Six years ago the Federal Reserve hit rock bottom. It had been cutting the federal funds rate, the interest rate it uses to steer the economy, frantically in an unsuccessful attempt to get ahead of the recession.
Eventually it could cut no more, because interest rates can't go below zero. On December 16th, 2008, the Fed set its interest target between 0 and 0.25 per cent, where it remains today.
The fact that we've spent six years at the so-called zero lower bound is amazing and depressing. What's even more amazing and depressing, is how slow our economic discourse has been to catch up with the new reality. Everything changes when the economy is at rock bottom. But for the longest time, nobody with the power to shape policy would believe it.
What do I mean by saying that everything changes? In a rock-bottom economy “the usual rules of economic policy no longer apply: virtue becomes vice, caution is risky and prudence is folly”.
Government spending doesn’t compete with private investment – it actually promotes business spending. Central bankers, who normally cultivate an image as stern inflation-fighters, need to do the exact opposite, convincing markets and investors that they will push inflation up. “Structural reform”, which usually means making it easier to cut wages, is more likely to destroy jobs than create them.
This may all sound wild and radical, but it isn’t. In fact, it’s what mainstream economic analysis says will happen once interest rates hit zero. It’s also what history tells us.
Lessons of 1930s
If you paid attention to the lessons of post-bubble Japan, or the US economy in the 1930s, you were more or less ready for the looking-glass world of economic policy we’ve lived in since 2008.
But as I said, nobody would believe it. By and large, policymakers and “Very Serious People” in general went with gut feelings rather than careful economic analysis. Yes, they sometimes found credentialed economists to back their positions, but they used these economists the way a drunkard uses a lamp-post: for support, not for illumination.
And what the guts of these serious people have told them, year after year, is to fear – and do – exactly the wrong things.
Thus we were told budget deficits were our most pressing economic problem, that interest rates would soar any day now unless we imposed harsh fiscal austerity.
Sure enough, the predicted interest rate spike never happened – but demands that we cut spending have cost millions of jobs and damaged our infrastructure.
We were also told repeatedly that printing money would lead to “currency debasement and inflation”. The Fed, to its credit, stood up to this pressure, but other central banks didn’t.
The European Central Bank, raised rates in 2011 to head off a non-existent inflationary threat. It eventually reversed course but has never gotten back on track. European inflation is far below the official target of 2 per cent, and the continent is flirting with outright deflation.
But are these bad calls just water under the bridge? Isn’t the era of rock-bottom economics over? Don’t count on it.
It’s true that with the US unemployment rate dropping, most analysts expect the Fed to raise interest rates sometime next year. But inflation is low, wages are weak, and the Fed seems to realise that raising rates too soon would be disastrous.
Meanwhile, Europe looks further than ever from economic lift-off, while Japan is still struggling to escape from deflation. China, which is starting to remind some of Japan in the late 1980s, could join the rock-bottom club sooner than you think.
So the counter-intuitive realities of economic policy at the zero lower bound are likely to remain relevant for a long time to come, which makes it crucial that influential people understand those realities. Unfortunately, too many still don’t; one of the most striking aspects of economic debate in recent years has been the extent to which those whose doctrines have failed the reality test refuse to admit error, let alone learn from it.
The intellectual leaders of the new majority in Congress still insist that we’re living in an Ayn Rand novel; German officials still insist that the problem is that debtors haven’t suffered enough.
This bodes ill for the future. What people in power don't know, or worse what they think they know but don't, can definitely hurt us. – Copyright New York Times 2014
