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Surveying the Damage of Low Interest Rates

December 15, 2017

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Surveying the Damage of Low Interest Rates

Few would disagree that it was necessary to slash interest rates in the immediate aftermath of the 2008 global financial crisis. But after a decade of ultra-loose monetary policies across advanced economies, growth remains tepid, financial risks have proliferated, and middle-class savers have lost out.

WASHINGTON, DC – For years after the 2008 financial crisis, policymakers congratulated themselves for having averted a second Great Depression. They had responded to the global recession with the kind of Keynesian fiscal and monetary stimulus that the moment required.

But nine years have passed, and official interest rates are still hovering around zero, while growth has been mediocre. Since 2008, the European Union has grown at a dismal average annual rate of just 0.9%.

The broad Keynesian consensus that emerged immediately after the crisis has become today’s prevailing economic dogma: as long as growth remains substandard and annual inflation remains below 2%, more stimulus is deemed not just appropriate, but necessary.

The arguments underlying this dogma do not hold water. For starters, measures of inflation are so poor as to be arbitrary. As Harvard’s Martin Feldstein notes, governments have no good way to measure price inflation for services and new technologies, which account for an ever greater share of advanced economies’ GDP, because quality in these sectors varies substantially over time. Moreover, real estate and other assets are not even included in the accounting.

The dictate that inflation must rise at an annual rate of 2% is also arbitrary. Swedish economist Knut Wicksell’s century-old concept of a “natural” interest rate – at which real (inflation-adjusted) GDP growth follows a long-term average while inflation remains stable – makes sense. But why should the inflation rate always be 2%? And why aren’t services, new technologies, or, say, Chinese manufactured goods excluded from the measure of core inflation, alongside energy and food?

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