Higher interest rates won’t kill the economy

In his great 1936 book The General Theory of Employment, Interest and Money, the British economist John Maynard Keynes (rhymes with “brains”) announced the eventual “euthanasia of the rentier.” Rentiers are people who live off the interest on capital. They clip bond coupons for a living. Keynes’ argument was that in a generation or two interest rates could, would and should go so low that making a living off interest would be impossible.

For the last five years, anyone relying on interest for their income has been having a hard time of it. Rentiers haven’t quite been euthanized but the expansionary monetary policies followed after the Crash have left many of them on life support.

Now, however, the U.S. Federal Reserve Board is signalling that interest rates may soon be heading back up. People with savings are looking forward to earning more — provided they haven’t locked themselves into long-term assets at current interest rates. The rest of us are wondering what effect higher rates will have on the economy’s health.

Unfortunately, despite a couple hundred years’ study, economists still disagree about the likely effect of higher interest rates.

Some say it’s past time they went up: the big increases in national money supplies of the last half-decade have created a dangerous risk of inflation.

Others fear we’re headed into 1937 all over again. In 1937, four years after the bottom of the Great Depression, the Federal Reserve thought it was time to rein in money growth and raised private banks’ reserve requirements. The resulting contraction of the money supply pushed the U.S. economy back into a recession that only the Second World War got it out of.

We economists don’t practise a very precise science but you’d think we could do better than completely contradictory advice.

Part of the problem is the long run vs. the short run. Keynes thought interest rates could get very low because he felt that in the long run an industrial economy that consistently ran close to flatout could generate enough savings to undertake just about any physical investment that could possibly earn a positive financial return. (To write about the satiation of investment demands in the depths of the worst downturn of the industrial age was cocky but Keynes was intellectually flamboyant.) But if we did eventually reach the point where the typical investment project earned just one or two per cent a year, the owners of the capital behind it couldn’t earn more than one or two per cent a year and would have to go out and find honest work in order to make a living.

Note that whereas in the mid20th century only about half of Canada’s highest-income earners worked, today more than 75 per cent do.

Though Keynes was right about the possibility of rapid economic growth coming out of the Great Depression — the four decades following it set all sorts of growth records — he was wrong about the eventual disappearance of profitable things to do with savings. Everywhere you turn, it seems, new technologies are providing things people want to buy. True, if technology suddenly stood still, we might run out of profitable investments, but there seems very little danger of that. As a result, new money-making opportunities spring up every day. The range of consumer goods and consumption possibilities available now, a lifetime after the Depression, would shock even someone with Keynes’ imagination, just as what will be available a lifetime from now would doubtless shock us were we to live to see it.

In the short run, however, the interest rate has more to do with the buying and selling of financial assets than with balancing saving and physical investment. If the interest rate on financial assets falls, that does make it easier to finance physical investment — and that has been the purpose of the easy money of the last five years.

On the other hand, lower interest rates don’t guarantee lots of physical investment. What they bring is more investment than would otherwise take place.

If the demand for new investments has been hammered for other reasons, lower interest rates help but they won’t work miracles.

In the same chapter in which he wrote about the euthanasia of the rentier, Keynes talked about the “uncontrollable and disobedient psychology of the business world.” The Crash of 2008 left that psychology badly shaken.

The very low interest rates we’ve had since then almost certainly have helped restore that psychology and encourage more investment than would otherwise have taken place. But they obviously haven’t worked any miracles.

Businesses’ “animal spirits” aren’t all the way back to where they were in 2007 — which actually is a good thing, since they may well have been too buoyant then.

But with the slow improvement certainly in the North American economy, they’re probably strong enough now that giving a little life back to rentiers won’t euthanize the rest of the economy.