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EVERY economics student learns that higher interest rates depress growth by curbing borrowing and spending. That, according to the conventional wisdom, is why the Bank of Japan (BoJ) must continue to hold interest rates at historically low levels; a rise in rates would risk tipping the economy back into recession and deflation. Yet a few brave economists believe, to the contrary, that higher interest rates would actually encourage households to spend more, not less.

After holding interest rates at zero for most of the previous seven years, the BoJ has raised rates twice since last July, to 0.5%. But inflation has turned negative again, with the core measure of consumer prices (excluding food, including energy) falling by 0.3% in the 12 months to March. Last week, in its half-yearly outlook, the BoJ slashed its inflation forecast to only 0.1% in the year to March 2008. Moreover, although GDP expanded by a respectable 2.3% in the year to the fourth quarter, most of that growth came from investment and exports. Japan's economy cannot be removed from the sick list until consumers start spending again.

By most measures monetary policy is still incredibly loose: the rise in short-term rates over the past year has been partly offset by a drop in bond yields; and the yen's real trade-weighted value is at its lowest for at least 30 years. Nevertheless, most economists reckon that the BoJ should not even think about raising interest rates again until inflation picks up and consumer spending revives. Even by the end of next year, the market expects short-term rates to be only 1-1.25%.

The problem is that ultra-low interest rates risk creating economic distortions, such as the excessively weak yen, asset-price bubbles, or inefficient investment. Worse, low interest rates may themselves be discouraging consumers from opening up their wallets. Debtors gain from low interest rates but savers lose, and Japanese households have the biggest stash of savings (relative to their income) among developed economies. Their net financial assets, excluding equities, amount to 3.2 times personal disposable income, compared with a ratio of only 1.9 in America and 1.1 in Germany (see left-hand chart). Over half of Japanese households' gross financial assets are in deposits that earn adjustable rates of interest (in America the figure is just over one-tenth), but only one-quarter of their liabilities are at floating interest rates.

Brian Reading of Lombard Street Research estimates that Japanese households' net financial assets with adjustable interest rates are equivalent to more than twice disposable income. But in recent years, savers have earned peanuts on their assets, whereas debtors have gained relatively little from low rates, because most of their debts are at fixed rates (see right-hand chart). Tadashi Nakamae, a Japanese economist, estimates that, using 1992 as a benchmark (when interest rates were over 5%), households have suffered a cumulative net loss of interest income of over ¥200 trillion ($1.8 trillion) as a result of near-zero interest rates, equal to fully 65% of annual income. It is hardly surprising that household spending has been depressed.

Japan's zero-interest-rate policy was designed to bail out debt-laden firms and banks, but today, with much healthier balance sheets, they no longer need that subsidy. Mr Reading argues that the BoJ should lift interest rates back to normal levels soon. But what is a normal interest rate for Japan? Based on the expected rate of nominal GDP growth this year, it is at least 2.5%. Mr Reading thinks it could be as high as 3.5%. He calculates that a three-percentage-point rise in rates would add 4.5% to disposable income and lift consumer spending by 3.5%.

But might increased consumer spending not be cancelled out by reduced spending by debtors: ie, firms and the government? Corporate investment is unlikely to be clobbered by dearer money, because interest payments are a small part of Japanese firms' costs and, just now, companies can finance most of their investment out of retained profits. Stronger consumer spending would also boost profits. Higher interest rates would increase the cost of government debt, but this need not lead to higher tax rates or lower public spending if faster growth in nominal GDP automatically lifted the tax take.

A more serious objection is raised by Julian Jessop of Capital Economics. The impact of higher interest rates on spending depends upon the relative size of the income effect (higher rates boost income and hence expenditure) and the substitution effect (higher rates encourage people to save more). For small changes in interest rates, says Mr Jessop, the income effect may dominate, but for large changes the substitution effect may be more important. His evidence is the sharp fall in the saving rate during the long period of low interest rates, from 14% of income in 1993 to 3% last year. (Although Japanese households have a massive stock of saving, their saving rate out of new income is now low.) Households may have decided it is not worth saving. A sharp jump in interest rates, however, might encourage them to squirrel more away rather than spend.

Another risk is that a sudden rise in interest rates would trigger a fall in share prices (though if higher rates did boost spending, and hence profits, share prices should eventually gain). A large increase in rates could also push up the yen as the carry trade unwinds (but, again, exporters could probably cope, since the currency is so competitive).

The theoretical case for raising interest income to lift Japanese consumer spending is persuasive, despite these risks. At the very least, it suggests that higher rates are unlikely to harm consumers, so the BoJ should try to normalise them as soon as possible to minimise economic distortions. Unfortunately, the BoJ is unlikely to have the nerve to test out the theory. Politicians will continue to argue that interest rates must not be raised much until spending recovers. Yet low rates keep consumers from spending as much as they could.

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