Is the Engine of the Economy Flooded?


When one hears talk about the Wicksellian natural rate of interest, one hears that a real rate below the natural rate will cause inflation and economic heating. Then a a real rate above the natural rate will lead to disinflation and economic cooling.

“Wicksellian analysis is an older tradition; it argues that there is at any given time a “natural” rate of interest in the sense that keeping rates below that level leads to inflation, keeping them above it leads to deflation.” Paul Krugman, July 7, 2014

So the logic looks simple, if we lower rates to below their natural level, the economy will heat up. That is like pushing down on the accelerator to speed up a car. OK… But does pushing down on the accelerator always speed up a car’s engine?… No

Case in point, Flooding a Car’s Engine.

“A flooded engine is an internal combustion engine that has been fed an excessively rich air-fuel mixture that cannot be ignited. This is caused by the mixture exceeding the upper explosive limit for the particular fuel. An engine in this condition will not start until the excessively rich mixture has been cleared. It is also possible for an engine to stall from a running state due to this condition.” (Link)

When an engine is flooded, pushing more and more on the accelerator does no good.

Low interest rates are an excessively rich air-fuel mixture. The Federal Reserve and most central banks around the world are trying their hardest to fuel their economies with ever lower interest rates. But the economies are not heating up. So real rates must obviously be above the Wicksellian natural rate, right?

But what if economies are “flooded” with a multitude of subsidies, while wages stagnate? Businesses receive benefits from sources other than consumption by labor income, namely low interest rate costs, lower taxes and direct subsidies. I am implying that real rates can be below the Wicksellian natural real rate, and the economic environment will not ignite while labor income is so weak. So even with the rich fuel of extremely low interest rates, the economy does not respond.

What would be the solution? Clear the excessively rich mixture by withholding the fuel for a sufficient period of time. Basically, take your foot off of the accelerator and wait for the engine to drain off the excess fuel. The Fed rate would have to rise a bit for some time. Then firms that can afford higher interest rate costs and higher wages will get stronger. The weaker firms will weed out. Then the Fed rate could be lowered but this time the economy would respond. The process is similar to waiting 20 minutes when your engine is flooded. Make the market work out its weaknesses.

It would help to also raise the “effective” taxes on high incomes and corporations. And to give more power to labor for getting higher wages.

Sensing Social Benefits

Most of us can sense that something is not right. Social benefits are not being maximized. We know that lower wages are dragging down the economy, even though lower wages should be good for business. We sense that higher wages would increase overall social benefits to society. But can we sense that higher interest rates would increase social benefits, even though low interest rates are supposed to be good for business expansion?

Low interest rates in the face of falling labor share of income is pointless. You end up flooding the production side expecting the demand side to rise. But when you flood the production side too much, while the demand side, labor income and fiscal policy, is obviously getting weaker, you end up with reduced social benefits for society overall.

The economy may be like a flooded engine.