There is discourse in the econoblogosphere currently about why interest rates are low and may stay low for a long time. Larry Summers says that we may even have a negative natural real rate at full employment, even though Ben Bernanke sees that as somewhat impossible.
It is fairly common knowledge that excess debt and leveraging built up before the crisis. That is economic inefficiency. So we now have a situation where debt is actually growing again internationally. China has accumulated economic inefficiencies in its surge of investment. The effect is to subdue borrowing for global investment which leads to lower interest rates internationally.
So how do we cure the past economic inefficiencies that seem to still be with us? Do we keep interest rates low so that firms and people with debt on the margin won’t go bankrupt? Or do we raise interest rates to start cleaning them out?
If we keep interest rates low, marginal debt will continue and the global economy will LIMP along for who knows how long. And would the economic inefficiencies indirectly fade away through renewed growth as we approach full employment? Maybe, maybe not. Mark Thoma has said, and I agree, that wages will not rise due to globalization, technology and slack/weakness in the labor’s power to ask for higher wages… even at full employment. Thus, inflation would stay low even at full employment. As well, aggregate demand will stay low from weak wage growth.
If we raise interest rates in the US, the economy will slow down some as Janet Yellen has said. A rise in interest rates will hinder firms and people on the margin. Some of them may even go bankrupt. Also, the dollar will rise stressing marginal foreign firms that have borrowed in US dollars. Economic inefficiencies will be directly forced out through higher interest rates.
There exist economic inefficiencies that weaken the global economy. We can get rid of them in an indirect way that may not work even at US full employment or a direct way with some discomfort.