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Short and long-term interest rates

Sudhir Mulji

Last year in conversation with two distinguished economists I raised the question about the potential recession. Both were confident that central bankers aided by economists had learnt how to deal with an economic downturn.

It was mainly a question of spending more and cutting interest rates and there was no difficulty at least in the West in persuading politicians for doing just that. The mechanics of crude pump priming were part of every textbook, the difficulty was in ensuring that these actions did not go too far. Reining in expenditure was always more difficult than expanding it.

Yet the performance of international central bankers in the present down-turn has not been as successful as might have been anticipated. It is always difficult for governments to suddenly start spending money usefully. It is particularly to direct it to goods that are surplus in production.

To the extent that expenditure can be encouraged much has been done. No one, as Joe Stiglitz points out, attacks richer countries for running budget deficits. That piece of advice is reserved for poorer countries who run budget deficits because they have no other option.

Further when effective demand is to be spurred interest rates are reduced swiftly. In the US the Fed Fund Rate - the US short-term rate has been reduced from 6 per cent to below 2 per cent in two years. Liquidity by way of currency and bank deposits has increased substantially from $850 billion to $920 billion in the last five years. There is no shortage of money.

But in spite of these dramatic changes activity has not picked up in America. It is true that Greenspan believes that output is growing at a healthy pace of three per cent, mainly led by consumer spending, particularly on housing, which throughout the nineties has been booming in America. One view, expressed to the Congress by the Federal Reserve chairman, was much of this growth was due to large population immigration into America.

Whatever the reason, the world of officials, even such pragmatic officials as the chairman of the Fed have cut the rate of interest to a limit where they feel that further reductions cannot be justified. Two arguments predominate: first, there is the worry that cutting rates is to emulate the Japanese, who brought them down to zero and look what that policy has done for them. No growth, dreadful misinvestment and no room to manoeuvre.

The second argument for not cutting rates further is the underlying anxiety that inflation if it takes off will not be easy to control. Both Alan Greenspan and Mervyn King the deputy governor of the Bank of England believe that they need more evidence before they can recommend further reductions from the low level that has already been achieved.

They prefer to wait until their figures clearly show that we are heading into an economic crisis and that rate cuts are not just another tool for greedy businessmen trying to make money by profiteering from lower interest rates.

Yet the crisis that is now upon us is not that of false accounting or the looting of corporate funds by US executives for personal gains It is one of the ironies of the stories doing the rounds that, the ex-head of Tyco who is now under investigation, donated four million dollars to Cambridge University for the study of corporate governance. But dramatic as these stories are they are not the real issue. The problem is that low interest rates are not working and the question is why not?

In reconsidering matters what has become self-evident at least to me, is the non-operative character of low interest to real investment. With short-term low interest funds you can certainly speculate but you cannot with any degree of certainty invest. Take a hypothetical example.

Suppose you expect to earn 5 per cent per annum from a project and let us assume you can project that level of income continuing for thirty years, would that justify borrowing overnight funds at 1.75 per cent?

The answer is not unequivocal. For no one expects the rate of interest to continue for thirty years at today's level. Thus the investor is not only taking the risk that the project may not yield the expected return but the further risk that the short-term rate is only indicative of immediate conditions. No one knows what the longer-term rate could go to.

Throughout the structure of US interest rates, the yield curve has sharpened acutely. The Fed Rate has dropped from 6 per cent to less than 2 per cent but the rate for longer bonds has not fallen nearly so sharply. The 30 year long bond still yields over 5 per cent and the choice between investing in a government bond and an industrial project yielding the same amount is surely unequivocal.

The general point is that a reduction in the rate of interest should not be equated with a reduction in the schedule of interest rates. If anomalies persist a so-called reduction in the rate of interest will not have the desired effect.

I have attempted to illustrate the issue by concentrating on US interest rates to avoid the argument that such reasoning only applies in countries where interest rates are not free because of the government's monopoly power.

Nowhere do interest rates move as freely as the United States; but the government as a substantial borrower still imposes enormous influence on the schedule of interest rates. The structural problem often cited by the Reserve Bank as a reason for its inability to influence market rates is as absent in the United States as in more regulated economies.

The answer to the solution was proposed by the supposedly leading advocate of pump-priming John Maynard Keynes. He certainly advocated pump priming in times of ineffective demand. That is an overall increase in expenditure without resorting to taxation, but like the fertile economist that he was, he also advocated other ideas.

In his open letter to the American President on the new deal he said: "I put in the second place (the first place being an increase in government expenditure) the maintenance of cheap and abundant credit, in particular the reduction of the long-term rate of interest. The turn of the tide in Great Britain is largely attributable to the reduction of long-term rate of interest,which ensued on the success of the conversion of the War Loan.

"This was deliberately engineered by the open-market policy of the Bank of England. If only the Federal Reserve System would replace its present holdings of short-dated issues by purchasing long-dated issues. .. Such a policy might become effective in a few months and I attach great importance to it." (Volume 21 of the Collected Works page 297)

What might have been effective in the thirties could still be effective at this turn of the century. Institutions may well have changed but the fundamentals of economics have not.

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