Economic newspapers and business journals have to bear the largest share of the blame that this fallacy has recently experienced a very strong revival. With the financial crisis of 2008, Central Banks around the world have lowered interest rates aggressively to zero or even below in order to stimulate the economy, unfortunately sometimes to little avail. Many journalists but also some economists have thus confidently proclaimed that low interest rates are an indicator of easy money, even though nothing could be further from the truth. This mistake is based on the simple confusion between the short-run liquidity effect and the long-run income effect. To my knowledge, the Swedish economist Knut Wicksell from Lund University was the first to explain in the beginning of the 20th century why interest rates are usually high during periods when money is easy. This point was reiterated a number of times by other prominent economists thereafter, most notably Milton Friedman. Indeed, the economic rational is almost overly simplistic. A country where monetary policy is described as easy or accomodative should display high money growth rates as well as high inflation rates. Imagine an economy where the broader money supply M2, which inlcudes bank credits, is growing in the double digits, i.e. above 10%. Let’s say that this economy experiences an inflation rate of about 10% as a result of this double digit growth rates in the broader money supply.
What about the nominal interest rates in this hypotehtical economy? Well, with an inflation rate of 10% any lender would be a fool to lend money at below 10% as he would make a loss. Consequently, depending on the credit worthiness of the borrower nominal interest ranges will range from slightly above 10% for governments and other low-risk borrowers to significantly higher for risky borrowers. A world in which money growth rates and inflation is high will also display high nominal interest rates. This is the so-called income effect. Interest rates are thus high in booms when money is easy. Now, what about a world where money growth rates and thus credit growth are stagnating and inflation hovers around at zero. In such a world lenders will not make any losses by lending out money at zero interest rates because inflation is absent. Consequently, nominal interest rates will be barely above zero for low-risk borrowers such as governments, large successful corporations and other high credit-worthy individuals. The low interest rates since the financial crisis are a symptom of the economic weakness of advanced economies. Furthermore, they are also a signal that financial markets have lost their faith in Central Banks. At present, financial markets expect the Fed to undershoot its inflation target for the next 5 years if not longer. The same can be said for the ECB and the Bank of Japan. The latter suffered already from 2 decades of deflation and zero interest rates before the financial crisis. Nobody in their right mind would claim that monetary policy was accomodative as prices kept falling for more than 20 years. Only with the initiation Abenomics, a bold monetary stimulus program to inflate the Japanese economy, did the country finally get some relief and achieved a positive rate of inflation for the first time in decades. Unfortunately, even the record purchases of government bonds and equities by the Bank of Japan have proven to be inadequate and the country currently risks to slide back into mild deflation. After almost a decade of extremely low inflation levels, the notion that low interest rates are equivalent to monetary easing should have been buried long ago. Unfortunately, the fallacy is repeated more often than ever.
One of the main problems lies in the fact that the public believes that Central Banks have perfect control over interest rates, but again nothing could be further from the truth. It is true that Central Banks nowadays steer the economy by adjusting the short-term interest rate. This is in strong contrast to earlier periods where Central Banks targeted the money supply more directly. Lowering the interest rate, all else equal, will usually lead to monetary easing. This is the so-called liquidity effect. However, this must not always be the case. It all depends on how the so-called Wicksellian rate of interest or natural rate of interest behaves. This is the hypothetical interest rate that balances savings and investment at full employment. Over the last couple of years we have seen a number of incidences where Central Banks cut interest rates, but stock markets tanked and the economy crashed nevertheless. On each of those occasions financial markets expected a more aggressive rate cut, but the Central Banks in question did not deliver. If the natural interest rate falls faster than short-term interest rate set by the Central Bank, then monetary policy is effectively getting tighter and not easier despite the fact that interest rates are actually falling.
Most people also do not seem to understand that the natural interest rate is endogenous. It responds to economic conditions and is determined by the marginal producivity of capital as well as the savings and investment behavior of economic agents. Central Banks can only influence these variable very indirectly at best. Central Banks in advanced economies didn’t decide to set interest rates at zero for now almost a decade. They did it because they had no other choice. The global real interest rate fell from roughly 5% in the 1980s to about 0% nowadays. Some Central Banks like the Swedish Riksbank as well as the ECB have tried to raise interest rates over the last years, but to no avail. They found themselves in the unfortunate situation that they had to reverse course because economic conditions deteriorated again at a rapid pace. Similarly, the Fed planned to increase the short term interest rate up to four times this year, but everybody seems to have realized now that such a move would be an economic catastrophe. Markets currently price in one more interest rate hike this year while the Fed still seems to be determined to hike rates twice, most likely an unforgivable mistake given the weak state of the world economy and the fact that there is some slack in the U.S. labor market. Furthermore, inflation in the U.S. is still below the official target of 2% and rewill remain there for the foreseeable future. Interest rates are low and will thus remain low in the slow-growth low-inflation world we live in. The low interest rates are a sign of extreme Central Bank incompetence, as those institutions failed to take the bold actions that were required to reinflate the economies of the North Atlantic and to end the current economic stagnation we face. The people who demand higher interest rates should lobby for more aggressive stimulus by Central Banks. Only when the current economic stagnation will end and prices and wages will start to raise, will we also see some kind of reversion in the rate of interest to higher levels.
Knut Wicksell explained in 1906 why interest rates are procyclical:
In good times, when trade is brisk, the rate of profit is high, and, what is of great consequence, is generally expected to remain high; in periods of depression it is low, and expected to remain low. The rate of interest on money follows, no doubt, the same course…
Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.
. . .
After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.
Knut Wicksell on monetary economics:
Milton Friedman on the interest rate fallacy:
Brad DeLong on John Stuart Mill and other 19th century economists who apperently understood Macroeconomics better than many contemporary: