Within an economy, there are different industries. and each industry would require a different central bank interest rate to function best. But there cannot be a different interest rate from a central bank for each and every industry.
What happened when Sweden raised its interest rate?
We hear that Sweden raised its interest rate a few years ago and their economy went into a recession. But here is Adair Turner from an interview with INET. (link) Listen to between 23:45 minutes and 26 minutes. In this space of time, he says…
“Essentially, the economy is not efficient and rational enough that we can assume that all sectors have the same concept of what the rate of return is… and therefore respond in an equal way to a rate of interest increase. We’ve seen this actually within the last few years in Sweden. 3 years ago back in 2011-2012 the Swedish central bank, Riksbank, was worried about a credit-asset price bubble getting going in Stockholm property in particular. It decided against the trend of central banks to raise its interest rate. It raised… didn’t make a blind set of difference to the credit and asset price cycle in Stockholm, but what it did do was drive the Swedish economy into a recession.”
The implication of his words is that interest rates are set low enough that even the most marginal of industries will get a break. Thus interest rates have fallen to the level of the least healthy industries, while some industries benefit greatly from low interest rates.
So these questions then arise… Does any industry struggle with low interest rates? What industry might require a zero % interest cost? And are these industries then socially optimal?
Limits on Development
Even for those industries, like high-end housing, that might laugh at low interest rates because they could still do well with much higher interest rates, there are still limits to their investment, such as demand. They can only develop their investments within the limits of the demand in the market. So interest rate costs become a non-issue. They have all the money they would need to develop their investments. So interest rates are not a limiting factor.
What about the industries where a rise in interest rates would be a limiting factor? These industries are marginally profitable. They hold back other costs too such as wages. In the end, these businesses hold back social benefits, like wage increases, by not being profitable in a socially beneficial sense. They can also drag down the Wicksellian natural real rate which further justifies low interest rates.
Giving out Grades
Take a generation of doctors going through school. Let us say that the standards for passing the examinations are lowered so that even the students who barely passed their classes have an easier time getting their medical licenses and eventually a job. The best students will still get good jobs and perform good medicine. But there will be a larger percentage of doctors that are not so good. They will make more mistakes. The growing numbers of these doctors lowers the social benefits of the medical industry.
Yet, there are reasons to lower the standards of the examinations. Those students have to pay back their student loans. The creditors expect those students to pay back the loans. The students need to pass the licensing exams. The country may need more employment. Schools need to show success rates for their students and so on.
Sweden’s Recession in Context
It is becoming generally accepted that interest rates will stay low and maybe near the zero-lower bound for a long time. The economy does not want to risk a recession. Many point to Sweden as proof that raising interest rates would cause a recession. But the truth of Sweden reveals that many marginal socially-beneficial businesses would be at risk. And remember, the recession in Sweden was not any greater than elsewhere in Europe. (This graph is from Paul Krugman’s post on Denmark.)
Whereas Sweden raised its Riksbank interest rate from 1% to 2%, Denmark only raised it from 0.7% to a little over 1% for a shorter period of time. It looks like Denmark had more adverse effects, and that Sweden grew better afterwards.
Europe as a whole did much worse over the same period of time. The European central bank raised its benchmark rate during 2011 from 1% to 1.5%. (link to data for graph at trading economics)
Sweden looks to be doing better than most. So why is the Swedish rise in their interest rate such a scary thing?
My view is that a moderated rise in the Fed rate would clean out some marginal sectors of the economy. There would be some businesses that fall out. But then afterward the Fed rate could come down and growth would be better. Sweden raised their rate more than others for a longer period of time, and lo and behold, they bounced back better.
Just like I would think based on viewing the global economy as a flooded engine. Sweden shows me the value of raising the interest rate for a period of time and then lowering it in order to un-flood the engine.