, and rightly so. That is precisely why individuals and the smarter of the banks are refraining from rampant consumption and irresponsible lending, respectively. Demand for security is high, which is why individuals are saving more.
Altering the interest rate by lowering it viz the market rate merely makes unprofitable ventures seem profitable, even though there is neither the capital to sustain the production nor the evidence of demand for such projects.
Non-Austrians have a tendency to omit time from their analyses. High spending indicates a low time-preference, ie) people prefer future consumption to present consumption, and the reverse is also true. Governmental fiat can only paper over (or do I repeat myself?) this reality and create a further misallocation of resources.
Typically, the Interest Power deems that only IT knows what should be demanded, rather than the people. It is merely a form of central planning and social engineering; the War on Reality continuing unabated.

J. Strupp said...

I think Rajan seriously downplays the impact of falling risk aversion in equities in the last year or so. His last paragraph seems to just glaze over that fact. Bottom line, the world crawled off the ledge in early 2009 and equity prices responded in kind.

"...,I think we have to be more cautious about advocating negative real rates as a cure-all."

I don't believe anyone is, by any means, saying that negative rates/QE are a cure-all for our problems. It's the best option on a short list of bad options, given our current situation.

That being said, what exactly is Rajan advocating here? That the Fed. is supposed to begin immediately unwinding their balance sheet and raise interest rates because he fears a possible asset bubble due to the Fed's current negative rate posture? I guess I'm at a loss as to how the severe bout of deflation and mass unemployment to follow will put us into a better situation moving forward.