Why We Should Exit Ultra-Low Rates: A Guest Post by Raghuram Rajan


Raghuram Rajan, a University of Chicago economics professor and former chief economist of the IMF, has been popping up on the blog a lot lately -?answering our questions about his new book Fault Lines and weighing in on the financial reform bill. Now he’s back with a guest post, clarifying and expanding his views on the Federal Reserve’s ultra-low interest rate policy.

Why We Should Exit Ultra-Low Rates
By Raghuram Rajan

I usually don’t comment when an economist responds to what I am supposed to have said in press quotes because it leads to more confusion than clarity. However, Professor Paul Krugman has a large following, and he has criticized me repeatedly for my stance on Fed policy, especially my exhortation for the Fed to exit its policy of ultra-low interest rates sooner rather than later. I will try and address his latest concerns, which are in response to a Bloomberg article. But before I start, let me declare that I am as much for getting out of this recession as anyone else. However, I would like to get out of this recession in a way that is sustainable and does not merely pump up growth in the short-term only to see it collapse later. This is where Krugman and I differ the most.

Krugman (and many others) have in mind a Keynesian world where some distortion is keeping aggregate demand unnaturally low. The favorite Keynesian explanation is sticky wages. Because corporations cannot reduce wages to the level commensurate with the (now low) value added by additional labor, corporations will not hire. Hence the Keynesian answer to the problem of continued unemployment seems to be to give corporations an interest rate subsidy to offset the additional burden caused by excessively high wages. Hopefully, this will make investment profitable and induce corporations to invest and create jobs.

What is the appropriate level of this subsidy? Whatever it takes to bring jobs back, according to Krugman. We have had short-term interest rates at negative real levels for two years (which means anyone invested in money market funds gets less back than they put in). Whether this has had a sizeable beneficial effect on corporate investment and employment is anyone’s guess, but it certainly has not brought unemployment down, so Krugman wants more. Most people cannot see anything wrong with this, so let me try an analogy to make my point.

Since the problem is one of driving up demand, any subsidy applied to a general input should work. So following the Keynesian/Krugman model, why not subsidize energy – for example, cut oil, gas and coal prices substantially and keep them low “for an extended period”? Corporations will see their energy bills cut substantially and see profits rise, so they can employ more people. Unemployment will come down, and we will move out of recession. Eventually, we can withdraw the subsidy when the economy is healthier. The benefits are clear. We will get out of the recession and put many unfortunate people back to work. And the sooner we put people back to work, the less long-term damage is done to their employability. So why not do it now?

The sensible economist will, of course, have some objections.

Reason 1: The cost. Someone has to pay for the energy subsidy. If the government simply declares fuel prices to be half of what they currently are and enforces the lower price, fuel suppliers will shut down and refuse to sell anything. So the government has to pay the subsidy upfront to suppliers for them to supply at the mandated price. Even if the government absorbs the cost today, the taxpayer will have to fork out sometime. So the obvious and immediate cost will make taxpayers (and the government) think carefully about whether they want fuel subsidies.

Why cannot the same argument be made for the subsidy implicit in low rates? After all, there is a direct cost to maintaining ultra-low rates, and it is paid by anyone who has financial assets and is forgoing the normal return on them. Assume owners of financial assets hold 20 trillion dollars worth of assets (this is an underestimate), and are paid 2 percent lower real rates per year than they would otherwise obtain because of the Fed’s policy of maintaining zero nominal rates. This implies an annual stimulus of $400 billion in real money, off the backs of those who own financial assets. Given that it has been going on for two years, this is a subsidy that is now bigger than TARP (and coincidentally also goes largely to bankers, who are the biggest short term borrowers in the market). If the government raised taxes explicitly to provide the interest subsidy, everyone would carefully scrutinize the use this money was being put to.

“Because the Fed picks investors’ pockets silently and forcibly through its ability to set the short-term interest rate, no one asks questions about cost.”

Because the Fed picks investors’ pockets silently and forcibly through its ability to set the short-term interest rate, no one asks questions about cost.

Reason 2: The short-term distortions. A second reason not to subsidize fuel is that it will distort activity. Drivers who are environmentally conscious will be penalized while those with Hummers will be rewarded, with consequent damage to the environment. The biggest subsidies will go to those who are most irresponsible about their energy use. This will keep the economy from becoming more energy efficient and make it uncompetitive in the longer-run.

Again, similar arguments can be made about ultra-low interest rates. Ultra-low rates encourage people to borrow to acquire assets, and are partly responsible for both the over-building in housing and the over-indebtedness of households, as well as the over-leveraging of the financial sector. More generally, a subsidy to capital will imply greater capital intensity (and waste) of capital, greater short-term leverage and excessive growth of sectors that rely on either fixed asset investment or credit. Is this the appropriate way to go (especially if we want more labor-intensive sectors to grow to provide the jobs that are needed), and is it sustainable?

Reason 3: The long-term distortions. Suppose every time the population splurged on Hummers and caused energy prices to go through the roof, the government, seeing the damage to the economy, came through with its energy subsidy scheme. The government would justify its actions, saying it was not willing to see the economy crash simply to uphold a vague theoretical ivory tower principle like “moral hazard.” Such actions would reinforce the incentives for people to buy Hummers (provided they could see enough others doing so) and reduce the incentives for people to buy a Prius. In other words, the prospect of periodic subsidies could create the very actions that bring about the need for subsidies.

The analogy to the moral hazard that is engendered in financial markets should be clear: The asymmetric Fed policy of cutting rates sharply when the economy is in trouble and not raising them quickly when it recovers gives the financial sector fewer incentives to worry about credit or liquidity risk. The financial sector has come to rely on the Fed to bail it out through ultra-low interest rates whenever it gets into trouble, and the Fed has developed a reputation of obliging.

“Indeed, the Fed is now trapped because of the expectations it has set…”

Indeed, the Fed is now trapped because of the expectations it has set — because the market “expects” ultra-low rates, the Fed cannot even return to normal low rates without the market taking fright. And it is hard to find a Wall Street economist who is not urging the Fed to undertake stronger, unorthodox actions.

I don’t want to push the analogy too far. But you get the point – cutting rates is not without cost. But what about the benefits? Are they as large as the Keynesians state them to be?

The real problem is that corporations are not hiring quickly. But corporations did not hire quickly following the recession of 2001 (or that of 1990-91), and the sustained monetary stimulus that many economists supported then led, in no small part, to the housing boom and bust. It did not, however, lead to an explosion in corporate investment. Before saying the real problem is that we are not providing enough monetary stimulus, should we not worry about why corporations didn’t invest then and what other problems will emerge as we keep rates ultra-low while hoping corporations will see the light? I am not arguing that ultra-low interest rates will have no effect on investment, only that I am not convinced the effect (relative to merely low interest rates) is huge, and recent history bears me out.

I would rather that more emphasis be placed on improving skill levels in the unemployed work force and assisting the unemployed to both prepare and look for the jobs that are being created in the economy. This will take time, but will probably be more effective than praying that ultra-low rates bring back the jobs.

Before concluding, let me emphasize that even though I discussed the direct costs of ultra-low rates above, my greater concern is with the indirect costs. The way low interest rates work (apart from the direct cost of capital effect) is by raising asset prices and incentivizing investment in riskier assets. Even as corporations proved unwilling to invest last time, house prices rose, households could borrow more and lending became increasingly crazy. Of course, bond prices aside, there are not many hints of asset bubbles in industrial countries today. But by the time a central banker stares a bubble in its face, it is too late. After a few years of rising house prices between 2001 and 2004, every broker was peddling houses as a dream investment that could never fail. So what if the Fed was raising interest rates at a measured pace from 2004? By that time, house prices were clipping along at double digits every year, and the Fed rate increases made little difference. Of course, the Fed now disingenuously claims that the worst excesses in the housing market were committed when it had already started raising rates, and therefore it is not responsible for the housing boom. But it was complicit in setting off the boom by keeping interest rates too low for too long before then!

I have been making these points long enough that quotes should not be taken out of context. I am not advocating that the Fed raise rates to 2 percent overnight. That would be irresponsible. I am saying that as worries (largely about financial turmoil emanating from Europe) settle down and we return to expecting steady but slow growth, we should not wait for employment to come back substantially before we start the process of raising rates to a low normal. The Fed should, of course, give the markets a clear sense of the path to expect and perhaps indicate it will pause after reaching the “normal” low rate. If asked what a “normal” low rate is, I would say one candidate is zero real short-term rates. With inflation between 1.5 and 2 percent, that would mean a 1.5 percent to 2 percent nominal rate before the Fed pauses again.

Post script: Professor Krugman asks if I have a model or if I am making things up as I go. He clearly knows the vast literature in banking and finance that makes some of these points about the costs of low rates. But specifically, Douglas Diamond (the father of the modern study of banking) and I, as well as Emmanuel Farhi and Jean Tirole, have been writing models about the adverse consequences of sustained low Fed rates. Bill White, for whom I have great admiration due to his prescient warnings when he was at the Bank for International Settlements (BIS) during the bubble years, as well as his able colleague, Claudio Borio, have an enormous body of well-argued papers as well as empirical work warning about the effects of ultra-loose monetary policy. There are a number of papers now showing that low interest rates induce risk taking. And this is just the tip of the iceberg. Professor Krugman, there is a lot of work out there for anyone who cares to read it!

Michael F. Martin

Here here. I find it mystifying that the same mistakes made by the Fed after the dot com bubble can be repeated now without any seeming awareness.

It's not hard for even a non-specialist like me to spot what's going on. The Fed's keeping rates low is encouraging investors to buy more bonds and bond derivatives on leverage. Something like what happened at the household level -- i.e., the replacement of fixed with floating rate mortgages -- is now happening at the firm level through interest rate swaps.

The Fed needs to move rates up a notch just so that the market can figure out who has what exposure to rate increases now -- the use of derivatives makes it nearly impossible to figure out where the interest rate risk is concentrated.


Keynesians, pwned.


Could you work through for us your comparison using a subsidy for weatherizing houses and commercial buildings instead of the energy subsidy strawman you used?

A first glance it seems like that would have a more direct impact on creating jobs, producing a lasting effect, and supporting "good" behavior instead of "bad" (wasteful, excessive) energy use.

But your point is that any stimulus is same. Or have I misunderstood?

Joe in Jersey

Seems like common sense when some one lays it out like that. We are postponing the pain, maybe making it worse. Too big too fail is an absurdity.


Don't we need risk taking? The lender still seeks worthy risk (who gets a Hummer).


A couple of comments:

1) This feels like a strawman. Krugman argues against raising interest rates, and Rajan rails against fuel subsidies. I dislike Krugman as much as the next guy, but this post doesn't exactly count as a "direct hit" against him. Analogies can only take you so far. At some point you need to point out the flaws in the logical argument of your opponent as he stated it.

2) Isn't it odd that Keynesians blame unemployment on sticky wages, but many of them favor a minimum wage? How do they know that the market clearing wage doesn't fall below the minimum wage for some occupations during a recession? If wages need to adjust, why not let them?

Mark Brucker

I don't believe that at all accurately represents what Krugman is saying. I don't think he's said that there's a distortion or stickiness of wages keeping demand low. He said with virtually no inflation/possibly negative inflation interest rates would have to be significantly negative to help get out of the very low demand attributable to lack of private demand and insufficient government demand with state and local governments cutting drastically and lack of federal stimulus.

Robbie Laney

Great article. It just goes to show the failed principles of Keynesian economics. We need to end the Fed's manipulation of the market. Unfortunately, the government is so corrupt that measures to pass a bill to even audit the Fed have been met with a stone wall.


i think the essential critique by Krugman of your policy views is that they will unnecessarily prolong/worsen the unemployment rate- and so some of this debate about monetary policy is esoteric- we need government stimulus to create jobs, preferably in infrastructure/alt energy- this is how we got out of the great depression, and this is the 'model' which he claims you ignore- in fact, if you are for getting us out of the recession, why pick the straw man of energy subsidy, when you could just use the historic example of government jobs to stave off unemployment?


This is clear response to the ideology-driven writings of the former-Enron adviser. It makes plain sense, so of course Krugman is against it. The obvious point he refuses to acknowledge is that Fed manipulations, with interest rates as well as with the value of the currency, in fact steal from one group to pay off another. Good governments prevent theft; they do not perpetrate it.

Mike B

In a nutshell, I think your argument can be summarized in the following manner: there is no free lunch, not even for Keynesians! Giving money to person A that you take from person B results in no incremental net spending (let alone productivity) but distorts market-based decisions to misallocate resources.


Finally, someone speaking truth to arrogance.

Wonks Anonymous

The problem is not labor market failure, "sticky wages", the problem is capital market failure. Interest rates cannot go below zero no matter how much supply and demand want to force them below zero.

Yes I know that they all taught you that Keynesian economics depends on sticky wages. It is not right in this case.

In this situation the opportunity cost of borrowing to finance public projects is essentially zero. Resources are idle while consumers and banks strive to build up money balances. Their purchases of governemnt securities show that these are considered to be reasonable substitutes for cash.

Of course your straw man - energy extraction subsidies - is silly. It is a strawman. There are many other wothwhile public works projects that might be funded with cheap or free capital.

You guys should really stick to price theory or learn how to construct economic models that use more than two equations.



1. The cost ignores the cost of unemployment.
2. The distortion would be higher rates. Rates are nominally low for a reason, not just because the Fed decided on it.
3. Rates are not really low, they are high because they cannot be lowered any more. Encouraging more debt was a mistake, and would be a mistake if that was what it was doing, but it is not. Deleveraging continues unabated. The Fed must raise asset prices.
4. Bad exchange rate policy is a large part of this, but forcing a depression to cure that is no improvement.


Why does maintaining a 0 fed rate lower the real rate rate of return on investments? That seems to be an important assumption of your reason #1 that you don't explain. You just say "assume owners... are paid 2% lower real rates per year")

That doesn't seem obvious to me. Won't encouraging people to invest rather than hold cash by lowering the interest rate *increase* the real rate of return that owners of financial assets receive?


Having low rates, by itself, is not necessarily going to be helpful. To increase employment, you also have to have A) a business willing to borrow (and thus take on some risk) to fund startup or expansion and B) someone willing to loan money to that business person. If I owned a business and was watching the news report on the possible "double dip" we might be nearing/in, I wouldn't be all that fired up to add risk at this time. If I'm a bank with money to loan, I'm going to look at the news and think pretty hard before I loan money to anyone who actually needs it (who doesn't have existing assests to back the loan). So what we really need is an improved outlook, which no one can really manufacture. Catch-22.


Everyone is missing the point.
America needs Eisenhower tax and spend policies.
Tax at 1950 rates-people with money will be forced to invest rather than paying taxes.
Spend like the 1950s- rebuild the Highways, Rail Roads, help cities/counties rebuild infrastructure. Get America Ready for the 22nd Century before the Chinese or the Indians do it.
MAKE AMERICA COMPETITIVE FOR THE NEXT 100 YEARS while we solve the depression an the same time.


I have to agree with Krugman's analysis here, and I also second the notion that this is a HUGE strawman by Rajan. Fuel subsidies? How is that in any way related to debt financed in your own currency? Fuel and other energy sources are finite resources, possessed by a certain part of the world, and even though energy is used in almost all aspects of the economy, it most definitely would create a distortion toward energy-heavy industries, whereas interest rate changes are much more universal in their effects (e.g., a dotcom could borrow as much as an aluminum smelter might).

This is just so academically dishonest, and from a Professor at the University of Chicago! Admit when you're wrong, and please help find a solution to this problem instead of grasping at straws.

As an aside, I also second dcipes' solution. Seems to me that the bigger problem is income inequality, which leads to situations where the (former) middle class borrows up to debt capacity until it can do so no more, causing a large crash. The money that the rich and corporations have gathered chases after high-return safe investments (an oxymoron) before the crash, inflating asset bubbles, and then sits gathering dust in low-return safe investments (unlikely to be spent) after the crash.

Intuitively, it seems obvious that the middle class, employed in infrastructure projects or other government sponsored, but privately executed, project is more likely to spend their wages than the rich, creating a higher velocity of money in the economy and lead to full employment.


Drill-Baby-Drill Drill Team

Professors Rajan and Krugman BOTH agree we should Exit Low Rates, and we will do it sooner or later....the Question is WHEN.

TIMING IS EVERYTHING. Ask a comic or musician.


#7/Bruckman has the key point. This post actually IGNORES Krugman's lengthy and repeated arguments about the zero bound liquidity trap.

Rajan is refuting a point Krugman isn't making.

I say this even though I greatly appreciate Rajan pointing out something Krugman ignores: Low interest rates are effectively an extremely high tax on retirees and others with fixed incomes, transferring about $380 Billion a year from those that can least afford it, to Wall St. Banks.

Try to imagine Krugman's response if say Sarah Palin or John Boehner proposed a tax on retirees to subsidize Goldman Sachs. But that's what we've got today.