Why Low Interest Rates May Not Help the Economy Fully Recover
After seeing the United States through its worst global crisis since the Great Depression, the former chairman of Federal Reserve, Ben Bernanke, has taken to explaining complex economic concepts and commenting on policy on a blog for the Brookings Institution. Bernanke was in academia before his stint at the Fed, and his professorial instincts are at fine display on his blog, where he reduces complicated topics to simple relationships.
Recently, he tackled the problem of prolonged low interest rates. The topic has generated much attention and controversy. Designed to kickstart the economy by encouraging consumers to spend, the policy has been in effect since the recession in the United States and is part of a broader effort to revive the global economy. But the efforts have yielded mixed results so far.
Bernanke explains possible reasons for its failure and suggests a future course of action. Although they do a fantastic job of explaining the interest rate problem, Bernanke’s posts still leave some questions unanswered.
What caused low interest rates?
In his blog post, Bernanke contrasts two theories as causes for low interest rates.
The secular stagnation theory, which was first proposed by William Hansen, holds that a slowdown in population growth coupled with advances in technology innovation results in replacement of men with machines. Thus, secular stagnation increases productivity (due to machines) and decreases demand (due to high unemployment). Further interest rate reductions result in a cycle of high productivity and low demand.
Japan is a textbook case of secular stagnation. The country is trapped in a spiral of low interest rates, an aging (and, increasingly, temporary) labor force, and huge public debt. This has occurred in spite of increased productivity.
According to Larry Summers, who is a proponent of this theory, increased infrastructure spending can help revive the economy. This is because infrastructure projects generate demand by employing low-skilled workers in capital-intensive industries.
In the second of his explanatory blog posts, however, Bernanke argues that the U.S. economy does not face secular stagnation for two reasons. First, negative real interest rates would make any project profitable, in infrastructure or otherwise. Second, he subscribes to the notion that the current slowdown in the U.S. economy is due to “temporary headwinds” in the larger global economy. As an example, he points to the fact that a concert of circumstances — low housing prices were offset by rise of overall prices of food and drain in demand — occurred during the supposed boom period of the U.S. economy in the past decade.
Instead, Bernanke posits that a global savings glut is responsible for the current economic recession. Lack of suitable investment options has resulted in a global tightening of purse strings. Unlike secular stagnation, which can be corrected through monetary policy action, fiscal action is required to spur spending for a global saving glut. This means that a country with sustained low interest rates can induce demand in its economy by depreciating its currency. Sweden successfully rode out a depression in the 1990s with this strategy. The Asian Tigers adopted a similar strategy in the late 1990s to power their way through the economic crisis.
Bernanke’s hypothesis for a global savings glut is sound, especially within the context of a global interconnected economy. But it leaves some unanswered questions.
For example, it does not explain the persistence of low wages. Low wages are a byproduct of weak demand (and high interest rates, which promote savings). In spite of sustained low interest rates, wages have not increased even as demand has picked up. Calibration of the international economy to generate demand may not have a substantial effect on low wages because they are driven by a complex mix of factors, including unemployment insurance and local healthcare insurance laws.
There is also the problem of overstating the importance of current accounts. A country’s current account, which is the difference amount that it spends on imports versus exports, is an important indicator of the health of an economy. A current account deficit implies more imports (and, therefore, more focus on domestic demand) while a current account surplus implies more exports (and, therefore, less focus on international markets).
According to Bernanke’s post, a large swath of the world, including Germany, China, and the Asian tigers, have been running a current account surplus for some time. In effect, this means that their economies are focused on exports. Refocusing their priorities to domestic demand will help correct trade imbalances between countries. But Bernanke does not dwell on the effect of sustained current account deficits. Developing nations, such as China, are already becoming important markets for U.S. products. Further boosts in domestic consumption could lead to overheating in the target markets. We are already seeing the effects of this overheating in certain parts of the Chinese economy. Flight of capital from these economies (such as the one that happened during the Asian financial crisis of 1997) could seriously endanger growth prospects for the world economy and trigger another crisis.