Setting up the next Keynesian bubble and bust?

Keynesian demand management endures with the regular adjustment of short-term interest rates and the lowering of long-term interest rates, once short-term interest rates have been driven to their ‘lower bound’. That a call for negative real interest rates should be supported by an economist who finds salvation in bubbles can be no surprise. A proposal from Larry Summers and supported by Paul Krugman is the antithesis of economics. Interest rates serve as all other prices: they allocate scarce resources.

The manipulation of interest rates to steer economic growth has microeconomic consequences, some of which are more widely acknowledged than others: the redistribution of income from savers to borrowers and the increased capitalised value of pension fund liabilities are widely acknowledged. More subtle and less-well documented is the impact of inter-temporal price changes upon business decisions.

Even in the deepest recession, market mechanisms remain relevant because resources have value, even though they may not be in current use. Prices that are shaped by expenditure patterns incentivised by macroeconomic interventions incite microeconomic adjustments that serve the unsustainable. Even as a recession is lifted, a chain of adjustments continues which adds to the legacy of inter-temporal price distortions.

The world is wise to credit ‘bubbles’ once they have burst; and when a bubble bursts, attention may turn to a business cycle theory founded upon the dynamics of a money economy. Austrian Business Cycle Theory identifies excessive credit as a root cause of a cyclical boom-and-bust; and it focuses upon the detail by which an over-extension of credit generates an inherently unsustainable boom.

Credit is a normal arrangement. Many items are produced and delivered in advance of payment. Even with bespoke items, trade credit is likely to be involved. The one-on-one relationship of trade credit not only sets a unique interest rate (with minimal bearing upon interest rates generally); it also limits the impact of any local default. This is not so when either newly issued sovereign currency and/or commercial bank-credit money are the relevant instruments. Where a ‘surge’ in either (or both) is sustained in providing a stimulus to business activity, ‘bubbles’ are likely to arise.

Interest rates reflect inter-temporal trading agreements in the same manner as commodity spot prices reflect inter-spatial trading agreements. That interest rate variations are one and the same as variations in inter-temporal price relativities affords insight into the directional impact of monetary excesses. Hypothetically, (say) a 5-point interest rate reduction would be instantaneously offset by a simultaneous commensurate change in inter-temporal price relativities (spot/forward prices rising/falling). This hypothetical inter-temporal adjustment of prices has an inter-spatial parallel with any currency realignment, where (say) a 5-point currency devaluation would be instantaneously offset by a simultaneous commensurate change in inter-spatial price relativities (domestic/foreign prices rising/falling). Both inter-temporally and inter-spatially, money would then be neutral, leaving real transactions unaffected.

With simultaneous and commensurate price adjustments, the real economy is unaffected by interest rate (temporal) and/or exchange rate (spatial) movements, but the practical issue is the proximity of compensatory adjustments to actual adjustments. As a general feature, a network of inter-spatial/inter-temporal price distortions is likely whenever a monetary authority attempts to over-ride interest rates and/or currency exchange rates that would otherwise take their values from the spontaneous interplay of market trading. Given that price-adjustments lag and that some lags are longer than others, the manipulation of interest rates is a credible source of credit-led booms and busts.