Interest Rates: Nothing to Fear but Fear Itself

by: New Deal 2.0

By Marshall Auerback

Someone needs to deal with the unemployment crisis. But that someone is not the Fed.

David Leonhardt has an interesting piece in the NYT this week that accuses the Fed of being too “timid” in its response to the jobs crisis. Leonhardt is actually on the right side of this issue, but his reasoning is flawed. The real problem is not the Fed’s timidity, but the misconception that central banks can do something about unemployment. That’s the job of fiscal policy. Arguably, the Fed’s zero interest rate environment has exacerbated deflationary pressures, as it robs savers of income. The argument that higher interest rates will destroy our economy because of debt servicing omits this income effect. Evsey Domar raised the counterargument in a paper he wrote at the Fed in the 1940s: higher interest rates equal higher payments to private credit holders, which increases the tax base, increases GDP, and thwarts the vicious debt spiral.

In fact, Italy prior to the days of the euro provides a perfect illustration of this point. It had 12% deficits as a percentage of GDP, 12% inflation, 12% interest rates, and 12% household savings. Perfect unity. Randy Wray made precisely this point to the Italian government and explained that, counter to all mainstream economic thinking, if the Italians wanted to reduce their deficit and inflation, all they had to do was CUT rates. The opposite clearly applies when incomes are too low.

There’s a lot of academic literature that is ignored by the “fiscal sustainability” crowd, but when I hear arguments like the one in Paul Krugman’s recent piece, it seems that they often miss a crucial point: namely, that high rates create a huge income effect, which can actually create boom conditions, or at least high inflation, which reduces the real cost of debt service. I’m not necessarily advocating this, but I think it would offset many of the ills they describe. You have to look at the overall economy in the context of these sectoral balances, which I have discussed in other papers.