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The Trouble With Interest Rates

Conservative economists are wrong to accuse central banks of keeping interest rates unnaturally low. On the contrary, interest rates are higher than they should be, and central banks are doing the best they can in a difficult situation.

BERKELEY – Of all the strange and novel economic doctrines propounded since the beginning of the global financial crisis, the one put forward by John Taylor, an economist at Stanford, has a good claim to being the oddest. In his view, the post-crisis economic policies being carried out in the United States, Europe, and Japan are putting a ceiling on long-term interest rates that is “much like the effect of a price ceiling in a rental market where landlords reduce the supply of rental housing.” The result of low interest rates, quantitative easing, and forward guidance, Taylor argues, is a “decline in credit availability [that] reduces aggregate demand, which tends to increase unemployment, a classic unintended consequence.”

Taylor’s analogy fails to make sense at the most fundamental level. The reason that rent control is disliked is that it forbids transactions that would benefit both the renter and the landlord. When a government agency imposes a rent ceiling, it prohibits landlords from charging more than a set amount. This distorts the market, leaving empty apartments that landlords would be willing to rent at higher prices and preventing renters from offering what they are truly willing to pay.

With the economic policies Taylor criticizes, this mechanism simply does not exist. When a central bank reduces long-term interest rates via current and expected future open-market operations, it does not prevent potential lenders from offering to lend at higher interest rates; nor does it stop borrowers from taking up such an offer. These transactions don’t take place for a simple reason: borrowers choose freely not to enter into them.

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