Money Magic

CHICAGO – Economic growth in the United States seems to be slowing again. This might reflect temporary factors, like the Japanese tsunami, which disrupted supply chains and caused some factories to suspend operations. Also, high oil prices have taken a toll on disposable income, impeding growth in consumption demand. This has led to a build-up of inventory – and thus to cuts in production. Recoveries are rarely without blips, especially when they are as weak as this one. But, regardless of whether the factors behind the latest slowdown are fleeting or enduring, there will be calls on the US Federal Reserve to do something. Some Americans view Fed Chairman Ben Bernanke as a modern-day wizard, able to revive the economy through a swish of his monetary wand – first ultra-low interest rates, then quantitative easing, and perhaps eventually money-printing. If inflation is low, they want the Fed to use every spell it knows to revive the economy. Like the World War I generals who reacted to every slaughter of their men by sending even more over the top of their trenches in a vain attempt to overwhelm the enemy, “free money” types react with “More!” if their policy does not seem to be working. More than any other policy action, monetary policy suffers from the sense that there is a free lunch to be had. Yet the interest rate is a price for the savings that are transferred to spenders. To the extent that the Fed manages to push this price down (and some economists will dispute its ability to push any meaningful interest rate down), it taxes the producers of savings and subsidizes the spenders of savings. Clearly, no government considers pushing down the price of any real good an effective way to stimulate the economy – any gain to consumers is a loss to producers, and the loss typically will outweigh the gain if the market price is a fair one. So why are savings different? One view is that corporate investment is held back by labor-market rigidities (wages are stubbornly too high). Moreover, significant societal benefits – for example, more cohesive families and communities – come from investment that creates jobs, so a lower interest rate will give corporations the necessary subsidy to invest. There is, however, scant evidence that the real problem holding back investment is excessively high wages (many corporations reduced overtime and benefit contributions, and even cut wages during the recession). Moreover, with interest rates for large corporations at their lowest level in decades (negative in real terms for the largest, so that savers are in fact paying corporations to borrow their money), the cost of capital is probably not the main reason why they are not investing more in the US. A huge subsidy would certainly induce them to reconsider, but should we not ask whether there are more effective ways to fix the problems holding them back? A second view is that households are scared and saving too much – they need to be pushed into consuming by lowering the returns to savings. It is hard to imagine, though, that with the US household savings rate at about 5%, and with households severely indebted, they are saving too much. While it might be nice to get them to spend a little more now, and save more later, it is hard to engineer this easily. After all, the housing bubble was caused, in part, by pushing credit on households so that they would spend the US out of the recession that followed the dot-com bust. A third channel through which easy money might work is by pushing up the value of assets like stocks, bonds, and houses, making people feel wealthier – and thus more likely to spend. For this channel to be sustainable, though, the wealth gains must be permanent. Otherwise, what goes up will come down, leaving households even more frightened of financial markets. Clearly, someone is paying a price for ultra-low interest rates: the patient and uncomplaining saver. Interestingly, if traditional spenders such as firms and young households are unwilling or unable to take advantage of low interest rates, low rates could even hurt overall spending, because savers like retirees receive lower financial incomes and curtail spending. This is not a heretical concern. As with any tax and subsidy, the net effect depends on whether those taxed cut back spending less than those subsidized. Economists have sensibly advocated that China raise the interest rates that it pays on bank deposits so that Chinese households earn more and consume more. Some Japanese now wonder whether their ultra-low interest-rate policy could be contractionary. Equally worrisome are the distortions that easy money creates. Evidence from the recent crisis suggests that ultra-low rates prompted a wide range of portfolio adjustments, whereby Asian and Middle East central banks and funds ended up holding the safest low-interest securities, while the US and European financial sectors went on a risk-taking binge. History never repeats itself exactly, and those singed by fire do learn not to play with matches, but we should be aware that unnaturally low interest rates have consequences other than inflation. Finally, what of inflation itself? While wage inflation in the US is contained, global monetary policy is probably excessively loose – one reason that oil prices have taken off. The Fed blames (rightly) foreign central banks that are keeping interest rates too low to prevent their currencies from appreciating against the dollar; but the Fed cannot set policy assuming others respond with a theoretical ideal. High oil prices now curtailing growth in the US are partly an unintended consequence of current policy. There are many things that the US needs to do to create sustainable growth, including improving the quality of its work force and infrastructure. Easier money is not one of them. Raghuram Rajan is Professor of Finance at the Booth School of Business, University of Chicago, and author of Fault Lines: How Hidden Fractures Still Threaten the World Economy. Ends