The International Economy, 2016
In recent months, there has been a growing backlash against the policy of ultra-low and negative interest rates being pursued by central banks around the world. While many have correctly argued that fiscal policy would be more effective in boosting demand and employment, this option is largely foreclosed for political reasons in much of Europe and the United States. In this context, the relevant issue is not whether or not fiscal policy would be more desirable, but rather whether stimulative monetary policy is better than doing nothing to boost the economy. The answer to this is clearly yes, as the arguments on the other side have little merit.
Most of the claims on the evils of low interest rates center on the idea that they will distort the economy and possible lead to dangerous bubbles. Neither of these claims can stand serious scrutiny.
The economic distortion claim implies both that we have reason to believe that the equilibrium interest rate is substantially higher than current rates and that there are substantial distortions from this gap. The first assertion is simply an empty assertion. We have all the major economies in the world operating far below their potential levels of output. Why would we believe interest rates are below some “natural” rate?
Furthermore, there is little reason to believe there would be major misallocations from any gap that might exist. We see huge fluctuations in the prices of major commodities such as oil all the time. While these fluctuations do result in some misallocation, no one considers such price fluctuations to be a major economic problem for the world economy, even if they might be for major oil exporters. Why would we think that a 1–2 percentage point change in real interest rates would lead to major distortions?
The argument on dangerous bubbles is even weaker. The bubbles whose crash led to the great recession were not difficult to see at the time to anyone who looked at the data with open eyes. In the United States, there was an unprecedented run-up in real house sale prices even as rents rose virtually in step with inflation. How could this have been explained by the fundamentals of the housing market?
Furthermore, vacancy rates were already hitting record levels even as house prices continued to soar. This is not consistent with any sort of fundamentals based explanation of house prices. And the bad loans of the bubble era were hardly a secret. They were a frequent topic in the business press as commentators joked about things like “NINJA” loans, which stood for no income, no job, and no assets.
In addition, it was easy to see that the housing bubble was driving the economy. Residential construction hit record highs as a share of GDP in 2004–2005. Also, housing wealth–driven consumption was easy to see in the data. then-Fed Chair Alan Greenspan even co-authored several papers on the topic. Of course, it should have surprised no one that consumption driven by the bubble would disappear when the bubble burst.
In short, the idea that a dangerous bubble can grow undetected is absurd on its face. If the bubble is large enough to move the economy, then it can be seen. If it’s not large enough to move the economy, it is not dangerous.
In a weak global economy we have very good reasons to want low interest rates to help boost demand. There is not a serious argument on the other side.