by Mario Rizzo
It is well-known that John Maynard Keynes favored permanently low interest rates in order to foster adequate and stable investment demand. Let us first focus on stability and then we’ll see a connection to adequacy.
What happens when counter-cyclical policy (aka Lerner’s “functional finance”) is practiced?
The Wall Street Journal ran an excellent small article by Richard Barley, focused mainly on the UK, that makes interesting general points. Investors must try to figure out when the current policies of quantitative easing will be reversed. Those who are long (or plan to be long) in the securities which central banks have bought are quite interested in timing.
First, consider what Keynes had to say on the subject in early 1937:
“A low enough long-term rate of interest cannot be achieved if we allow it to be believed that better terms will be obtainable from time to time by those who keep their resources liquid. The long-term rate of interest must be kept continuously as near as possible to what we believe to be the long-term optimum. It is not suitable to be used as a short-period weapon.” (“How to Avoid a Slump,” The Times, Jan. 13, 1937, p.13).
This is because if people expect interest rates to rise they will hold money rather than buy all sorts of assets, that is, “invest.”
Now let us look at what the Wall Street Journal is saying:
“The snag is that some government-bond markets are so potentially distorted by central-bank programs that it is hard to feel confident of where prices should be…
Moreover, investors also need to second-guess both when and how central banks will decide to call time on quantitative easing…
If the BOE [Bank of England] calls a halt to quantitative easing once the program is complete, the best bet is that issues that have seen heavy central-bank buying will become relatively illiquid and hence unattractive…”
So when economists, like Paul Krugman, say that there is not enough investment spending and attribute this to a “liquidity trap” they fail to see how the central bank is contributing to the very problem they are complaining about.
Let me be clear that I do not advocate, as Keynes did, permanently low interest rates. But the problem we are facing is that the Fed (and BOE) has expanded the amount and types of securities it buys with the result that current interest rates are distorted. I well understand that, from a simple aggregate demand perspective, policymakers are desperate to stimulate investment spending. But when one realizes that we do not live in a one-period model, expectations matter. They do not always cooperate in the way that produces the desired result.
The fundamental problem that got us where we are is the distortion of interest rates induced by poor monetary policy. In a different way, the distortion of interest rates continues.