In theory, interest rates are one of the jewels of capitalist economies. The theory has been well tested over the past half-century, and it has failed. Interest rates have become a mark of shame. The recent increase in yields on government bonds in much of the world – by a quarter, from 1.65 percent to 2.1 percent since the beginning of May for 10-year U.S. government bonds – is only the latest chapter in a long and depressing story.
The theory starts well, with a plausible behavioural generalisation. A lower interest rate encourages less saving and more consumption today, while a higher rate encourages saving now and boosts consumption in the future. But the theoreticians are not content with that; they want mathematical precision. They get it by adding some extraordinarily unlikely assumptions about knowledge, uncertainty, defaults, growth, and inflation.
The result is almost magical: a single “natural” interest rate which serves as a sort of economic fulcrum. At this ideal rate, saving and consumption are supposed to be balanced correctly, and the financial system is perfectly aligned with the real economy of making and selling.
It turns out, though, that actual interest rates, those agreed between borrowers and lenders, are often quite different from the natural rate. No problem for the theory. This ideal-real gap can and should be closed by wise and powerful monetary authorities, otherwise known as central bankers.
Of course, these high priests of finance must first uncover this hidden natural interest rate. The theory provides a technique. The result is encapsulated in the dual mandate of the U.S. Federal Reserve. The natural rate has been reached when the levels of unemployment and inflation are both low – the first rises if the rate is too high, and the second if it is too low.
