My earlier post on interest rates fueled a hot discussion on the LinkedIn, and I enjoyed all responses so much that I cannot but continue musing over this not only hot but very important in terms of economic policy topic.
My epistemological approach so far has been that of Karl Popper, meaning that falsification is a good way to come closer to the truth. Following this path, I have tried to falsify the idea that low interest rates are to blame for economic crises, financial crises, asset bubbles and so on. The statistics of 19th century US economy provide enough material for the falsification (which is never absolute, I admit).
Yet one of the commentators quite rightly mentioned: if low interest rates are not of major influence, could it be that there is at least some influence? Therefore, we cannot limit ourselves to falsification.
And, of course, since the beginning of the 20th century the US has gotten the Federal Reserve, which manipulates the money and interest rates on the national scale. There are central banks in other countries with similar functions.
Let us see what John Maynard Keynes says on the issue of interest rates in his “The General Theory of Employment, Interest, and Money”(I use 1997 edition).
He starts with the notion of marginal efficiency of capital. It is crucially important for defining the role of interest rates in economic growth. Sadly, modern decision making ignores this parameter. It is widely accepted now that interest rate stimulates growth, if its value does not exceed that of natural interest rate, closely connected to natural rate of unemployment (that was the idea of Swedish economist Knut Wicksell, initially accepted by Keynes, yet dropped in “The General Theory…” ).
Keynes regards interest rate primarily in conjunction with marginal efficiency of capital. We’ll see later that it opens a road to think in terms of major role of technological factors in all the vagaries of economic growth under capitalism.
So how does Keynes define the notion of marginal efficiency of capital?
“The reader should note that the marginal efficiency of capital is here defined in terms of the expectation of yield and the current supply price of the capital asset. It depends on the rate of return expected to be obtainable on money if it were invested in a newly produced asset; not on the historical result of what an investment has yielded on its original cost…” (J. M. Keynes, p.136).
At once, we can see the stark contrast with relying on the trend, which shapes the “natural” interest rate in the past. By definition a trend is a smooth movement, so possible “black swans” are out of the question, the inherent uncertainty is out of the question. We can only extrapolate what has happened in the past. When matters change, we talk about “new normal”, the new trend, that is. Why should we extrapolate this “new normal” into the future? May be a new “new normal” is around the corner. All this looks very arbitrary.
For Keynes, though, the perceptions about future, with inherent degree of uncertainty, interact with interest rates, creating a complex of feedbacks.
Here is his line of thought. Savings are the basis for investment. It is what remains after subtracting consumption from income, so the propensity to consume defines the amount of savings. Yet savings come in different forms. There is liquidity in the form of cash, bringing in no interest, and various forms of securities with the yields, defined by market. Individuals and businesses always define the degree of their liquidity preference, depending on the attitude toward risk. Interest rate, actually, is the reward for parting with cash.
If the rate of interest goes down, meaning “if the reward for parting with cash were diminished” (J. M. Keynes, p.167), people switch to more cash and the demand for cash will exceed the supply. That means, inversely, that the change of the amount of money affects the rate of interest. That means the monetary policy plays its role in shaping the rate of interest.
So we need to differentiate between “the results due to a change in the rate of interest and those due to a change in the schedule of the marginal efficiency of capital” (J. M. Keynes, p.174).
Simply put, the marginal efficiency of capital is the perception about future gains, brought in by real investments, and the rate of interest is the result of consumer preferences, liquidity preferences, market speculations with debt products and monetary policy of central bank.
Yet the relationship between these two sides affects the rate of economic growth. According to Keynes, while it is natural to think that low interest rates stimulate investments and economic growth, it may be a false conclusion, in case the perceptions of business community regarding future marginal efficiency of capital are even lower, so it is more lucrative to play in the debt market than to bother building some new efficient production facilities.
Does not this remind us the current situation in the economies of the rich world?
In the US, for example, we see (2014) the accumulation of trillions of cash dollars on the accounts of companies. As a result, the investments do not grow fast, even though the interest rates are very low and the volume of money printing, probably, has reached its limits. The reason is clear- the state of confidence in the future among businesses is rather poor (especially in Europe).
Certainly, we must think not only in terms of tweaking the monetary policy, but also in terms of creating different incentives for businesses to invest.
Now it is clear that the causality link between low interest rates and economic crises, booms and busts is complicated by the perceptions about future marginal efficiency of capital.
Keynes even believed that booms and busts of capitalist economy were mainly due to the fluctuations of the marginal efficiency of capital (J. M. Keynes, p.313).
If this is true, the specific character of technological revolution of modern times must be part of the equation. There is a statistical proof, provided by Edward C. Prescott, Nobel Prize Laureate, that changes in technology are crucial for developing business cycles. Currently (2014) labor productivity in the US and other developed countries grows very slowly. Are there any fundamental, technology-related reasons for that? Some economists think that the era of computers has not yet revealed all its efficiency, in comparison with enormous effect of the use of electricity.
In light of all this complexity, the interest rates’ role in causing crises or healing the economies in crises should not be exaggerated.
John Maynard Keynes. The General Theory of Employment, Interest, and Money (1997 edition). Originally published: New York: Harcourt, Brace & World, 1938.