Low interest rates have been the mantra of economic policy for quite some time, even more so since the various public-sector stimulus packages that followed the GFC have been accompanied nowhere by anything like the kinds of recovery policy-makers had sought. As soon as it became clear that public spending to re-generate growth and employment had fallen well short, creating deficits and debt with no upward turn in our economies, there was a shift towards monetary policies to encourage the recovery public spending had not achieved. As a result, we have seen quantitative easing, record low rates of interest and now even the introduction of negative rates to raise the level of demand. It is, however, becoming evident, at least to some, that these policies are also doing nothing to re-generate growth, even though our economics texts say they should.
There was a time, however, when it was universally recognised that monetary policies of this kind would only make matters worse, but that was a very long time ago. Perhaps we should go back and see what economists used to say about such things before we go even farther in this direction, whose continuation will make it ever more difficult to extract ourselves from the abyss of our own creation we now find ourselves in.
So let us begin with this question:Can interest rates be too low? There is a pair of diagrams you run across in theory texts that show the supply and demand for credit on the diagram to the left and the level of investment on the diagram to the right. There is then an increase in money or credit shown on the left-hand diagram, which lowers rates of interest. The effect on the right-hand diagram is that the lower rate of interest leads to an increase in the level of investment. And that is all you need to know about the state of theory in the modern world. Lowering interest rates will lead to a rise in investment. And that would be the end of it were it not for the fact that we have had the lowest interest rates on record across the world and investment has been abysmal. Our economies are falling into a black hole, and low rates of interest or not, no one seems able to do a thing about it.
As with so much in modern economic theory, the great watershed occurs with the publication of Keynes’s General Theory in 1936. Here is the sentence that has changed the entire way economies are looked at in the modern world:
The conviction, which runs, for example, through almost all Professor Pigou’s work, that money makes no real difference except frictionally and that the theory of production and employment can be worked out (like Mill’s) as being based on “real” exchanges with money introduced perfunctorily in a later chapter, is the modern version of the classical tradition.
Unless you know how pre-Keynesian economists looked at these things, you have no idea what has changed and how economic theory is now different. It is a straightforward fact that virtually no economist alive can tell you how Mill would have looked at these issues, which had, of course, been the way it had been looked at by economists almost as far back as economic issues had been discussed. So here we will take you back to that tradition and try to explain just how badly deranged modern economic theory is—and by “modern” I mean the theory that has been at the centre of economic discourse now for eighty years.
So what is Keynes saying in that passage? There were these classical economists who looked at the economy in terms of the actual underlying flow of goods and services. Then, when they had worked out how the economy operated in real terms, they brought in money at a later stage to show how the existence of money and credit had major effects on the operation of an economy, and in fact were often a major disturbing element. Keynes would have none of that, nor does a modern text. The real economy beneath the flow of money is now so completely disregarded that I am not sure it is ever actually mentioned. It is all money flows, so much spending, so much saving and all calculated in terms of the amounts of money either spent or not spent.
Saving in a modern economics text is the difference between income and consumption. Here is the first statement that pops up in Google under “saving in economics”:
Savings, according to Keynesian economics, consists of the amount left over when the cost of a person’s consumer expenditure is subtracted from the amount of disposable income he earns in a given period of time.
You receive an income of 1000, you spend 700 and the last 300 is by definition saved. It’s all in money, and more particularly, it is all current. Saving is the proportion of current income not spent. It is all in the here and now, the latest period alone, what you did this month or this quarter, or, for annual data, what you might have done over the past year.
National saving, the same thing. Again from Google under “national saving economics”:
In economics, a country’s national savings is the sum of private and public savings. It is generally equal to a nation’s income minus consumption and government purchases.
That is all any economist now knows. Saving is a sum of money that is left over after governments and individuals have spent what they have out of whatever incomes they have available to spend.
In the modern world, saving is a void. There is income that is spent and there is saving which is unspent. The entire issue is reckoned in the flow of money, without actually looking at the underlying flow of goods and services, and most particularly, at the underlying use of the existing resource base. The following quote is from my second-favourite economics book of all time, Henry Clay’s Economics: An Introduction for the General Reader (my favourite being John Stuart Mill’s Principles of Political Economy). I have just written an article on Clay’s Economics to mark the hundredth anniversary of its first publication in 1916. I have described it as the best introduction to economics ever written. It is possibly unreadable to most people today since it goes against the grain of what most economists believe, and I imagine, what most economic policy advisers prefer to believe. But here is Clay discussing saving:
We may put the case concretely by saying that “savings” constitute a demand for buildings, machines, materials, stock-in-trade, while the rest of income is a demand for food, clothing, shelter and other goods and services for immediate consumption; both are spent, but the object of spending is different in the two cases. (Clay 1916: 235)
And for you Keynesians out there, it should be noted that the next chapter is devoted to explaining the causes of unemployment from a classical perspective. Since modern economics has been founded on the belief that excessive saving is the central cause of recession and unemployment, I will add this from Clay in his explanation of both:
All that will be attempted in this chapter is to show that they are not inconsistent with the account of the working of the economic system, given in the last chapter. (Clay 1916: 245)
And just for completeness, let me take you to Mill himself. My reluctance is only due to how difficult he is to read, but in this instance I think he is as clear as one could want. Saving is what allows capital to accumulate, and without saving, no accumulation can occur. But what is that thing called “capital”?
Capital, by persons wholly unused to reflect on the subject, is supposed to be synonymous with money. To expose this misapprehension, would be to repeat what has been said in the introductory chapter. Money is no more synonymous with capital than it is with wealth. Money cannot in itself perform any part of the office of capital, since it can afford no assistance to production. To do this, it must be exchanged for other things; and anything, which is susceptible of being exchanged for other things, is capable of contributing to production in the same degree. What capital does for production, is to afford the shelter, protection, tools and materials which the work requires, and to feed and otherwise maintain the labourers during the process. These are the services which present labour requires from past, and from the produce of past labour. Whatever things are destined for this use—destined to supply productive labour with these various prerequisites—are Capital. (Mill  1921: 54—emphasis added.)
Capital is made up of “things”, and we can only accumulate capital by saving—that is, by producing more actual goods and services than we use up in current consumption. I don’t think any modern economist would necessarily deny it. But it is also not emphasised. No one doing an introductory course in economics is taught that saving is the basis for growth. Saving, if it is discussed at all, is used to explain why economies enter recession and why a stimulus to soak these excess savings up is often necessary to end a downturn. And as much as I find the Keynesian theory of recession utterly wrong, none of it is up for discussion on this occasion. The issue for now is saving, rates of interest and in particular the focus on the stock of capital goods as the way in which saving needs to be understood. Saving is not money. Saving is the actual resources that are used as part of production. People borrow money, of course, which is how these resources are secured. But saving consists of these resources. Because the underlying resource base is nowadays all but ignored, economic theory finds it near impossible to think about the actual mechanism at work that allows an economy to function, or to think about what interest rates are designed to do.
There was a time when interest rates were about the supply and demand for that real stock of saving that could be used in productive activity. But sometime around the days of the Great Inflation, maybe even before, interest rates became the weapon of choice in trying to deal with rising prices. Under Reagan in the US, Thatcher in the UK, and Paul Keating in Australia, interest rates were used as a bludgeon to crush the wage-driven inflation that was at the centre of the rise in prices. Although monetarism, then at its height, argued that it was the growth in the money supply relative to productivity that was at fault, whatever insight into the inflationary mechanism this might have given, there was no relief from rising prices that came from trying to limit the increase in the supply of money.
For myself, working as I was at the time in the midst of Australia’s industrial relations system, the notion that inflation could be controlled by limiting the growth in the amount of money sloshing around an economy looked exceptionally weak. The proliferation of definitions of “money”—M1, M3, M3A, M6 and others—were in large part due to the inability of economists to find some measure of money whose growth rate would actually correlate with the growth in the price level. No such definition of money has ever been found, and there is no doubt that the obsession with money supply statistics that had been at the heart of policy in the 1970s and 1980s has completely disappeared. It has been years since I have looked at any such stats and I cannot think of a single instance in the past twenty years when anyone has bothered to mention money supply growth in print.
So instead, we have left out the issue of the growth in the amount of money, and now merely relate inflation control to something called “the natural rate of unemployment”. I find it utterly astonishing, but anti-inflationary policy is now entirely based around keeping the unemployment rate high enough to slow the rate of inflation. If inflation is too high, interest rates are raised with the expressed intent of increasing unemployment. You may think it unconscionable to use the unemployed in this way, but this is how things are done. For the more technically minded, the relationship between inflation and unemployment is shown by a diagram called the Phillips Curve, named after Australia’s most influential economist, Bill Phillips (who, to be technical about it again, happened to have been born and raised in New Zealand). Phillips first devised the diagram in the 1950s. It has ever since been a staple of economic management, as useless as the correlations between unemployment and inflation have in reality turned out to be.
The problem has become that inflation is now near zero across the world even with interest rates also near zero. In fact, so worried are economic policy-makers about what is going on, negative interest rates are the coming fashion: you may eventually find yourself having to pay banks to hold your money. Policy-makers and their friends in the economics departments of our universities are continuously on the hunt for some kind of understanding of what is going on. That they cannot make any sense of things is merely because they don’t know where to look.
Where they need to look is in the economic texts of pre-Keynesian economists. There they would find what they need to know, but the sad fact is that they are unlikely to make sense of most of it, so badly miseducated have they been. They are still, unfortunately, enthralled by a book that was commenced at the lowest point of the Great Depression, but published when the Great Depression was well and truly over. It is one of the shallowest books on economic theory ever written, embarrassing for any economist who might ever bother to read it, which sensibly no one ever now does. But the damage it has done continues unabated. There is no end to the misbegotten issues between its covers, but here we are looking at saving, investment and the role of the rate of interest.
At the centre of a proper understanding of rates of interest is the recognition that when someone is looking to invest, what they borrow is money but what they are actually seeking are capital assets, labour time and other forms of input such as electricity and transport. There was therefore a dual focus that was essential to make sense of what actually went on. One had to absolutely keep an eye on the market for money and credit, and at the same time to be completely mindful of the supply of real resources available for productive investment.
The distinction made was between what was called “the money rate of interest”, which represented the supply and demand for money and credit, and “the natural rate of interest”, which looked at the supply and demand for the available real savings that an economy had at its command.
This was an absolute staple among economists. Keynes was aware of this distinction, and in fact had employed the dual concepts in his Treatise on Money, the book he wrote in 1930 prior to The General Theory. But in The General Theory he was no longer interested in what caused an economy to grow and prosper, but was instead interested in what caused it to employ, and in particular what would lead to increases in aggregate demand. Famously, he stated that while it might be better that such stimulus expenditures would be on useful, value-adding kinds of output, given the urgency of the need to employ such considerations could be discarded. Although most economists have run across this statement from The General Theory, I will include it for those who may not have seen it already. If you would like to see the inspiration for the massively wasteful expenditures that constituted the “stimulus” that followed the GFC, here it is:
If the Treasury were to fill old bottles with bank-notes, bury them at suitable depths in disused coal-mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of repercussions, the real income of the community, and its capital wealth, would probably become a good deal greater than it actually is. (Keynes 1936: 129)
Those old timey economists from the Dark Ages of Classical Thought knew that nothing could be more certain to make a bad situation worse. In a recession, resources are not being fully utilised, there is deep dysfunction in the operation of the economy, the resource base is not deployed where it ought to be, but the pool of national savings—the resources essential in maintaining an economy’s strength and building the economy into the future—remain scarce and cannot be scattered into various forms of unproductive expenditure without serious cost to the economy. There is no doubt that some of those resources need to be shifted from the loss-making ventures which are contracting during the recession, and into the profitable ventures that need to be built, whose development will allow the economy to regenerate its rate of growth during the recovery. To follow the Keynesian script would be madness. And if you think I’m being extreme about the views of classical economists on reading The General Theory, you should read Hubert Henderson’s review, Henderson having been Keynes’s co-author for their 1929 joint argument in favour of public spending during the high-ish unemployment of the 1920s. The notion that a government ought to replace private investment with public spending was seen as economic illiteracy of the highest order. But that was then.
Keynes, who had an unerring eye for the weaknesses in his argument, dealt with this distinction between the money rate and the natural rate over three pages of The General Theory (1936: 242-244). The core point Keynes was trying to establish—something that literally no modern economist accepts—was that interest rates were a purely monetary phenomenon in which the supply and demand for actual resources to invest played absolutely no part. Interest rates were dependent on something called “liquidity preference”, the rate at which you could get people to part with their cash.
The fact of the matter is that the moment you recognise that the real resources are crucial for maintaining economic growth and raising living standards over time, but which are in very short supply even at the worst of times, ought to make anyone extremely hesitant about their support for a Keynesian stimulus. The catastrophic rise in debt accompanied by the glacially slow improvement in the labour market, along with the fall in real earnings, were once understood as the certain outcome from following a Keynesian prescription. It is just too bad that many if not most economists across the mainstream no longer learn a single thing about any of this.
Let us start where a classical economist started, with the immense scarcity of productive capital assets relative to the infinitely large number of goods and services that could be produced that would improve living standards and make people materially better off. The likelihood that we are anywhere near running out of the demand for such consumer goods and services is no more true today than it was when Keynes wrote his General Theory. The idea that our savings are running to ground for lack of any possible productive activities they could be profitably used in is absolute nonsense. If you are of the view that the recession we are in the midst of is because we have more savings available than we have uses we can make of those savings then we will have to differ. But if you are a Keynesian that is the argument you are reduced to needing to believe.
Instead, we begin where the classics began by recognising that there are far more uses for those resources than there are resources available for use. As is always the case, some of our capital assets can no longer serve a productive function and are redundant. Others are being used in enterprises that cannot earn a profit and will eventually find the market re-directing them to other kinds of work. Labour as well will find itself needing to shift from many of the jobs it is currently engaged in into other kinds of work where their employers can earn a positive return employing them. There is thus an immense range of productive inputs across the economy that is needed to maintain our capital base and then to extend it through higher investment. These resources are not free. And in every instance, their owners—whether the owners of capital or labour—are doing what they can to ensure they are getting the highest return that they can get on what they own. I need hardly point out that if a shopfront becomes vacant, its owner does everything possible to find a new tenant, even if it might mean having to lower the rent.
The supply and demand for these real resources is what is referred to as the natural rate of interest. It is a concept that goes back to the nineteenth century and to my mind is essential if you are to understand how an economy functions. And because the availability of such resources is limited, and because they are costly, the natural rate of interest is well above zero. These resources are not free. Their use comes at a cost.
In a properly functioning market economy, the money rate of interest—the price of credit—needs to be at the same level as the natural rate. That is what equilibrium in the money market means. Money rates of interest should therefore not be zero, or anything like zero. That they are has been catastrophic for the management of our economies and has been one of the major reasons recovery has been so slow.
So what happens when the money rate of interest is below the natural rate? The demand for the stock of capital goods at such low rates of interest exceeds the supply. The quantity of productive assets being maintained and created diminishes, which is another way of saying that the real level of investment falls. The capital stock is allowed to run down. Our economy becomes less productive. Real wages fall. Living standards are pared away. Economic growth diminishes. Employment growth slows. If you see things as the classicals saw them, as the return on the ownership of capital assets falls, there is less investment and therefore less capital.
But it’s worse than this. Low interest rates mean that lenders are less discriminating in deciding where the money they lend goes. At high rates of interest rates, lenders become very keen to make sure that whoever borrows the money will be capable of paying the money back. When interest rates are much lower, there are many low-quality investments that can be financed at less risk to the lender. The repayment may be more assured, but the economy’s future growth is diminished. Low interest rates mean that those who do get the now-more-limited supply of productive resources are less likely to create the kinds of growth that higher interest rates would tend to encourage.
The one supposed advantage of low interest rates, but an advantage only to governments, is that it allows public expenditure to be financed at a lower monetary cost. Governments can borrow to cover their debts. Meanwhile, with the funding pulled away from the private sector, inflation is kept low since most of the goods and services within a consumer price index are privately produced. So long as the private sector is sluggish, the CPI remains relatively dormant. So long as the standard by which monetary policy is assessed is dependent on the growth in the price level, interest rate policy is apparently filled with success.
The underlying reality is far more grim. The crucial classical distinction between “productive consumption” and “unproductive consumption” has now absolutely disappeared, ridiculed by our modern economists, who have no idea what classical economists meant. Consumption in bygone days meant using things up, as in consumed by a fire. Productive consumption meant using up resources in a way that allowed the economy to expand. Unproductive consumption was the use of resources to satisfy the wishes of buyers without any thought to future growth. It was the difference between investment and consumer demand in today’s jargon.
Productive consumption was the use of an economy’s resource base to encourage the economy to grow. Most of it was driven by the private sector, but there was no reason that some of it might not come from the public sector in building roads and bridges. But whoever might do the work, the aim was to build the economy. More value had to be created than the resources that had been used up.
Unfortunately, under the misdirection of Keynesian theory, any old public expenditure is seen as creating growth. Subsidising losing investment projects is believed to induce future rates of growth. Public sector waste is tolerated if not actively encouraged, since it adds to aggregate demand. The fact that we are drawing down on our resource base without leaving a net positive return is ignored as if such considerations are irrelevant. And because economic theory continues to misinform policy, there is the absolutely wrong belief that such spending is helping to build a stronger economy. Nothing could be further from the truth, as we will learn to our regret in the years to come.
Can interest rates be too low? There is nothing more certain than that they can, just as it is equally certain that rates have been too low for many years. Our economies are starved for capital yet our reigning economic theory argues that recessions are caused by too much saving. We think we can make our economies grow by letting politicians choose which investments will be the most productive, when it is only business firms under the pressures of the market that can lead to higher rates of productive investment and create the conditions for rising real wages, full employment and an improved standard of living.
But as importantly as anything else, the belief that low interest rates are good for growth may be the worst delusion of all, causing one economy after another to fall into a low-productivity trap from which it is almost impossible to find a way out. Interest rates are not intended to battle inflation. They are intended to allocate our capital into their most productive uses. We are ruining ourselves by taking an approach to interest-rate adjustment which everyone in their ignorance believes is actually doing ourselves good. They are profoundly wrong, but you would have to go back to the economic theories of eighty years ago or more to find out why.
Steven Kates is Associate Professor of Economics at RMIT University in Melbourne. He has just published his edited collection, What’s Wrong with Keynesian Economic Theory? (Edward Elgar 2016).
“National savings definition”—Wikipedia, the free encyclopedia—accessed August 2016
“Savings definition”—Investopedia—accessed August 2016
Clay, Henry. 1916. Economics: an Introduction for the General Reader. 1st ed. London: Macmillan.
Henderson, H.D.  1955. “Mr Keynes’s Theories.” In The inter-war years and other papers: a selection from the writings of Hubert Douglas Henderson. Edited by Henry Clay. Oxford: Clarendon Press.
Kates, Steven. 2016. “Clay’s Economics: the Best Introduction to Economics Ever Written.” History of Economics Review.
Keynes, John Maynard. 1936. The General Theory of Employment, Interest and Money. London: Macmillan.
Mill, John Stuart.  1921. Principles of Political Economy with Some of their Applications to Social Philosophy. 7th ed. Edited with an introduction by Sir W.J. Ashley. London: Longmans, Green, and Co.
 For some idea of Henderson’s reaction, in which he was representative of his entire generation of economists, let me just quote this from the beginning of his 17-page critique, which he wrote and presented less than three months after The General Theory was published:
“Mr Keynes, by his latest book, has made it impossible for anyone who wishes to do serious work in the field of economics, or is concerned for the future of economics as a subject of study, and who disagrees with him as fundamentally as I do, to refrain from criticizing him.” (Henderson  1955: 161)