Why Are Interest Rates Low?
By Arnold Kling
My sense is that we do not know enough about the effect of ultra-low interest rates to state categorically that they are an unmitigated good for reviving the economy. But perhaps the most important cost of low rates is its effect on risk taking and illiquidity seeking. Remember that the United States Fed under Greenspan helped precipitate the recent crisis by keeping rates too low too long. That suggests we cannot be sanguine about the risks that are being taken now. Indeed, many of those who urged Greenspan to keep rates ultra low then are urging the Fed to keep rates ultra low now.
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My sense is that Scott Sumner believes that interest rates are low because expected nominal GDP growth is low. Therefore, he would argue that monetary policy should be more expansionary.
My sense is that Krugman and DeLong believe that interest rates are low on U.S. Treasuries because there is a lot of demand for safe assets. Therefore, the U.S. should create more safe assets by running larger deficits.
Rajan is implicitly suggesting that interest rates are low because the Fed is already pursuing a very expansionary monetary policy and is forcing rates to be unnaturally low.
Of the three explanations, I find Rajan’s the least plausible. That is because I come to this discussion with a belief that the Fed is much less of a factor than just about anyone else presumes. I believe in a Fischer Black view that capital markets are rich and complex, and interest rates are set by these markets. The Fed at most affects relative supplies in a tiny segment of these markets. In this view, monetary policy does not matter much. So from a policy perspective, I do not have a horse in this particular race.
I lean to a Sumnerian explanation for the recent drop in long-term rates. Economic growth and employment have been weaker than many of us expected, so long rates have come down.
I do not think that we have seen a dramatic increase in the spreads between corporate and government debt in the last month or so (I do not have time to check this, so I could be wrong). If the increase in risk spreads has been modest, then the DeLong and Krugman view has only modest plausibility.
My view of interest rates in the past two years is that markets have been trying to tell the financial sector to shrink. Investors do not trust banks. They would like to invest directly in stocks, government debt, and non-bank corporate debt. Government policy has been an all-out effort to help banks and to fight against the market. These efforts include the Fed’s balance sheet moves, TARP, and the recent actions of the Eurocrats.
Sumner, Krugman, DeLong, and Rajan are acting as if macroeconomic stability is the main policy issue. My view is that the policy makers in fact are focused on bank stability first and foremost. Policy makers tell us, and tell themselves, that the key to macroeconomic stability is bank stability. That is one story. My story is that they are less able and less motivated to bring down the unemployment rate than they are to prop up banks.