A version of this letter was published in the Financial Times today.
Larry Summers is right to point out how few tools central bankers have to “delay and ultimately contain the next recession”. (FT, 6 December, 2015). We share his pessimism. However his analysis of the so-called “neutral rate of interest” being lower in the future than in the past” is based on the flawed notion of a “growing relative abundance of savings relative to investment”.
As Keynes explained and understood, in an economy based on credit, investment is not constrained by savings (and vice versa). Many of those who lay claim to his theories still do not accept this basic principle of a credit-based economy – applied in the UK since the founding of the Bank of England in 1694.
This flawed analysis leads Summers to misunderstand the direction of interest rates for those active in the real economy – rates often distinctly higher than prevailing central bank policy rates.
The most important feature of the dynamics of the long term rate of interest is not, as Summers argues, the recent reduction, brought low by successive financial crises, and in particular the dot.com crisis. No, the most important feature – causal of financial crises – is the long-standing and severe elevation of rates prior to the dot.com crisis. As Dr. Geoff Tily on PRIME has shown, real corporate rates of interest before 2001 were double the rates that prevailed during the ‘golden age’; and broadly equivalent to rates that preceded the great depression. The average rate over 1923-9 was 5.9 percent and over 1980 -2000 was 7.2 percent.
Central bankers long ago abandoned influence over these elevated real rates for the corporate sector. This explains why they were impotent when high real rates punctured private debt bubbles and caused crises. Until Keynes’s understanding of monetary theory and his associated policies are revived, central bank impotence will continue to be a feature of financial crises.
Policy Research in Macroeconomics (PRIME)