Paul Krugman recently responded to Gavyn Davies’ excellent post on Keynesian Yellen vs Wicksellian BIS. Krugman argued that if an interest rate is set too low the economy overheats and we have accelerating inflation. However as Krugman points out there is no sign of overheating implying that by definition interest rates cannot be too low.
To make sense of Wicksell’s credit-based framework, it is critical to understand that his argument – whereby the natural rate equals the money rate will lead to price stability – is fundamentally flawed. His colleague David Davidson pointed this out to him at the time, as did Wicksell’s Swedish heirs Lindahl and Myrdal. The flaw is this. When productivity increases, the natural rate of interest rises but prices tend to fall. This happened when China entered the global supply chain. According to Wicksell, falling prices means that money rates need to fall to boost prices. Thus, to stabilise prices the differential between the two rates needs to widen further making the two concepts incompatible.
The second issue to note is that when the natural rate is higher than the money rate there is no necessary impact on the general price level. As the Swedish economist Bertie Ohlin pointed in the 1930s, excess liquidity created during a Wicksellian cumulative process can flow into financial assets instead of the real economy. Hence a Wicksellian cumulative process can have almost no discernible impact on the general price level as was seen during the 1920s in the US, the 1980s in Japan and more recently in the credit bubble between 2002-2007.
So should interest rates rise or remain at their subdued levels? Firstly the evidence that QE is in fact supporting the recovery – is tenuous at best. Indeed, the low levels of business investment may in fact reflect this intervention given the central bank is signalling to firms that the economy is still in intensive care and requires highly unconventional policies. This problem of course was pointed out by Keynes in the General Theory. As such there seems to be little reason to continue to support the on-going purchase of assets given 10 year nominal yields are still in the 2.5% region.
However it’s also worth noting that there is not much evidence that inflation is a concern related to such low levels of interest rates. Nominal wage growth is unlikely to gain significant steam until unemployment is below the 5.5% mark. Even then it is not clear that inflation will behave as it has in previous cycles. Nominal wage growth is being depressed through a combination of globalisation and in some sectors the substitution of capital for labour resulting in returns to capital increasing at the expense of returns to labour. The net result of this is that future aggregate demand may well be lower as low to middle income households have a higher propensity to consume. This lower aggregate demand itself may also be acting as a break on job creation, which will result in even less inflationary pressure.
During the period 1870-1890 in Britain, the returns to labour increased at the expense of capital with relatively higher real interest rates and mild deflation. In an age of globalisation that puts downward pressure on nominal wages this may well be the best option to stabilise nominal income leading to rising prosperity for all.
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