Posted by: Dirk | January 26, 2011

Are low interest rates subsidies to banks?

Paul Krugman responds to Axel Leijonhufvud, saying basically “not really”.
Since I taught it yesterday morning, the IS/LM model’s money market came to my mind when I read the articles. In the IS/LM model, savings can be kept as money or bonds. Bonds carry a moderate interest rate, so that if the interest rate of the central bank is identical to the bond rate there is not much difference (except for maturity, which is not featured in the IS/LM model – nevertheless it is important). In a situation of a very low interest rate, how will savings be split up between money and bonds?

In the model, bond prices are sky-high since they carry relatively high nominal yields. Since bond prices would come down as the interest of the central bank moves up, savings are held in cash. It is the expectations that interest rates will rise in the future and lead to a fall in bond prices that stops people from buying bonds. If interest rates are really, really low, even an increase in the money supply might be absorbed into holdings of cash.

We can see that in reality banks invest their money into bonds even at very low interest rates and bonds being expensive. Apparently, a positive spread is a positive spread, never mind the consequences. However. Axel had pointed this out in his article on VoxEU already, writing:

Quite apart from its distributional effects, the policy is not without risk.

* To the extent that it succeeds in inducing the banks to load up on long-term, low-yield assets, a return to more normal rates will spell another round of banking troubles.

So, I agree with Axel. Low interest rates are a subsidy now. I also agree with Paul (and, again, Axel) – there is a potential downside tomorrow. The behavior of most big banks in the last years has shown, however, that nobody there cares about tomorrow. Let me quote Chuck Prince of Citi: “As long as the music is playing, you’ve got to get up and dance.” (2007). Until you drop, I would add.

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Responses

  1. […] the transfer of wealth from savers to banks via market interest rates that are below natural rates a shell game. While savers collect meagre interest rates from their banks, these get a free lunch by investing […]

  2. […] of the LM side’s financial implications in an economy that hits the zero lower bound, be my guest. LD_AddCustomAttr("AdOpt", "1"); LD_AddCustomAttr("Origin", "other"); […]


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