Oct 29th 2016

Would Higher Interest Rates Boost US Growth?

by J. Bradford DeLong

J. Bradford DeLong, a former Assistant US Treasury Secretary in the Clinton administration, is Professor of Economics at the University of California at Berkeley.

BERKELEY – Blackstone CEO Tony James recently published a column in the Financial Times titled “To revive America’s economy, raise interest rates.” This is a very bad idea.

Let us imagine that we have been transported to a parallel universe, one where the US Federal Reserve has not held interest rates at or near zero. Instead, this Fed has gradually raised interest rates for the past six years, and the federal funds rate is now 400 basis points higher than it currently is. Before looking at what this alternate-universe economy would look like, let us review what has happened in the real world.

In the fourth quarter of 2015, households, businesses, and foreign investors saved $940 billion in the United States. Of that amount, $185 billion was invested in newly issued government bonds, and the other $755 billion flowed into interest- and dividend-paying savings vehicles such as loans, corporate bonds, and new equity issues, which in turn added to the US private sector’s productive-capital stock.

In our hypothetical scenario, $755 billion in new savings vehicles would not have been created in the fourth quarter of 2015 to fund investment. With higher interest rates, that $755 billion could still have been as high as $735 billion, or it could have dropped to as low as $700 billion. In any case, we know that it would have been lower, and that the liquidity balances that support spending would have been deprived of $20-55 billion.

Perhaps James only talks to firms that do not rationalize their investment plans when interest rates rise; but many firms certainly do. For example, interest rates play a major role in the construction business, especially on the coasts, where real-estate values are especially sensitive to financing costs and available cash flows. Increased financing costs and reduced liquidity can also dampen consumer-goods purchases and prevent small businesses from expanding.

The Fed could respond by adding to the economy’s cash stock, but then interest rates would fall, and we would be exactly where we are now. On the other hand, if the Fed maintained the higher federal funds rate, financial flows would be diverted away from productive investment and into idle cash balances, spending would decrease, and the economy would enter a new recession.

At this point, James would object that this is not what he wanted at all. He would have expected the confidence fairy to show up and spur production and demand across all economic sectors, so that businesses still would have created $755 billion in new savings vehicles, aside from government bonds, in the fourth quarter of 2015.

With the confidence fairy’s arrival, everything would indeed be fine: the economy would be stable and close to full employment, interest rates would be higher, and the negative effects of abnormally low interest rates that James lists would all disappear. According to James, these effects include “companies substituting capital for labor to an unnatural degree”; economic hardship for “the elderly and others who depend on income-producing investments”; higher retirement-savings requirements; “systemic risks” in the financial system as investors buy “esoteric assets” to “grasp for higher returns”; and lower bank profitability from lending.

But these problems would not be averted by the Fed independently raising interest rates. Rather, businesses must create savings vehicles and make investments, to which the Fed can then respond by allowing interest rates to rise, in order to head off excess demand and high inflation.

The Federal Open Market Committee cannot dictate this process from the Eccles Building in Washington, DC. But the Fed has now tried to induce the creation of more savings vehicles, in part through $3 trillion in purchases of long-term securities.

The Fed has removed an annual $30 billion in duration risk from private-sector balance sheets – which bond issuers previously had to pay savers to bear – and that freed-up risk-bearing capacity has presumably been used to fund risky investment projects. But surely James would agree that financial organizations that assess and bear duration risk are not necessarily competent to judge other risky ventures.

If we want more savings vehicles to push up interest rates in loanable-funds markets, so that the Fed can then increase the federal funds rate, there is an obvious solution: the government itself should create savings vehicles. For example, a government-sponsored infrastructure bank could start borrowing $100 billion every quarter to finance infrastructure projects. With that, concerns about abnormally low interest rates would be a thing of the past.

In the meantime, the Fed should certainly not take the lead in raising interest rates when there is no evidence of excess supply in savings vehicles. To do so would be akin to building a half-mile landing strip in the Pacific Ocean in 1944, and thinking that cargo-bearing B-17s would suddenly start to land.



Copyright: Project Syndicate, 2016.
www.project-syndicate.org

 


This article is brought to you by Project Syndicate that is a not for profit organization.

Project Syndicate brings original, engaging, and thought-provoking commentaries by esteemed leaders and thinkers from around the world to readers everywhere. By offering incisive perspectives on our changing world from those who are shaping its economics, politics, science, and culture, Project Syndicate has created an unrivalled venue for informed public debate. Please see: www.project-syndicate.org.

Should you want to support Project Syndicate you can do it by using the PayPal icon below. Your donation is paid to Project Syndicate in full after PayPal has deducted its transaction fee. Facts & Arts neither receives information about your donation nor a commission.

 

 

Browse articles by author

More Current Affairs

May 26th 2022
EXTRACT: "No, I am not arguing that Powell needs to replicate Volcker’s tightening campaign. But if the Fed wishes to avoid a replay of the stagflation of the late 1970s and early 1980s, it needs to recognize the extraordinary gulf between Volcker’s 4.4% real interest rate and Powell’s -2.25%. It is delusional to believe that such a wildly accommodative policy trajectory can solve America’s worst inflation problem in a generation."
May 26th 2022
EXTRACT: "It will be critical in this context how China will act and whether it will prioritise its economic interests (continuing trade with Europe and the US) or current ideological preferences (an alliance with Russia that makes the world safe for autocracies)."
May 26th 2022
EXTRACT: "The document is full of embarrassing and damming stories of illegal gatherings and bad behaviour. There was “excessive alcohol consumption”, a regular fixture referred to as “wine time Fridays” and altercations between staff. Aides are shown to have left Downing Street after 4am (and not because they had worked into these early hours). Cleaning staff and junior aides were abused, and a Number 10 adviser is on record before the infamous “bring your own booze” party...."
May 17th 2022
EXTRACT: "But even a resounding Russian defeat is an ominous scenario. Yes, under such circumstances – and only such circumstances – Putin might be toppled in some kind of coup led by elements of Russia’s security apparatus. But the chances that this would produce a liberal democratic Russia that abandons Putin’s grand strategic designs are slim. More likely, Russia would be a rogue nuclear superpower ruled by military coup-makers with revanchist impulses. Germany after World War I comes to mind."
May 8th 2022
EXTRACT: "For citizens of states that are members of NATO, taking all possible steps, short of all-out war, to ensure that Russia does not conquer Ukraine is not even an altruistic sacrifice. It is a long-term investment, for themselves and their children, in freedom, democracy, and the international rule of law."
May 4th 2022
EXTRACT: ".....a remarkable transformation is taking place in Ukraine’s army amounting to its de facto military integration into Nato. As western equipment filters through to the frontline, Nato-standard weaponry and ammunition will be brought into Ukrainian service. This is of far higher quality than the mainly former Soviet weapons with which the Ukrainians have fought so capably. The longer this process continues and deepens, the worse the situation will be for the already inefficient Russian army and air force."
May 3rd 2022
EXTRACT: " The conventional wisdom among students of the Russian arts and sciences is that Russian culture is “great.” The problem is that, while there are surely great individuals within Russian culture, the culture as a whole cannot avoid responsibility for Putin and his regime’s crimes." ---- "Russianists will not be able to avoid examining themselves and their Russian cultural icons for harbingers of the present catastrophe. What does it mean that Fyodor Dostoevsky was a Russian chauvinist? That Nikolai Gogol and Anton Chekhov were Ukrainian? That Aleksandr Solzhenitsyn was an unvarnished imperialist? That Aleksandr Pushkin was a troubadour of Russian imperial greatness? May these writers still be read without one eye on the ongoing atrocities in Ukraine?"
Apr 29th 2022
EXTRACT: "The following day Lavrov met his Eritrean counterpart, Osman Saleh, in Moscow. Eritrea was the only African country to vote against the UN resolution condemning the invasion. In this refusal to condemn Russia, Eritrea was joined by only Belarus, North Korea and Syria. Even longstanding allies such as Cuba and China abstained. It’s an indication of Russia’s increasingly limited diplomatic options as this war continues."
Apr 24th 2022
EXTRACT: "Although the milestone lasted only for a brief time, it points to a future in which California runs on 100% wind, solar, hydro and batteries, a future that will certainly arrive even faster than the state plans. As it is, California is ahead of its green energy goals." ...... "A world of 100% green energy and electric cars is not only a healthier and more comfortable world, it is a world where oil and gas dictators like Vladimir Putin are defunded."
Apr 17th 2022
EXTRACT: "Kazakhstan’s authorities have also showed uncharacteristic leniency in allowing public rallies in support of Ukraine. Thousands of protesters holding banners reading “Russians, leave Ukraine”, “Long Live Ukraine” and “Bring Putin to trial” marched across the capital, Almaty, wrapping monuments to Lenin and other Soviet-era figures with yellow and blue balloons symbolising the Ukrainian flag."
Apr 15th 2022
EXTRACT: "People’s identification with the Soviet Union appears to have a clear and growing basis in Russian public opinion. Surveys we have conducted throughout the Putin period show that Soviet identification among the general population – something that had been steadily declining after the collapse of the Soviet Union in 1991 – began to increase in 2014, when the Russian government annexed Crimea and supported rebellions in the Ukrainian regions of Luhansk and Donetsk. By 2021, almost 50% of those surveyed identified with the Soviet Union rather than the Russian Federation."
Apr 13th 2022
EXTRACT: "Worse yet, the Hungarian government has effectively been helping Putin by prohibiting the shipment of weapons to Ukraine across its borders. Hungarian public TV spreads Russian disinformation day and night. The day before the election, an assembly of ordinary people expressing solidarity with Ukraine was framed on state television as a “pro-war rally.” "
Apr 13th 2022
EXTRACT: "It may well be that the Russian army’s fate has already been sealed in what is likely to be a long war. The single qualification to this may be that Russia could default to escalation using “weapons of mass destruction” of one form or another – whether tactical nuclear warheads or chemical weapons."
Apr 13th 2022
EXTRACTS" "Ukraine and Russia produce a substantial amount of grain and other food for export. Ukraine alone produces a whopping 6% of all food calories traded in the international market. At least it used to, before it was invaded by the world’s largest nuclear power." ...... "When it comes to cereals like wheat, corn, rice and barley, the big players talk about millions of metric tonnes, or MMTs. A single MMT of wheat contains about 3.4 trillion food calories,." ....."Ukraine produced about 80 MMT of grain (a category that includes wheat, corn and barley) in 2021, and is expected to harvest less than half of that this year. A shortfall of 40 MMT is enough missing calories that a country like the UK could only make it up by having everyone stop eating for three years. That’s the thing about tonnes of grain: a million here and a million there and pretty soon you’ve got a real issue on your plate."
Apr 11th 2022
EXTRACT: "I don’t even know the little girl’s name. All I do know is what a friend of a friend wrote on Viber: that her relative, a senior nurse in one of Kyiv’s hospitals, “saw in the morgue a child with 20 varieties of sperm on her small body.” Since this information was conveyed in a private conversation, there is no reason to doubt its veracity."
Apr 8th 2022
EXTRACT: "Russian society has so far failed to stop Putin, just as German society failed to stop Hitler. And so, like a poisoned chalice, that task has fallen to the West, as it did in 1939. The West must now treat Putin and his regime the same way that Winston Churchill treated Hitler: Don’t talk to him, just defeat him. Dead-enders such as Putin are too fanatical and desperate to be reliable negotiating partners."
Apr 3rd 2022
EXTRACT: "From 1807 to 1814 on the Iberian peninsula, Napoleon had to fight Spanish, Portuguese and British armies while beset by ubiquitous, ferocious insurgents. He described this war as his “bleeding ulcer”, draining him of men and equipment. It is the west’s aim to make Ukraine for Putin what Spain was for Napoleon. In the absence of a negotiated settlement, Ukraine and Nato will continue to grind away at Russia’s army, digging away at that bleeding ulcer and prolonging Russia’s agony on the military front, as the west continues its parallel assault on its economy. If Putin’s plan is to proceed with the Korea model, he will fail. There is a strong possibility that Putin has only a limited idea of how badly his army is faring. So be it – he’ll find out soon enough that there is now no path for him to military victory."
Apr 1st 2022
EXTRACTS: "Policymakers expected that the country would be able to secure its energy supply entirely from renewable sources, so they resolved to phase out coal and nuclear energy simultaneously. The last three of Germany’s 17 nuclear power plants are set to be shut down this year." ---- ".... the share of wind and solar power in Germany’s total final energy consumption, which includes heating, industrial processing, and traffic, was a meager 6.7%. And while wind and solar generated 29% of the country’s electricity output, electricity itself accounted for only about a fifth of its final energy consumption." ----- "If Germany suddenly halted Russian gas imports, gas-based residential heating systems – on which half the German population, approximately 40 million people, rely – and industrial processes that rely heavily on gas imports would break down....."
Apr 1st 2022
EXTRACT: "For Putin, the past that matters most is the one the dissident author and Nobel laureate Aleksandr Solzhenitsyn exalted: the time when the Slavic peoples were united within the Orthodox Christian kingdom of Kievan Rus’. Kyiv formed its heart, making Ukraine central to Putin’s pan-Slavic vision. ---- But, for Putin, the Ukraine war is about preserving Russia, not just expanding it. As Russian Foreign Minister Sergei Lavrov recently made clear, Russia’s leaders believe that their country is locked in a “life-and-death battle to exist on the world’s geopolitical map.” That worldview reflects Putin’s longstanding obsession with works of other Russian emigrant philosophers, such as Ivan Ilyin and Nikolai Berdyaev, who described a struggle for the Eurasian (Russian) soul against the Atlanticists (the West) who would destroy it. ---- Yet Putin and his neo-Eurasianists seem to believe that the key to victory is to create the kind of regime those anti-Bolshevik philosophers most detested: one run by the security forces. A police state would fulfill the vision of another of Putin’s heroes: the KGB chief turned Soviet General Secretary Yuri Andropov."
Apr 1st 2022
EXTRACTS: "Ukraine, known as the breadbasket of Europe, is struggling to export last year’s harvest, and may be unable to produce much this year either. In addition, the war has caused a global fertiliser shortage, which will push up food prices around the world too. Coming at a time when the global pandemic had already increased food insecurity and depleted resources around the world, many countries may not be resilient to a major food crisis brought on by the war. Back-to-back global catastrophic events like this have not happened for close to 100 years." ----- "Another useful analogue is the case of Germany during the first world war. When war broke out in 1914, the German authorities had anticipated a short conflict – not too dissimilar to Russian assumptions a few weeks ago. Just like in Ukraine now, the first world war severely disrupted German farming."