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The financial crisis: The new economy approach on the paradox of low interests rates

Keynesian economic theory suggests that a reduction in interest rates operates as a stimulant, if the economy is under-performing. The U.S to combat the financial crisis of 2007, both at a domestic and international level, adopted such an extensive policy. However, a lower interest rates policy generates a capital flight and decreases the demand of investors, especially foreign ones, in yields for assets denominated in U.S. dollars. Albeit, this does not apply in the case of the U.S. economy, as this macroeconomic policy of reduction in interest rates was accompanied with a high demand in U.S. Treasury bonds.

Currently, $5.3 trillion or approximately 48% of the U.S. national debt is owned by foreign investors, mainly China who is the largest owner holding $1.15 trillion of Treasury bonds. Why is it that despite interest rates are as low as 0%and no immediate profits are generated, foreign investors’ demand instead of decreasing is increasing? Is this correlated with the “strength” of the U.S. dollar, which is still considered the only reliable and stable currency in terms of reserve foreign exchange rate? Alas, foreign investors, such as China, accumulate U.S. dollar assets to stabilize exchange rates and hold down the value of their currencies against the dollar. Or is the new economy view correct, and a higher notion of the American exceptionalism and the expectation that the U.S. as the leading hegemonic power, will in the long run overcome this crisis, and the economy’s comeback will be more powerful than ever?

This paper will focus on the impact of the reduction of interest rates in an attempt to boost the U.S. economy, in regards to the reasons behind the increase in inward capital by foreign investors and its controversiality in the maintenance of global economic balances. The first section of the paper, after providing a brief analysis on whether low interest rates have indeed stimulated the economy, will explore the main puzzle of why is it that foreign investors, mainly China, keep investing in the U.S. economy. The second section will review existing view, such as the new economy approach, which in this case will be in support of my argument. Finally, in the third section, using a Marxist approach, I am going to show what the impact of low interest rates has been on the average U.S. tax-payer, in regards of the new economy view.