HH Central Banks See No Way Out Of The Low Interest Rate Trap

Figure 1: US Credit Impulse and Private Demand

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Source: Macrobond. Credit impulse is calculated as the change in credit flows relative to GDP.5

Let’s start with a look at the Keynesian model. As it does not include a banking sector, it cannot explain money creation by banks and falls into the trap of assuming that savings are always equal to investments. Exogenous increases in money supply lower the interest rate and shift the LM (liquidity preference–money supply) curve along the IS (investment-savings) curve to achieve a higher level of production. Money drains operate in the opposite direction. But in our existing credit money system, new investments are funded not only with existing money savings but also with money created by banks for the investors through credit extension. As an intermediator in the money market and lender of last resort to banks, the central bank steers the money market rate and thereby indirectly (normally) the credit rates. In our time of quantitative easing, the central bank exerts also a direct influence on longer-term credit rates. Thus, as money and credit are created by banks and the process is managed by central banks, interest rates are (ever more closely) tied to the monetary policy of the central banks.

Figure 2: Old-Age Dependency and Household Savings Rate in OECD Countries, 1995–2018

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Source: Organisation for Economic Co-operation and Development (OECD). Household savings rates in percent of GDP.

And here comes Hayek into play. If the central bank knew at what interest rate existing money savings would be equal to the demand for funds by investors, all would be fine. But the central bank cannot know this rate. Nevertheless, it presumes to know. In vain attempts to set the market rate at the level of the unknown natural rate, the central bank follows an error-correction process, with rates either too low or too high. The result of this is a credit boom-bust cycle, shown for the US in figure 1, which is accompanied by fluctuation in real private demand.

But even if the Keynesian model is incomplete and therefore misleading, could the Keynesians nevertheless be supported by empirical facts? The answer is no. We could not find support to the view that ageing societies save more.6 In fact, as figure 2 shows, changes in the old-age dependency ratio in Organisation for Economic Co-operation and Development (OECD) countries are not linked to systematic changes in household savings rates. If at all, households tend to save less when populations age. Moreover, we also fail to find a systematic decline in the marginal productivity of capital, as suggested by the secular stagnation theory (see figure 3).

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Beating Buffett 2 months ago Member's comment

Good read, thanks.