Central Banks See No Way out of the Low Interest Rate Trap
Since the 1980s, slower economic growth in the industrial countries has been accompanied by declining interest rates. They have even turned negative in more recent years. At the same time, investment, productivity, and real GDP growth all have slowed. Recession caused by lockdowns of the economy to fight the corona pandemic in 2020/21 has accelerated the demise of interest. Even as the world economy recovers, central bankers around the world have signaled that interest rates will be kept low for a long time to come. What is going on here? Various economists have provided different theoretical and empirical explanations for the global decline of interest rates.
The Keynesian perspective in the tradition of Alvin Hansen and Larry Summers has attributed secularly declining nominal and real interest rates—and thus declines of the “natural rate”—to a global savings glut driven by aging societies, a declining demand for fixed capital investment, and a declining marginal efficiency of fixed capital.1 From this perspective, monetary policy has simply adjusted to these changes and lowered nominal and real interest rates. The corona crisis has only reinforced what has been going on for a long time before. Owing to the lockdowns, household and company incomes fell off a cliff, so the neutral rate has dropped even more, probably deeply into negative territory.2 In sum, central banks simply take account of exogenous forces, such as secular stagnation and the corona crisis, by aligning policy and market interest rates with a natural rate of zero or less.
By contrast, from the point of view of Austrian economic theory developed by Ludwig von Mises and F.A. Hayek, the deep plunge of interest rates has been policy driven.3 While central banks have aimed at stabilizing economic activity with strong interest rate cuts during crises, they have hesitated to lift interest rates during the recoveries following.4
From an Austrian perspective, negative interest rates are not possible under free market conditions. Human beings strive to achieve their goals earlier rather than later (i.e., have a positive time preference by nature), and they will take detours only when they are compensated for this (through interest in the case of saving).
The question of who is right in this debate is not only of academic interest, for if the “Keynesians” are right, a return to “normal” interest rates should be possible when circumstances change accordingly. Central banks would simply follow an increase in the “natural rate,” possibly resulting from the policies adopted to counter the pandemic. But if the Austrians are right, central banks face a dilemma: if they tighten monetary policy, they risk triggering another credit crisis, and if they leave monetary policy extremely easy, they risk debasing their money through an uncontrolled rise of inflation. Here we argue that the Keynesian view is flawed, both from a theoretical and an empirical perspective. Since it is the dominant view, this does not bode well for the future.
Figure 1: US Credit Impulse and Private Demand
Source: Macrobond. Credit impulse is calculated as the change in credit flows relative to GDP.5
Let’s start with a look at the Keynesian model. As it does not include a banking sector, it cannot explain money creation by banks and falls into the trap of assuming that savings are always equal to investments. Exogenous increases in money supply lower t
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