Abstract
Are low-interest rates an incentive to misprice capital? In the traditional view, low-interest rates prompt increased consumer spending, business investment, and economic growth. However, the case of the housing bubble/bust indicates that low-interest rates may lead to a misallocation of financial and real capital. Central bank policy is one example of administered rates and the purposeful change in the pricing of credit. However, there is no obvious truth that whatever the central bank policy rate is, that is the correct rate for long-term economic growth. The “Conundrum” cited by Chairman Greenspan hints at the limits of our expertise. The yield curve allocates credit over time but also reflects market expectations. After the U.S. presidential election in 2016, markets priced in higher inflation, on the expectation of incoming expansionary fiscal policy. Yet, the upward momentum in long-term yields was largely reversed.
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Notes
- 1.
John Stuart Mill, Principles of Political Economy, with some of Their Applications to Social Philosophy (1848; 7th ed., reprint ed.,) Longmans, Green, London, 1929, p. 709.
- 2.
Research from the late 1970s supported the expectation that changes in short-term rates would impact long-term rates. See Timothy Cook and Thomas Hahn, “The Effect of Changes in the Federal Funds Rate Target on Market Interest Rates in the 1970s,” Journal of Monetary Economics, 1989, 24 (November): 331–351.
- 3.
“Fed’s New Strategy Confronts Old Questions on Financial Trade-offs,” September 30, 2020, Wall Street Journal.
- 4.
Leon Walras, Elements of Pure Economics, 1874, published 1954 by Routledge, Abingdon, UK.
- 5.
The difficulties of determining a natural rate of unemployment and long-run projections in growth and inflation are highlighted in Jerome Powell’s speech at Jackson Hole, “New Economic Challenges and the Fed’s Monetary Policy Review,” August 27, 2020 and published on the Federal Reserve’s website, https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm.
- 6.
See Holston, Kathryn, Thomas Laubach, and John C. Williams, “Measuring the Natural Rate of Interest: International Trends and Determinant,” Journal of International Economics, 2017, 108 (May, S1): S59–75.
- 7.
“The Influence of the Rate of Interest on Commodity Prices,” 1898 reprinted in Erik Lindahl, ed., Selected papers on Economic theory by Knut Wicksell, 1958.
- 8.
For a broader review of resource misallocation in a society see Diego Restuccia and Richard Rogerson, “The Causes and Costs of Misallocation,” Journal of Economic Perspectives, 2017, 31 (3).
- 9.
Charles Kindleberger, Manias, Panics, and Crashes, Basic Books, New York, 1978. p. 132 and A Stylized Outline of Financial Crises at the end of the text at what I will term p. 253 although the pages are not numbered for the Outline. Ross Robertson, “History of the American Economy,” Second Edition, Harcourt, Brace & World, Inc., 1964, pp. 138–140.
- 10.
Ben Bernanke, “Global Savings Glut and the U.S. Current Account Deficit,” Virginia Association of Economists, March 10, 2005.
- 11.
Jerome Powell, August 2020.
- 12.
An Update to the Budget Outlook, 2020 to 2030. Congressional Budget Office, September 2020.
- 13.
An early exposition of the role of inflationary expectations is discussed by William E. Gibson “Interest Rates and Inflationary Expectations: New Evidence,” American Economic Review, 1972, 62: 845–865.
- 14.
Robert A. Mundell, “Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates,” Canadian Journal of Economic and Political Science, 1963, 29 (4): 475–485.
- 15.
Measuring the Natural Rate of Interest, Holston, Laubach and Williams, December 15, 2016, Federal Reserve Bank of San Francisco.
- 16.
John B. Taylor, Discretion versus Policy Rules in Practice (1993), Stanford University, Stanford, CA.
- 17.
This has been a long-term debate not just for the current 2020 corporate markets. See Richard Fisher, “Fed’s Fisher Concerned Credit Spreads Have Narrowed too Much,” Reuters, June 30, 2014.
- 18.
Robert Townsend, “Optimal Contracts and Competitive Markets with Costly State Verification,” Journal of Economic Theory, 1979, 21 (October): 265–293.
References
Ben Bernanke, “Global Savings Glut and the U.S. Current Account Deficit,” Virginia Association of Economists, March 10, 2005. A view on the global imbalance of saving and investment.
Jim Collins, “Good to Great,” Harper Business, 2001. An examination of the proper allocation and misallocation of credit in many real-world cases. One of my twelve must reads.
Congressional Budget Office, “An Update to the Budget Outlook, 2020 to 2030,” September 2020. This annual update is an essential starting point for both the economic and financial market outlook for the intermediate and long-term.
Timothy Cook and Thomas Hahn, “The Effect of Changes in the Federal Funds Rate Target on Market Interest Rates in the 1970s.” Journal of Monetary Economics, 1989, 24 (November): 331–351. Research from the late 1970s that supported the expectation that changes in short-term rates would impact long-term rates.
William E. Gibson, “Interest Rates and Inflationary Expectations: New Evidence,” American Economic Review, 1972, 62: 845–865. An early exposition of the role of inflationary expectations.
James Grant, “Bagehot,” W.W. Norton, 2019. A biography, and a view, of the role of central banking in England during the Victorian period.
Holston, Kathryn, Thomas Laubach, and John C. Williams, “Measuring the Natural Rate of Interest: International Trends and Determinant,” Journal of International Economics, 2017, 108 (May, S1): S59–75.
Erik Lindahl, ed., Selected papers on Economic theory by Knut Wicksell, 1958. “The Influence of the Rate of Interest on Commodity Prices,” 1898. Wicksell’s work is often cited but the original idea is worth the read.
John Stuart Mill, Principles of Political Economy, with some of Their Applications to Social Philosophy (1848; 7th ed., reprint ed.,) Longmans, Green, London, 1929. One of the economic classics that provides a framework for decision making.
Robert A. Mundell, “Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates,” Canadian Journal of Economic and Political Science, 1963, 29 (4): 475–485. An essential read into the role of global capital flows and financial markets.
Jerome Powell, Speech at Jackson Hole. “New Economic Challenges and the Fed’s Monetary Policy Review,” August 27, 2020 and published on the Federal Reserve’s website, https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm.
Diego Restuccia and Richard Rogerson, “The Causes and Costs of Misallocation,” Journal of Economic Perspectives, 2017, 31 (3). A broader review of resource misallocation in a society. Unfortunately, misallocation is too common an occurrence.
Ross Robertson, “History of the American Economy,” Second Edition, Harcourt, Brace & World, Inc.,1964, pp. 138–140. A primary read on economic history which sadly is not taught in many American universities anymore.
John B. Taylor, Discretion versus policy rules in practice (1993), Stanford University, Stanford, CA. A statement of the Taylor rule that is often cited in both academic and business writings.
Robert Townsend, “Optimal Contracts and Competitive Markets with Costly State Verification,” Journal of Economic Theory, 1979, 21 (October): 265–293. Information is not free and often very difficult to verify—as we have increasingly experienced in recent years with social media.
Leon Walras, Elements of Pure Economics, 1874, published 1954 by Routledge, Abingdon, UK. A focus on the linkages between markets and how price movements in one market depend upon movements in other markets.
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Silvia, J.E. (2021). Credit Allocation and the Role of Interest Rates as the Price of Credit. In: Financial Markets and Economic Performance. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-76295-7_4
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