Posted by: Dirk | April 5, 2013

Why is Kenneth Rogoff puzzled by low interest rates?

In an article published at Project Syndicate, Harvard professor Kenneth Rogoff writes about the long mystery of low interest rates. Here is the main issue:

A lot has changed since 2005. We had the financial crisis, and some of the factors cited by Bernanke have substantially reversed. For example, Asian investment is booming again, led by China. And yet global interest rates are even lower now than they were then. Why?

[…] One view holds that long-term growth risks have been on the rise, raising the premium on assets that are perceived to be relatively safe, and raising precautionary saving in general. (Of course, no one should think that any government bonds are completely safe, particularly from inflation and financial repression.)

There are more explanations, but I cannot take them serious so I will comment on this one. The idea of interest rates that Rogoff has is based on the loanable funds theory: the amount of saving depends positively on the interest rate, and the amount of investment depends negatively on the interest rate. Hence, the interest rate is established on the capital market. This theory was state of the art until about 1936.

John Maynard Keynes in his General Theory rejected this idea. Since I cannot find better words than his here is a quote from chapter 7:

The notion that the creation of credit by the banking system allows investment to take place to which “no genuine saving” corresponds can only be the result of isolating one of the consequences of the increased bank-credit to the exclusion of the others. If the grant of a bank credit to an entrepreneur additional to the credits already existing allows him to make an addition to current investment which would not have occurred otherwise, incomes will necessarily be increased and at a rate which will normally exceed the rate of increased investment. Moreover, except in conditions of full employment, there will be an increase of real income as well as of money-income. The public will exercise “a free choice” as to the proportion in which they divide their increase of income between saving and spending; and it is impossible that the intention of the entrepreneur who has borrowed in order to increase investment can become effective (except in substitution for investment by other entrepreneurs which would have occurred otherwise) at a faster rate than the public decide to increase their savings. Moreover, the savings which result from this decision are just as genuine as any other savings. No one can be compelled to own the additional money corresponding to the new bank-credit, unless he deliberately prefers to hold more money rather than some other form of wealth. Yet employment, incomes and prices cannot help moving in such a way that in the new situation someone does choose to hold the additional money.

So, investment does not depend on savings and therefore the interest rate must be determined by something else. Let us see what the European Central Bank thinks about the determination of the interest rate, they should know something about it – and they do:

What does monetary policy do?

Monetary policy operates by steering short-term interest rates, thereby influencing economic developments, in order to maintain price stability for the euro area over the medium term.

Right. This explains the short-term interest rate. Now let us look at the daily treasury yield curves of before the crisis and now:

Date 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr
01/03/06 4.05 4.16 4.40 4.38 4.34 4.30 4.30 4.32 4.37 4.62 N/A
Date 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr
04/01/13 0.06 0.08 0.11 0.14 0.23 0.36 0.76 1.23 1.86 2.70 3.08

Clearly, this picture is no surprise. The short run interest rates closely mirror the Fed Funds rate, which was pretty much 4% in January 2006 and pretty much 0% in April 2013. The Fed can decide where to put it. If capital inflows of China drive the US government bond prices up, the Fed has the power to neutralize this – if it wants to. I did not, so bond prices went up and interest rates (yields) down. Since banks can refinance by using government bonds as collateral, their yield and the short-term interest rate cannot diverge because of arbitrage. If the short term interest rate of the Fed is 2% but the yield on short-term government bonds is 4% banks will find it profitable to engage in arbitrage, borrowing from the Fed and buying government bonds. This would drive their price up until the yields are (almost) equalized. So, this is why the bond yields and the Federal Funds rate cannot diverge by too much. Have a look at the Fed Funds rate:


Then, as maturities widen, interest rates are on the rise since investors do not want to lock in the interest rate forever. They demand a premium when they lend longer. So, I ask, where is the long mystery of low interest rates? They are low because they are set by the central bank, and this is because central banks engage in monetary policy. Since we are in a recession in the euro zone and far away from full employment in the US, central banks have lowered interest rates in the hope that investment will pick up.

This puzzle only persists if you believe that the loanable funds theory is correct. If, however, you believe that banks create money endogenously to finance investment, which generates more incomes and subsequently, higher savings, and that this process is influenced by a central bank which sets the short-term interest rate, I can see no puzzle.



  1. That explains HOW he gets confused. The Why answer is more likely to be that he staked his reputation recently on a book which says when public debt is high, interest rates will soar. No one likes admitting they were wrong.

  2. […] the way: I have attacked Rogoff’s “interest rate puzzle” earlier this months in this post. He did not strike me as a knowledgable economist. Apparently, he did not read a single line of […]

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