An interesting public debate has started between two economists, Paul Krugman and Raghuram Rajan. The debate being that Krugman wants the interest rates to be kept low whereas Rajan wants them to be raised gradually.
Both Krugman and Rajan are economists of international repute. Rajan was the former chief economist of the Internal Monetary Fund and is currently a professor of economics at the University of Chicago. A native of Bhopal, India, Rajan has a doctorate in economics Massachusetts Institute of Technology and has authored the book Saving Capitalism from the Capitalists.
Krugman is a Nobel Laureate (2008) and currently a professor of economics at Princeton University. An op-ed columnist and a blogger for the New York Times and the author of numerous books, Kurgman’s biggest contribution is making geography relevant to economics again, and explaining the topic without any jargon so that the layperson could follow the economic debate.
So why is that two very brilliant economists have such divergent views about interest rates? There are numerous explanations for this academic fissure in opinions. Rajan belongs to the Chicago school of economics, which has favoured lower taxes and less regulation of the private sector. It also supports efficient market hypothesis, which posits that the financial markets have all the information they need to make decisions. Until the 2008 recession, this hypothesis was considered as real as the law of gravity. However, the recent recession has put some serious dents in this hypothesis.
Krugman is a Keynesian and believes that private sector may not have the perfect information all the time and it may lead to inefficient macroeconomic outcomes. The recent recession, which was brought about primarily by greed where unsecured housing loans were morphed into complex financial derivatives that were sold the world over, suggests that those who bought these products and those who declared these derivatives to be investment grade had no clue of the risks they were taking.
Keynesians argue for more involved government oversight and they also favour lower interest rates in times of recession to encourage businesses to borrow funds at cheaper prices to grow their businesses and create jobs.
Despite their divergent academic roots, their difference in opinion is not merely academic, but cultural as well. Rajan is rooted strictly in the scholastic culture in which an academic usually resides in an isolated intellectual universe and is seldom voted out of the job for offering the wrong advice. Therefore, Rajan advocates raising interest rates without waiting first for the unemployment to decline.
Krugman, on the other hand, is not just an economist, but also a popular columnist and an avid blogger. He is also a political animal and realises that in a very interdependent society, interest rates would impact unemployment, which would eventually determine the electoral outcomes. He knows well that in the past an increase in the interest rates followed an increase in unemployment rates in the United States. Raising interest rates now, when the unemployment is already in double digits in the United States, would have the same lagged effect a couple of years down the road.
I also believe that raising interest rates, even gradually, is likely to force scores more out of work in the next couple of years, which could eventually lead to the President of the United States (elections due in November 2012) and other Democratic legislators losing their jobs in the forthcoming elections.
An increase in unemployment would hurt the Democrats more than the Republicans. First, the incumbents always pay for any political or economic failure. Thus the Democratic President faces greater political risk in November 2012. Secondly, the geography of unemployment is rather uneven in the United States. The states that are mainly Democrat, such as New York, California, and Michigan, are experiencing above-average unemployment. Voters in these States who are sitting on the fence and who may have voted for Democrats in the past could vote for Republican the next time around should the economy fails to improve.
At the same time, the states that overwhelmingly vote Republican irrespective of the state of economy, such as Idaho and North Dakota, have lower than average unemployment rate that is unlikely to benefit Democrats.
So exactly who benefits by higher interest rates? My answer is Republicans, which is why it would be in the best interest of President Obama and his team of economic advisors to follow Krugman's policy of keeping interest rates low so that those Americans who currently have a job, can continue having one in the coming email@example.com.
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