In 1937 the English economist Joan Robinson proposed that “when capitalism is rightly understood, the rate of interest will be set at zero and the major evils of capitalism will disappear”. John Maynard Keynes, who had taught Robinson, suggested something similar a year earlier in slightly more qualified and technical terms, arguing that this would be “the most sensible way of gradually getting rid of many of the objectionable features of capitalism”.
Robinson and Keynes were writing during the great depression, when spending and investment were moribund and interest rates seemed like a stranglehold on the economy. Unlike the sort of temporary measure we saw from 2009-21 when rates were close to zero, they believed interest rates should be set at zero permanently as a way to purge capitalism of its most objectionable and destabilising features.
This was a time when the Soviet Union was challenging the western model of prosperity. Indeed, Robinson’s argument was in response to a Marxist, proposing it would lead to “even better results than the revolutionist theory”.
With interest rates rising steeply in the past couple of years and capitalism deeply unpopular among younger generations, it is worth returning to this idea. So what was the logic and how would it work?
The rationale
Inflation is sustained by consumers, businesses and governments spending in excess of the supply of goods and services. Central banks raise interest rates to reduce demand by discouraging borrowing and spending. This aims to restore equilibrium between supply and demand, and reduces inflationary pressure.
A major problem – setting aside the question of how well it works – is that this distributes the cost of curbing inflation very unevenly. A recent report by the Royal Bank of Canada said higher interest rates disproportionately hurt poorer and younger people, such as renters and first-time homebuyers. Anyone borrowing out of financial distress is likely to be in trouble with rising rates.
There are additional objections to positive interest rates. One relates to depleting resources.
Suppose I own a forest that regenerates at 2% per year and is worth £1 million in timber overall. I could log the forest sustainably, cutting down trees only in line with the speed of regeneration, which would earn me £20,000 a year.
But with interest rates at 5.25%, I would do better to cut down everything, invest my £1 million into bonds, and earn upwards of £52,500 in annual interest (I say upwards because the rate of interest on bonds is usually a little way above the central bank base rate).
If the interest rate were zero, it would reduce my incentive to log the entire forest today. It’s true I could still cut it all down and earn a passive income in other ways, such as holding shares that pay good dividends. But that would involve slightly more risk, since dividends are not guaranteed, and the underlying shares might lose value.
In general, to quote a recent op-ed, central banks raising interest rates make it harder to fight the climate crisis. A permanent zero rate might also discourage wealthy people from parking their money in bonds to earn a passive guaranteed income rather than taking entrepreneurial risks.
The fiscal alternative
If the interest rate were permanently zero, the government’s fiscal levers of taxation and spending would be the alternative means of controlling inflation. The economist John Kenneth Galbraith made the point that using progressive taxes rather than interest rates to control spending would put the greatest costs of maintaining stable prices on those best placed to weather them.
Targeted consumption taxes, for instance on luxury goods or products with an needlessly high carbon footprint, could be used to ensure that the most socially undesirable forms of spending are the first to be reduced during inflation. Likewise, socially desirable forms of spending such as essential infrastructure would be the first to increase during recessions.
Such a system would require several other changes. There would always be a danger that the government would manipulate tax and spending to try and win an election rather than focusing on inflation. This was the main reason independent central banks were given control over interest rates in the first place.
We could prevent that by restricting the inflation-controlling levers to just a few types of tax and spending. We could then give an independent body oversight of these levers to make sure they were not exploited for electoral purposes.
At the same time, there is a risk that permanent zero rates might encourage commercial banks to lend more irresponsibly. There wasn’t a lot of evidence of this in the UK when rates were close to zero in the 2010s. But we did see other economically hazardous activities such as companies borrowing cheaply to buy back their shares to drive up their prices. New regulatory frameworks could be introduced to prevent these kinds of activities.
Giving up control of the interest rate needn’t remove all central-bank control over lending. The “open secret of central banks” is that they also control lending through a list of types of loans that they are willing to take as collateral in exchange for providing banks with reserves (in practice these transactions are often indefinitely renewable, so they’re more like purchases).
Banks are strongly motivated to lend to customers according to this framework, since it gives them access to liquidity at low cost. Central banks claim to maintain “neutrality” on the types of loans on these lists, though others would disagree. The Bank of England includes mortgages but not construction loans, for instance, encouraging banks to lend more for buying houses than building them. Instead, central banks could openly use these frameworks to guide banks into making low-risk loans for socially and environmentally responsible ventures.
The future of central banks
Also worth mentioning is the current push by the Bank of England towards central bank digital currencies (CBDCs), in which buyers and sellers would transfer money directly without having to use the banking system. This could enable central banks to encourage or discourage certain spending in more targeted ways, for example by restricting what can be spent by people in certain areas or income brackets. If inflation was controlled using only fiscal levers, CBDCs could be used to reinforce this policy.
The idea of permanent zero rates is far outside the mainstream of economic thinking. But perhaps Robinson was right to suggest it as a viable compromise between capitalism and more radical alternatives: rewarding entrepreneurship without compounding inequality or incentivising the unsustainable use of resources. At a time like this, it’s an old idea well worth considering.