My pupil looked at me darkly and resentfully and blurted out: "I did not come to Oxford to have problems simplified!"
The term used in the opening paragraph--the "natural rate of interest"--was first coined by Knut Wicksell.
Recalling this sobering episode, I begin to suspect that my Indian student was wiser than me and wiser than he knew. Perhaps the clean logic and elegant simplicity of the Keynesian system, in which all Western economists now alive have been brought up, has misled us to see the economy as an elementary contraption made of a handful of Meccano pieces we can move around by just a handful of levers. All advanced economies are at present suffering from two very serious ills. One is an alarming year-by-year rise in the public debt at a rate faster, in some countries much faster, rate than the national income which is supposed to assure its service. The terminal form of this malady is where everyone's income is entirely absorbed by paying interest on the national debt, and everyone's sole source of income is the interest he gets on the savings he had lent to build up the national debt. For this to work, all income from labour and capital must be taxed at a 100 per cent, yet people must still be willing to work and invest.
The other grave ill common to advanced countries is chronic unemployment, especially of the young, at a rate high enough to drive to despair those who genuinely want to earn their living.
A very high fiscal deficit and very high and persistent unemployment are not absolutely incompatible in the Keynesian system. At a stretch, they could occur together, but they look strange and do not fit into our habits of thought. This is probably why the policy advice coming from experts and politicians on how to deal with these ills is breaking down into two contradictory streams: one wants to take a cure of fiscal austerity to slow down the accumulation of public debt, while the other, pointing to the "output gap" that shows the tens or hundreds of billions by which the economy is running below its capacity, argues that fiscal austerity is absurd waste when so many human resources are left idling on the dole. The two ills seem to call for mutually contradictory cures.
In the Keynesian economy, severe unemployment due to insufficient demand for goods and services is potentially a stable equilibrium. Investment is what it is because its marginal yield is decreasing and if more resources were invested, their yield would fall below the relevant rate of interest. Actual investment is matched by actual saving, hence the investment will generate a level of aggregate income which, in turn, will induce the amount of saving that matches the investment. The higher the share of marginal income that goes into saving instead of consumption, the lower will be the increment of aggregate income generated by incremental investment. (Economists call the inverse of this ratio the "multiplier"). The resulting sub-optimal equilibrium with its "output gap" is ascribed to over-saving. To remedy it, the consumer is exhorted to go out and put his credit card to work. Additionally, the government is very willing to do its bit and spend more, letting its debt rise a bit faster. As long as resources are left unemployed, piling on more debt can supposedly do no real harm. Some governments have been taking this medicine intermittently for decades, and all have gone on overdose since 2007. Orthodox Keynesians are rubbing their eyes in disbelief that such massive fiscal stimulus, never before seen in peacetime, is doing so little to reduce unemployment and narrow the "output gap".
Read more about liquidity traps at Liquidity Traps and Unicorns, by Arnold Kling. March 17, 2011. EconLog.
If the economy fails to respond to the fiscal push, can recourse to more liquidity to float it off the sandbank? A cardinal assumption of Keynesian theory is that the demand to hold money becomes infinitely elastic at some low but still positive rate of interest. This rate is the "liquidity trap". Old-style central bankers may be spinning in their graves at the noise of "quantitative easing" as more and more debt securities are sucked up by the central bank and are replaced with more liquid money and near-money, yet the interest rate relevant to capital investment will not go any lower. Hence, no matter whether the economy is splashing ankle-deep or knee-deep in liquidity, investment will remain inadequate to dent unemployment. However, as we look at real numbers in money and capital markets since 2007, we are left wondering about what has become of the "liquidity trap"? The interest rate at the short end of the yield curve is as near zero as not to matter, and even at the long end it looks negligibly low if the riskless rate of just over 3 per cent is deflated by the probable rate of future inflation which, too, should hover near or above the 3 per cent level. In other words, if the risk-free real rate is in fact at about zero, there is in fact no such thing as the liquidity trap and at least for the present, it cannot be blamed for the economy idling along at the lower edge of the output gap.
The upshot of all this is that much as the simplicity of a Meccano or Lego construction is pleasing to the mind that looks for clarity and order, the clarity in economics we need is not found in Meccanomics or Legonomics. The orthodox Keynesian full employment recipe of "fine tuning" by monetary and fiscal policy that was practiced with much confidence and some occasional success in the first few post-war decades, has been losing credibility since the '70s and looks very doubtful at present. The bucket and the axe are replacing the tuning fork as the policy tools government are trying to wield today.
One can only wish them success in whatever they attempt to achieve by these policies; but one wishes that they would listen to the little voice of doubt that whispers more and more persistently that the best policy of all might well be to have less policy altogether.