Macroeconomists and financial economists got a bad name in the aftermath of the Global Financial Crisis (GFC) and the Great Recession in and around the years 2007-08. The criticism inspired and motivated research that has resulted in several changes in policy formulation on the part of public authorities. It is interesting, however, that despite such changes in policy, the basic paradigm for policy for macroeconomic and financial stability has stayed more or less unchanged. So, we will continue to be vulnerable. But what is the alternative? Do we have one? Research carried out by this author and others shows the way out. This short article will present in a very simple way one part, though an important part, of this research. This is on interest rate policy for stabilization of aggregate real investment (I will abstract here from policy towards stabilization of aggregate consumption). Policy for maintaining low and stable inflation here is in the context of core inflation (I abstract from the issue of cost-push inflation here). Furthermore, I will confine myself here to a closed economy. Finally, I will abstract from issues of changes in an institutional structure that can support the proposed policy regime.

Though I have left out many important issues here, the analysis is, in a forthcoming book, expanded much further (and elaborated) to formulate a more comprehensive policy for macro-economic and financial stability; the new interest rate policy here is a part of the overall policy spelt out in the book.

Before we come to the proposed interest rate policy, let us quickly review (a simplified and stylized version of) the prevailing interest rate policy, and see where the fault lines lie. This will pave the way for formulating a new interest rate policy.

A critique of the prevailing policy

Consider a central bank whose main objective is to target low and stable inflation. Under the prevailing interest rate policy, the central bank raises the interest rate if the inflation rate is high, and it lowers the same if the inflation rate is low. This helps maintain low and stable inflation. Though the focus is supposed to be primarily on maintaining low and stable inflation, the central bank is, in practice, flexible enough to take care of other objectives such as maintaining a high and stable growth rate of GDP if there is a serious recession or financial crisis in the economy.

Let us take a close look at the prevailing interest rate policy in a recession. If the central bank lowers the interest rate to tackle a downturn in the real economy, the interest income of saving entities falls. Note that there is an implicit tax on saving entities and there is an implicit subsidy for investing entities for whom the interest cost is reduced. So, we have an implicit tax-subsidy scheme at work behind the central bank’s interest rate policy in a recession! Clearly, the implicit subsidy on interest cost for investing entities in a recession is financed by an implicit tax on saving entities in the same period. So, there is a balance in the implicit budget related to the interest rate policy of the central bank in a recession. In a boom in the real sector, the central bank is often not active (unless the inflation rate goes up, which it does worry about, but that is a case of inflation targeting).

With this rather very brief exposition of monetary policy, we can now list the difficulties with the prevailing interest rate policy.

First, it is only in a serious recession or financial crisis that the policy is concerned about, other than maintaining low and stable inflation. At other times, the focus is basically on inflation alone. And even in the case of a major recession or financial crisis, which is when the central bank considers ‘other’ objectives adequately, it faces a serious trade-off between different objectives. It ends up making a compromised choice, given the paucity of policy tools.

Second, the prevailing interest rate policy has adverse effects on distribution. This is obvious, given the nature of the tax-subsidy scheme that is implicit in the central bank’s interest rate policy. Saving entities like pensioners and retirees lose and investing entities can gain as a result of the central bank’s interest rate policy in a recession.

Third, the low interest rate in a recession helps in raising not just real investment but also financial investment. Investors can borrow funds at a low interest rate and invest in assets like stocks. In the process, the expected profits can be high. Also, firms can borrow funds and use these for the buy-back of their own shares. This can increase earnings per share. So, ‘genius’ investors like Warren Buffett gain hugely as a result of the prevailing policy. The policy can raise debt levels and asset prices beyond their fundamental values. Clearly, financial stability is at stake, given the prevailing interest rate policy (this appears to be the situation in the US in recent years).

Fourth, in a recession, the central bank lowers the short-term interest rate, which is, in turn, expected to affect the long-term interest rate. It is the latter which is more relevant for real (long-term) investment and it is this long-term interest rate which the central bank is, at the end of the day, interested in targeting. But there is an indirect, uncertain and lagged effect of central bank’s (short-term) interest rate policy.

Fifth, under the prevailing interest rate policy, the central bank can reduce the interest rate up to a point. After the nominal interest rate hits the zero lower bound (ZLB), the central bank cannot reduce the interest rate any further. Thereafter, the central bank needs to introduce policies like Quantitative Easing (QE). It is not clear if QE is an effective policy. Also, once introduced, QE may need to be kept in place for long, and it can be difficult to exit from such policies.

We see that the prevailing interest rate policy has significant and lasting adverse side-effects, or shortcomings. All this is a motivation for an alternative interest rate policy.

The proposed interest rate policy

It is proposed that the prevailing interest rate policy should be replaced by an altogether new policy. The policy suggestion is that there should be an explicit tax-subsidy scheme instead of an implicit tax-subsidy scheme related to the interest rate. This is good for transparency. But even more important, the proposed policy is, as we will see, well-targeted, and not blunt. Finally, the use of an explicit tax-subsidy scheme by the Treasury (or the Ministry of Finance) overcomes, as we will see, the paucity of policy tools with the central bank.

The proposed policy is actually quite simple and straightforward. Let the treasury give an explicit subsidy on real investment in a recession. This is equivalent to a reduction in the interest rate, which reduces the interest cost incurred in the process of borrowing funds for the purpose of making a real investment. Also, let the treasury impose a tax on real investment in a boom. This is equivalent to a rise in the interest rate at which the firm borrows funds for the purpose of investment in a boom. With such an explicit tax-subsidy scheme over the business cycle (instead of an implicit tax-subsidy scheme within the recession period as is the case under the prevailing interest rate policy), the treasury will have a balanced inter-temporal budget related to the interest rate policy.

The previous section presented a critique of the prevailing policy. Let us now see how the proposed policy is superior to the prevailing policy.

First, observe that since investment and aggregate demand for output are sought to be maintained under the proposed interest rate policy by an explicit tax-subsidy scheme by the treasury, the central bank is now freer to maintain low and stable inflation. In other words, inflation targeting can be more meaningful, if it is supplemented by the proposed interest rate policy to deal with fluctuations in investment and output. Note that the proposed interest rate policy may be used not only in times of a serious recession but also more generally in any recession where policy intervention is, it is felt, required. This is unlike what happens in the case of the prevailing interest rate policy.

Second, the proposed policy affects the borrowers only, and not the lenders. The reason is simple. Investing entities are affected by a tax-subsidy scheme on their investment, and not through a change in the interest rate in financial markets. So, there are no (first order) effects for lenders or saving entities. They simply receive the interest income, given the market interest rate. Accordingly, there is no redistribution from the savers like retirees and pensioners to the business sector due to the proposed interest rate policy. The explicit subsidy in a recession can be financed by borrowing against the explicit tax that can be imposed on investment in a boom. The burden of financing need not fall on an implicit (or explicit) tax on saving entities in a recession (or at any other time).

Third, the proposed interest rate policy is a tax-subsidy scheme that is applicable to real investment only; it is not relevant for financial investment. The reason is simple. The public authorities do not intervene to affect interest rates in financial markets; in such markets, interest rates are determined by forces of demand and supply. And the Treasury will, under the proposed policy, not give a subsidy for financial investment. This is unlike what the central bank ends up providing under the prevailing interest rate policy.

It is true that there may be some misuse of the proposed explicit subsidy, but observe that what may be viewed as misuse under the proposed policy is actually what is allowed by design and by law under the prevailing interest rate policy. So, the issue of the possible misuse of the proposed policy is misplaced. Moreover, even if there is some ‘misuse’ under the proposed policy, it will always be much less than the ‘use’ for financial investment under the prevailing policy.

Fourth, the proposed policy is well-targeted in yet another sense. It affects investment directly by reducing the effective cost of (long-term) investment projects. This is unlike what happens under the prevailing interest rate policy wherein the central bank changes the short-term interest rate, which is expected to affect the long-term interest rate, which is, in turn, expected to affect the cost of long-term investment projects.

Fifth, it is very interesting that under the proposed interest rate policy, the treasury can always give a subsidy in a recession so that the effective (post-subsidy) interest rate is negative. There is no zero lower bound for such a post-subsidy interest rate. So, policymakers are not constrained under the proposed regime in this context. This is unlike what happens under the prevailing interest rate policy wherein the central bank faces a ZLB beyond which it cannot lower the nominal interest rate.

Conclusion

Interest rate policy is not the panacea for macroeconomic and financial stability. However, to the extent that it is useful, it can be improved substantially. This article has shown how this can be done.

The prevailing interest rate policy of the central bank (to the extent that is used over the business cycle) is non-transparent as it includes an implicit tax-subsidy scheme. In other words, the monetary policy includes elements of an implicit fiscal policy. More importantly, the prevailing interest rate policy is blunt. In contrast, the interest rate policy proposed here is well-targeted besides being transparent as it includes an explicit tax-subsidy scheme (that is different from the more familiar Keynesian fiscal policy).

All this raises an interesting question. How did we land up with the prevailing interest rate policy in the first place? For this, we need to consider the related history of economic thought. This is, however, outside the scope of this article.

 

By Dr. Gurbachan Singh

Dr. Singh is an independent economist, an adjunct faculty member at the Indian Statistical Institute (ISI), Delhi Centre. 

 

 

Further Readings

Feldstein, Martin, 2016, The future of fiscal policy, in Progress and Confusion: The State of Macroeconomic Policy, Edited by Olivier Blanchard, Kenneth Rogoff, Raghuram Rajan, and Lawrence Summers, International Monetary Fund, Cambridge, MA: The MIT Press.

Jeanne, Olivier, and Anton Korinek, 2010, Excessive volatility in capital flows: A Pigouvian taxation approach, American Economic Review: Papers & Proceedings, 100(2), 403-407.

Jeanne, O. and Korinek, A., 2018, Managing credit booms and busts: A Pigouvian taxation approach, Journal of Monetary Economics (print edition forthcoming).

Koo, Richard C., 2015, The Escape from Balance Sheet Recession and the QE Trap, Wiley. Singh, Gurbachan, 2012, Banking Crisis, Liquidity, and Credit LInes – A Macroeconomic Perspective, Routledge, Abingdon (chapter 11).

Singh, Gurbachan, 2014, Overcoming zero lower bound on interest rate without any inflation or inflationary expectations, South Asian Journal of Macroeconomics and Public Finance, 3(1), June, 1-38.

Singh, Gurbachan, 2015, Thinking afresh about central bank’s interest rate policy, Journal of Financial Economic Policy, 7(3), 221-232.

Singh, Gurbachan, 2018, A macroeconomic model with price flexibility, South Asian Journal of Macroeconomics and Public Finance, 7(1), 1-26.

Solow, Robert, 2012, Fiscal policy, chapter 8 in In the Wake of the Crisis: Leading Economists Reassess Economic Policy. Edited by Olivier Blanchard, David Romer, Michael Spence, and Joseph Stiglitz, International Monetary Fund, The MIT Press.