Interest Rates can do their Job!

In these times of faltering growth and worries about a relapse into recession, we ask pointed questions about the competency of our leaders and policymakers. Is Mr. Bush not doing his job? Is Mr. Greenspan not doing his? There is plenty of finger-pointing to be done, but to bring the original culprit into view, we must step back from the current politics and personalities and ask: Are interest rates not doing their job?

Nearly a lifetime ago, John Maynard Keynes launched his revolution largely on the basis of his belief that interest rates don’t do their job and that the market economy is inherently flawed by this shirking. So, just what, exactly, is their job? According to most of Keynes’s peers, interest rates keep investment in line with saving. Responding to ordinary market pressures in ordinary ways (supply and demand), interest rates can find their own level, thereby providing just the right incentives and constraints. Governed by this "natural rate of interest" (the pre-Keynesians always used the singular to express the idea), the resources that the business community commits to investment projects will be consistent with people’s willingness to forgo current consumption. Such market-directed saving and investment allow for healthy economic growth. Minor movements in interest rates can make small corrections to the growth rate, immunizing the economy against larger corrections in the form of recessions.

Keynes was blunt in rejecting wholesale even the possibility that things might work this way. The classical economists, he claimed, "are fallaciously supposing that there is a nexus which unites decisions to abstain from present consumption with decisions to provide for future consumption" (The General Theory of Employment, Interest, and Money, London: Macmillan, 1936, p. 21). Significantly, Keynes’s verdict of "no-nexus" left interest rates up for grabs. If they weren’t doing their job anyway, maybe they could be used for purposes of macro-management.

Keynes’s no-nexus macroeconomics is conducive to circular reasoning and is replete with self-fulfilling prophesies. Optimism inspires investment spending, which creates jobs and bolsters consumer demand; the favorable market conditions translate into high profits, justifying the optimism. But investment spending spurred only by unabetted optimism may not be sufficiently strong in the eyes of elected officials and policymakers. Lower interest rates engineered by monetary expansion may be called for. And if the easy money gives rise to over-optimism (a.k.a. "irrational exuberance"), higher interest rates engineered by monetary contraction may be in order.

Cool reflection on Keynesianism suggests some self-fulfillment of a different sort. If interest rates are used as a policy tool for abetting and abating investor optimism, then they cannot at the same time perform their growth-governing function as envisioned by the classical economists. Believing, as Keynes did, that interest rates don’t do their job gives license to a policy regime in which interest rates cannot possibly do their job.

Other elements of Keynesianism have similar self-fulfilling qualities. The labor market is slow to adapt itself to conditions of reduced investment spending. Wage rates, Keynes insisted, are sticky downward. Investment spending must be stimulated or government spending must be increased so that workers can be hired at prevailing wage rates. Here, too, policy turns belief into reality. The Keynesian belief that workers will not accept wage cuts begets a policy regime in which workers would be fools to accept wage cuts.

"Keynesian stabilization policy" should be seen for the oxymoron that it is. Keynesian policies do not stabilize the economy; they Keynesianize the economy. That is, a policy-driven economy mimics the unstable behavior that Keynes thought to be characteristic of a market economy.

So now the central bank has ratcheted the federal funds rate all the way down to 1.75 percent, the medium and longer-term rates coming down to a lesser extent. Having failed to stimulate much investment, the cheap credit has stimulated consumer spending instead. And neither Mr. Greenspan nor anyone else is sure what to do next. Is the current 1.75 percent too high or too low?

The answer, it turns out, is both. The 1.75 is too high in light of the volatile and faltering asset prices and the paucity of job-creating investment activities. But it is too low in the light of plausible values for the natural rate of interest, which alone can be associated with sustainable economic growth. Further, the too-high/too-low diagnosis gives rise to the very uncertainties that dampen investor optimism and hence whet political appetites for Keynesian stabilization policies.

Current interest rates are too policy-infected to have much significance at all except as a basis for guessing about future interest-rate policy. Keynes, we now should all see, did his job very badly. The Federal Reserve will eventually have to abandon interest-rate targeting if the market economy is to have a chance to right itself. (The Volcker Fed turned rates loose in 1979 under very different but equally untenable circumstances.) Interest rates can do their job, but they need some on-the-job training. Ongoing debate in Washington and on Wall Street suggests that in the foreseeable future, they’re not likely to get any.