I recently caught Carmen Reinhart taking a short-cut, and ending up with erroneous conclusions:
Reinhart is the toast of economic circles these days for speaking out about the newest way Western governments are using financial repression to liquidate their debts, particularly after a financial crisis. They’re doing this on the backs of savers, including pension funds, according to economists. In practice, financial repression can lead to “the rape and plunder of pension funds,” Reinhart tells Institutional Investor. Financial repression consists of very low nominal interest rates combined with captive lending by large banks or pension funds to a government. The low, stable interest rate facilitates the servicing costs of large public debts. Sometimes modest inflation is added to the mix. This results in zero to negative real interest rates that reduce government debt. Hence, broadly defined, financial repression is a wealth transfer from savers to debtors using negative real interest rates — with the government as one of the key debtors.
I’m sure my readers will immediately spot the error, but just in case here’s Milton Friedman in 1997:
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.
Some might argue that it doesn’t matter whether the low rates were caused by tight money or easy money, they help debtors either way. But this isn’t true. That’s because the tight money policy of 2008 that led to the low interest rates today also drove NGDP more than 10% below trend. Indeed it would be fair to say rates are low today precisely because NGDP fell so sharply. And this fall in NGDP hurt debtors like the US government much more than the low rates helped them. That’s why the debt to GDP ratio has risen sharply in the US, and most other developed countries.
In fact, very low interest rates (aka “tight money”) hurt both lenders and borrowers. How can both be hurt? Simple, it’s not a zero sum game. The Fed’s policy reduced real income and real wealth, leaving America a poorer place. Both lenders and borrowers have shared in that loss.
Admittedly the debt service costs are temporarily depressed. But when the economy recovers rates will rise again. But meanwhile the debt/GDP ratio will still be much higher than before the recession. In the long run tight money (aka “low interest rates”) makes the government worse off.
PS. I’m now so busy that I won’t be able to answer all comments. I’ll continue answering comments from the most recent 5 posts. Because this is a new policy, I’ll answer older comments one more time on Wednesday, to give commenters one more chance to respond to anything I said. I’ve recently been getting comments from as many as 15 different posts on a given day–and this is just too much work with my teaching responsibilities and my attempt to revise my manuscript. And I’m also doing new posts and keeping up with news in the blogosphere. Plus I’ll be doing a lot of traveling and speaking in the next month.