Wednesday, August 25, 2010

The problem with low interest rates

Raghuram Rajan, a finance professor at Chicago's b-school, explains the downside of near-zero interest rates today on NYT's Freakonomics website.  Rajan uses the following scenario to make a key point: suppose that instead of lowering interest rates the government instead decided to subsidize the price of another key input, say energy.  MBA 505 veterans can easily outline the adverse consequences: if the suppliers of energy do not get a subsidy they will shut down and if they do get a subsidy the costs to the budget are the same as traditional stimulus (tax cuts, government spending).  In financial markets the parallel is that either (1) lenders have little incentive to make loans with super-low interest rates and (2) the cost of low interest rates to savers is massive, perhaps on the order of $400 billion. 

Rajan points out additional distortions: too much borrowing will lead to future bubbles that once again will burst with lenders expecting another bailout.  He thinks the Fed should gradually begin to raise rates to 1.5 to 2 percent over the next year.  He also urges a rethink and expansion of programs that prepare workers for the jobs of the future (easier to say than to do, as any labor economist will tell you). 

My own take: low short term rates worked historically to shorten recessions by stimulating housing and consumer durables (such as cars, furniture).  One reason the stimulus is not working so well is that real estate and automobiles are going through structural transformations that will make these sectors permanently smaller. 

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