Over the last few weeks, it’s been very … interesting to read Paul Krugman’s characterizations of Raghuram Rajan’s arguments. One of Krugman’s is a talented writer who has gained a wide audience after years of incisive commentary, an advantage that his interlocutors generally lack. But it turns out that Rajan is a very lucid and talented writer in his own right, and he’s decided to engage his critics in a respectful, decidedly non-polemical way.
And it turns out that Rajan’s case against ultra-low rates is not a product of a “psychological desire to be tough.” Rather, it is based on a pretty convincing theory of how the global economy works. [Emphasis added.]
On the corporate side, it may be that wages and benefits are sticky, haven’t fallen enough given the tough economic conditions, and therefore a negative interest rate is needed to compensate for high unyielding labor costs. This is the old Keynesian explanation, and there is probably some merit to it, though companies have been very active pruning benefits and laying off older, better paid workers in order to reduce labor costs. But there are other reasons why companies may not want to invest in industrial countries. It may be that they already feel there is substantial excess investment there, and they have to work off the investment over time. Or it may be that they feel the returns to additional investment are small because profitability has fallen for other reasons than sticky compensation. Put differently, it is possible that corporations may genuinely need to be conservative on investment, and seriously negative real interest rates will propel excessive investment rather than offset a possible existing distortion, such as excessively high worker compensation.
Equally, it may be inappropriate to push households into spending more by making saving less attractive. U.S. households have been on a debt-fuelled spending binge, and are correctly repairing household balance sheets by saving more and paying down debt. Given that many of them, especially the elderly, have depleted nest eggs that they want to restore, negative interest rates may not be in their interest (and may not even get them to save less). Of course, debtor households could be helped, but many of them have long term fixed obligations that are unlikely to be affected by short term interest rates.
So why are so many Americans unemployed ? How do we return the economy to sustained growth? Are strongly negative short term real rates part of the cure? Perhaps we should recognize that the recoveries from the last two recessions (1991 and 2001) have been jobless, despite substantial monetary stimulus. Indeed, the negative real rates during the recovery in 2002-2004 did not prompt substantially more corporate hiring, but created a debt-fueled real estate boom and consumption orgy that we have yet to recover from. The rates were not low enough to prompt corporations to invest (they had just been through an investment boom), but low enough to trigger off a housing boom and a consumption boom. The remedy this time around cannot lie in creating unsustainable growth again.
This certainly isn’t a settled issue. But I’m more inclined to trust Rajan on these issues than Krugman, not least because Krugman seems so reluctant to fairly characterize Rajan’s arguments. It doesn’t hurt that Rajan had a far better track record when it came to anticipating the shape of the financial crisis.
I hope that Rajan keeps writing. It can be frustrating to see your arguments disingenuously attacked — here is a terrific example — and Rajan is presumably not accustomed to this kind of treatment in scholarly settings. Yet I remain convinced that good arguments will win out over unfair distortions.