Paul Krugman abhors the idea of raising interest rates. He points out that many of the supporters of raising rates have been totally wrong for years. He’s right. And I said they’d be wrong in real time just like Dr. Krugman did. But maybe there’s a legitimate argument now? Let’s explore some ideas….
1. If low interest rates aren’t stimulating the economy then maybe raising rates won’t hurt the economy? There’s been a popular line of thinking in recent years going by the name neo-fisherism. It basically theorizes that low interest rates could actually be deflationary. If these thinkers are right then maybe raising interest rates will be inflationary? Also, there’s not much evidence that low interest rates are still stimulating the economy effectively. In fact, many supporters of monetary policy argue that interest rates aren’t very effective to begin with (I generally agree). And if that’s true then maybe raising interest rates won’t hurt?
2. We were never in a liquidity trap. Keynes referred to a liquidity trap as a period where the Central Bank loses control of interest rates. This occurred in 2008, but only for the briefest of time. So the whole idea of a liquidity trap was wrong all along. If anything, the last 6 years have shown that reducing interest rates isn’t a highly stimulative form of monetary policy. Despite this, many economists like Dr. Krugman have latched onto the idea that we’re now in some sort of a permanent liquidity trap, but how long can this narrative last until we realize that it was simply incorrect all along? And if it is wrong then the thinking that interest rates should stay low forever could very well also be wrong.
3. We were in a balance sheet recession that ended long ago. As I highlighted in vivid detail over the last 6 years the USA was in a balance sheet recession, not a liquidity trap. Like Krugman, I too got most of the macro picture correct. The big difference was that I didn’t get worried about recession in 2013 when he did (see here and here). In other words, I got all of the big predictions that Krugman made and more along the way. But the important point here is, while Krugman believes we’re in a perma-trap, I highlighted the end of the balance sheet recession several years ago. And this means that the US consumer is much healthier than they were back in 2006-2012 when balance sheets were largely underwater due to high debt levels. The key point is, raising interest rates at this juncture wouldn’t put undue pressure on highly indebted consumers. In fact, consumer balance sheets haven’t been this strong in a very long time.
4. Raising rates would actually increase the budget deficit which would be a form of backdoor fiscal stimulus and further balance sheet improvement. If the Fed were to raise interest rates the US Treasury would incur rising interest costs. The current rate of interest on the national debt is about 1.5% with an average weighted maturity of 5.5 years. The vast majority of this debt is short duration and so lifting interest rates even marginally could have a substantive impact on the deficit. The total interest expense was about $230B last year so a raise in rates that lifts the average interest rate by just 1% could lift the deficit by almost $200B. This would not only increase the interest income earned by savers looking for safe income, but it would also add to the quantity of safe assets in the economy as deficit spending results in a net financial asset for the private sector that directly adds to financial net worth.
5. Banks are better positioned to handle a raise in rates and might even prefer it. The banking system is far healthier than it was back in 2008, but net interest margins have continued to decline. Further, income from a rise in the deficit and interest income could actually stimulate consumer spending and demand for loans thereby leading to a boost in net interest margins at the nation’s banks.
The bottom line is, we aren’t in a liquidity trap and we never were. So this line of reasoning for keeping rates low is not justified. Dr. Krugman is right that the rationalization for rising rates (to get ahead of inflation and asset bubbles) has been wrong over the years. But that doesn’t necessarily mean that the rationale for keeping rates low is right. I see no reason why the US economy couldn’t handle a modest increase in interest rates. In fact, it might actually provide a modest boost at a time when we could certainly use all the help we can get.