82, no. 35
Ditch the Keynesians
Why policy-infected interest rates must go
By ROGER W. GARRISON
In these times of faltering growth and worries about a relapse into recession, we ask pointed questions about our leaders and policymakers: Is Mr. Bush doing his job? Is Mr. Greenspan doing his? But to bring the true culprit into view, we must step back from politics and personalities and ask: Are interest rates doing their job?
Nearly a lifetime ago, John Maynard Keynes launched his macroeconomics revolution based largely on his belief that interest rates don't do their job and that, consequently, the market economy is inherently flawed.
According to most of Keynes's peers, interest rates keep investment in line with saving. In responding to ordinary market pressures--supply and demand--in ordinary ways, interest rates find their own level, thereby providing just the right incentives and constraints. Governed by this "natural rate of interest," the resources that the business community commits to investment projects will be consistent with people's willingness to forgo current consumption. Such market-directed saving and investment allows for healthy economic growth. Minor movements in interest rates can make small corrections to the growth rate, immunizing the economy against larger corrections in the form of recessions.
Keynes rejected wholesale even the possibility that things might work this way. In his 1936 work, "The General Theory of Employment, Interest, and Money," he argues that classical economists "are fallaciously supposing that there is a nexus which unites decisions to abstain from present consumption with decisions to provide for future consumption." Significantly, Keynes's verdict of "no nexus" left interest rates up for grabs. And if they weren't doing their job anyway, maybe they could be used for macro-management.
But Keynes's no-nexus macroeconomics is conducive to circular reasoning and self-fulfilling prophesies. Optimism inspires investment spending, which creates jobs and bolsters consumer demand; the favorable market conditions translate into high profits, justifying the optimism.
However, investment spending spurred only by unabetted optimism may not be enough for politicians and policymakers: Lower interest rates engineered by monetary expansion may be called for. And if the easy money gives rise to overoptimism (a.k.a. "irrational exuberance"), higher interest rates engineered by monetary contraction may be in order.
If interest rates are used as a policy tool for abetting and abating investor optimism, they can't at the same time perform their growth-governing function as envisioned by the classical economists. Believing, as Keynes did, that interest rates don't do their job gives license to a policy regime in which indeed those rates cannot possibly do their job.
Other elements of Keynesianism have similar self-fulfilling qualities. The labor market is slow to adapt to reduced investment spending. Wage rates, Keynes insisted, are sticky downward. Investment spending must be stimulated or government outlays must be increased so that workers can be hired at prevailing wage rates. Here, too, policy turns belief into reality. The Keynesian belief that workers won't accept wage cuts begets a policy regime in which, yes, workers would be fools to accept such cuts.
"Keynesian stabilization policy" should be seen for the oxymoron that it is. Keynesian policies don't stabilize the economy; they Keynesianize the economy. That is, a policy-driven economy mimics the unstable behavior that Keynes thought to be characteristic of a market economy.
So now the central bank has ratcheted the federal-funds rate all the way down to 1.75%, with medium- and longer-term rates coming down to a lesser extent. Having failed to stimulate much investment, the cheap credit has stimulated consumer spending instead. And neither Greenspan nor anyone else is sure what to do next.
Is 1.75% too high or too low?
The answer is: both. The 1.75% is too high in light of the volatile and faltering asset prices and the paucity of job-creating investment. But it's too low in light of plausible values for the natural rate of interest, which alone can be associated with sustainable economic growth. Furthermore, the too-high/too-low diagnosis gives rise to the very uncertainties that dampen investor optimism and hence whet political appetites for Keynesian stabilization policies.
Current interest rates are too policy-infected to have much significance, except as a basis for guessing about future interest-rate policy. Keynes did his job very badly. The Fed eventually will have to abandon interest-rate targeting for money-supply targeting (as it did in 1979 under Paul Volcker) if the economy is to have a chance to right itself. Interest rates can do their job--if they're allowed some on-the-job training. Unfortunately, the debate in Washington and on Wall Street suggests that in the foreseeable future, they're not likely to get any.
Roger W. Garrison, a professor of economics at Auburn University, is
the author of Time and Money: The Macroeconomics of Capital Structure
(Routledge, 2001), E-mail: firstname.lastname@example.org