Economic dysfunction: rooted in the real economy or in the monetary system?

The notion that interest rates have been falling for 30 years is a dominant theme of economic debate.

Policymakers refer to a ‘structural decline’ in ‘real long term interest rates’ that are determined by global ‘forces’.[1] They do not mean the central bank rates that can be directly manipulated, but an underlying condition of interest that is more closely indicated by rates on longer-term borrowing through government or corporate bonds. 

It is fundamental to current policy doctrine that these rates are regarded as mirroring weakness in the economy, normally understood through productivity growth.  Under the dismal ‘secular stagnation’ hypothesis, weakness will prevail indefinitely into the future.

This narrative is the reverse of reality on both counts.

First with regard to interest rates: the dominant feature of the chart below is the greatly elevated level of interest rates over the last 35 years relative to the previous 30 years. Interest rates may have come down since the turn of the millennium, but the reduction is hardly continuous and even in 2016 (partly projected) real rates are still above the average rate in the first post-war period.

US real corporate bond (BAA) yields

(Sources and discrepancies with the conventional wisdom are explored in greater detail here.)

(Sources and discrepancies with the conventional wisdom are explored in greater detail here.)

And then the relation between interest rates and outcomes: low interest rates through the golden age coincided with unprecedentedly high growth. The reversion to high rates coincided with a progressive decline in growth.

Interest rate and annual average productivity growth

This should hardly be a surprise. When it comes to conventional monetary policy, cuts in rates are aimed at fostering higher growth. Low interest rates make borrowing cheaper and should encourage entrepreneurs to expand activity (as well as encouraging consumers to spend). But mainstream economics takes a different approach to long-term rates, which are somehow dictated by events rather than dictating events. These simple figures show the mainstream analysis is contradicted by reality.

Moreover the conventional narrative around long-term rates has been inconsistent throughout. In the 1970s calls for the liberalisation of capital were aimed at increasing the availability of savings which would drive interest rates lower and foster higher growth.  A decade later the IMF recognised that rates had been very high:

These measures imply that real interest rates in the major industrial countries during the 1980s have been significantly higher than those that prevailed in the 1950s and early 1960s and even further above those of the 1970s. (IMF, World Economic Outlook, 1985)

Later in 1999 Christopher Allsopp and Andrew Glynn (‘The Assessment: Real Interest Rates’, Oxford Review of Economic Policy, 15 (2), Summer, 1–16) observed:

There is a widespread impression that real interest rates have been very high since 1980 in comparison with post-Second-World-War experience. The data … confirm that this is indeed the case.

 So this view of high rates to at least the end of 1999 overlaps by around 15 years with the present idea that rates have been in decline for 30 years.

In reality low rates of interest were deliberately engineered by the architects of post-war policy (successfully) to support aggregate demand, output and employment. Financial liberalisation removed the restraints on capital that had supported relatively low interest rates for C20Q3, and were exacerbated by the ‘Volker shock’ (i.e. sharp increases in the central bank policy rate) and overfunding of government debt (i.e. forcing more long-dated debt onto the market  than the market wanted).

To the extent that rate were lower from the start of C21, this followed a vast expansion of the global money supply as all restraints on finance were removed in the wake of the crash.  Since the GFC, central banks have had to open up their balance sheets to take up the slack.

These policy actions have taken place in desperation given the progressive decline in growth and global financial instability that were the consequences of high rates.

Moreover, even to the extent that interest rates are genuinely cheap, they are not sufficient given the collapse of business confidence amidst public retrenchment and private debt overhang. This should hardly be a revelation. Strictly (in Keynes’s scheme) this is not a liquidity trap, but a collapse in the marginal efficiency of capital that reflects the animal spirits of firms.  However, the immediate policy need is one and the same: a material increase in government spending to revive demand and business confidence.  The more challenging ask is to renew a global system that will foster permanently low interest rates on a sustainable basis.

The argument here mirrors exactly those of the 1920s and 1930s: whether economic dysfunction is rooted in the real side of the economy or in the monetary system. The difference this time around is that monetary argument is barely heard, if even acknowledged to exist at all. The point I am keen to make today is that subsequent experience showed the real argument does not even stand up in its own terms.  


[1] E.g. Ben Broadbent, ‘The distributional implications of low structural interest rates and some remarks about monetary policy trade-offs’, speech 18 November 2016.

P.S. Due to an error in the original posting this blog was amended at 17.18 on 23 December, 2016, to include a missing paragraph (between the charts) and heading.