Do persistent low interest rates stifle growth?


Mitsuo Shiota


May 3, 2022

Prof Keiichiro Kobayashi of Keio University referred to an article in his “Lecture on Economics” in Nikkei news paper on May 2, 2022 (Japanese).

He writes, “a group, including Prof Nobuhiro Kiyotaki of Princeton University, Prof John Moore of London School of Economics, theoretically proved that persistent low interest policy stifles growth, if borrowers can’t get finance based on their future cash flows, in their 2021 article.”

I found the referred article is “Credit Horizons”, read it briefly, and watched “2020 Princeton Initiative: Nobuhiro Kiyotaki on credit horizons” on YouTube.

The authors propose a model, assuming a small open economy whose interest rate equals to exogenously determined world interest rate. They also assume that investment is either plant or building, that plant in building is the only productive asset, and that engineers/entrepreneurs and savers make a very peculiar arrangement, in which plant investment decreases and building investment increases, as interest rate decreases. (For the details of the arrangement, please read the article.) They try to provide a perspective to “the credit and asset booms in Japan in the late 1980s and in southern Europe in the early 2000s” and their aftermath, and state “a persistently lower real interest rate leads to an initial credit and asset boom, but stagnation in the long run” in Chapter 7 “Final Speculative Remark.”

I think the authors propose a framework, and speculate that persistent low interest rates might stifle growth. I don’t think they prove so theoretically.

I also think empirically, if you want to examine Japan in the late 1980s and later, southern Europe in the early 2000s and later, your model should incorporate real exchange rate, which is not in the authors’ model.

In Japan in the late 1980s, trade frictions with the US prompted change from export-oriented to domestic-demand-oriented growth. At the same time, restrictions on capital flow were being abolished, and the Cold War was ending. These factors led to less trade surplus, higher yen, lower interest rate, and eventually credit and asset boom and bust. As the export market shrank, plant investment stagnated.

In southern Europe in the early 2000s, joining Euro prompted capital inflow and lower interest rate, and credit and asset boom. However, productivity growth was lower and inflation was higher than in Germany, so real exchange rate appreciated, and plant investment stagnated. It led to bigger deficits in current account balance and in target 2 balance, which is equivalent to foreign reserves in the fixed exchange rate regime, and eventually debt crisis.

In both cases, increased capital inflow (or less capital outflow in Japan case) caused lower real interest rates and higher real exchange rates. The reason why plant investment was sluggish was not a peculiar arrangement the authors assumes, but an appreciated real exchange rate.

Now the real exchange rate of the yen depreciated to the level before late 1980s, but plant investment is still sluggish. We may need to add inertia of manufacturing sector and demography to the model.