What are “normal” interest rates?

You can hardly have failed to have noticed the large amount of talk recently about returning to the sort of interest rates that prevailed prior to the 2007/8 crisis. Those rates are often described as “normal”.

In fact there are good reasons for thinking those rates were actually ABNORMAL and that the current very low rates are normal, or put another way, that the current low rates are the GDP maximising rates. Reasons for thinking that are as follows.

First, as David Hume pointed out nearly 300 years ago, politicians are always tempted to fund public spending via borrowing rather than via tax because voters notice tax increases and blame politicians for them, whereas voters tend not to blame politicians for the interest rate increases that stem from government borrowing. 

As Hume put it, “It is very tempting to a minister to employ such an expedient, as enables him to make a great figure during his administration, without overburdening the people with taxes, or exciting any immediate clamors against himself. The practice, therefore, of contracting debt, will almost infallibly be abused in every government. It would scarcely be more imprudent to give a prodigal son a credit in every banker’s shop in London, than to empower a statesman to draw bills, in this manner, upon posterity.” 

Simon Wren-Lewis (former Oxford economics prof) refers to that phenomenon as the “deficit bias”. Government borrowing which takes place for the latter reason obviously has the effect of artificially raising interest rates.

In contrast to the latter clearly unjustified reason for public borrowing, there are a host of ostensibly better reasons for such borrowing. Unfortunately even those reasons on closer inspection turn out to be feeble if not wholly invalid, for reasons I set out in section 2 of a recent paper.

This all lends support to the idea put by Milton Friedman in 1948, namely that government should borrow NOTHING. Warren Mosler (founder of Modern Monetary Theory) advocated the same “zero public borrowing” regime, as did Bill Mitchell (Australian economics prof.)

Re Friedman see his para starting “Under the proposal…” here.

Re Mosler, see his 2nd last para here. As to Bill Mitchell, see here.

As distinct to the above point that the current near zero interest rates are the norm or the GDP maximising rates, there is the related question as to whether governments and central banks ought to adjust interest rates so as to adjust demand. As I argue in the above mentioned recent paper, there is actually a good reason for thinking that interest rates should only rarely be adjusted, if at all.

The reason for thinking that is that in a perfectly functioning free market, the failure of interest rates to fall is not the cause of recessions lasting longer than we would like. The actual market failure that causes recessions to endure is the failure of wages and prices to fall, which in turn would increase the real value of the stock of money (base money in particular), which in turn would encourage spending. That’s known as the “Pigou effect”. The reason wages and prices do not fall significantly is of course Keynes’s “wages are sticky downwards” phenomenon: the fact that, particularly in heavily unionised sectors of the economy, it is very difficult to cut wages.

I deal with the Pigou effect in the 3rd section of the above mentioned paper.