Economists rarely agree on anything. Ask 10 economists to explain why the Indian economy is functioning the way it is, and you will hear varied explanations ranging from tight monetary conditions and banking crisis to ineffective fiscal policy and global economic conditions. Economics has a long list of “major" schools of thought: classical, neoclassical, Keynesian, Neo-Keynesian, monetarist, new classical, Marxist, Austrian, behavioural and many others. Many of these schools disagree with each other, even on basic assumptions like “human decision making is rational" or “utility can be measured".

However, most schools seem to agree on one hypothesis: Interest rates are negatively correlated with economic growth. That is, higher interest rates lead to lower growth and lower interest rates lead to higher growth. This hypothesis is critical as it lies at the heart of modern monetary policy practised by central banks around the world. So, is it supported by empirical evidence? The latest research seems to suggest otherwise.

In a recent paper titled Reconsidering Monetary Policy: An Empirical Examination Of The Relationship Between Interest Rates And Nominal GDP (Gross Domestic Product) Growth, published in the journal Ecological Economics, authors Kang-Soek Lee and Richard Werner test the interest-rate-economic-growth hypothesis. They analyse the relationship between three-month and 10-year benchmark rates and nominal GDP growth from 1957-2008 in four of the five largest economies in the world: the US, UK, Japan and Germany.

The results of their study debunk one of the oldest and most popular hypotheses of monetary economics. They find that nominal interest rates are consistently positively correlated with growth. The correlation between GDP growth and the three-month interest rate was as high as 0.8 for Japan over the 50-year period. Also, the study finds that it is GDP growth which affects short-term and long-term interest rates in all four countries. That is, interest rates follow GDP growth, not the other way round. Shockingly, this is the first study to systematically examine the relationship between nominal interest rates and nominal GDP growth in several major economies.

Of course, some studies in the past have questioned the broader and commonly assumed relationship between interest rates and economic growth. For example, a 2002 paper in the Federal Reserve Bank of New York’s Economic Policy Review, titled The Monetary Transmission Mechanism: Some Answers And Further Questions, reported that the correlation between federal funds rate changes and subsequent quarters’ real GDP growth in the US from 1984-2000 was almost zero. The authors conceded that the finding lent plausibility to the notion that monetary policy had become less effective. Even if we look at bank lending rates instead of market rates, the relationship seems to be tenuous. Interestingly, the US department of commerce considers the prime lending rate as a “lagging" indicator.

So, what could explain the results and the divide among economists on such a critical issue? The answer lies in one of the fundamental concepts in economics: equilibrium. The concept of equilibrium became a prominent theme in economics after 1776, when Adam Smith presented the concept of the “invisible hand" in his book The Wealth Of Nations. The theory was formalized by Léon Walras and Alfred Marshall in the late 19th century. A Walrasian or competitive equilibrium is a static state of the world in which markets clear because supply equals demand.

When a market is in equilibrium, prices become the key variables since there are no quantity constraints. Price movements bring about equilibrium in the market and problems in achieving equilibrium are usually attributed to sources of price rigidity. This focus on prices is the reason why most of the research and policy discussions in modern monetary economics are centred on interest rates. The hypothesis that interest rates are always negatively correlated with economic growth only holds in such a general equilibrium set-up.

The problem with general equilibrium is that it takes several unrealistic assumptions to show that a market can achieve and remain in equilibrium. In 1890, Marshall himself said, “The position of normal equilibrium at any time is rather to be regarded as one towards which the forces of demand and supply at the time are tending, than as one that is ever actually attained." Thus, in reality, markets are constantly in a state of disequilibrium. When markets are in disequilibrium, non-price factors like the quantity of money and credit become important. The short side principle suggests that in a supply-constrained market (like India), suppliers of credit have market power and get to decide whom to transact with. Since such markets are in disequilibrium, lower interest rates need not always lead to higher economic growth.

While the results of this new study will be heavily contested in the academic world, they would not come as a surprise to many market participants in Japan, where interest rates have been falling for more than two decades without a significant impact on growth. Even in India, benchmark interest rates have fallen by around 200 basis points in the last three years, while economic growth has slowed down. Many commentators have blamed high interest rates for muted economic growth. The latest research definitely warrants a closer look at that line of thinking.

Rohan Chinchwadkar is an assistant professor of finance at the Indian Institute of Management, Tiruchirappalli.

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