NEW HAVEN, Conn. (Project Syndicate) — In what could well be a final act of desperation, central banks are abdicating effective control of the economies they have been entrusted to manage. First came zero interest rates, then quantitative easing, and now negative interest rates — one futile attempt begetting another.
Just as the first two gambits failed to gain meaningful economic traction in chronically weak recoveries, the shift to negative rates will only compound the risks of financial instability and set the stage for the next crisis.
The adoption of negative interest rates — initially launched in Europe in 2014 and now embraced in Japan — represents a major turning point for central banking. Previously, emphasis had been placed on boosting aggregate demand — primarily by lowering the cost of borrowing, but also by spurring wealth effects from appreciating financial assets.
But now, by imposing penalties on excess reserves left on deposit with central banks, negative interest rates drive stimulus through the supply side of the credit equation — in effect, urging banks to make new loans regardless of the demand for such funds.
This misses the essence of what is ailing a post-crisis world. As Nomura economist Richard Koo has argued about Japan, the focus should be on the demand side of crisis-battered economies, where growth is impaired by a debt-rejection syndrome that invariably takes hold in the aftermath of a “balance sheet recession.”
Such impairment is global in scope. It’s not just Japan, where the purportedly powerful impetus of Abenomics has failed to dislodge a struggling economy from 24 years of 0.8% inflation-adjusted growth in gross domestic product. It’s also the U.S., where consumer demand — the epicenter of America’s Great Recession — remains stuck in an eight-year quagmire of just 1.5% average real growth. Even worse is the eurozone, where real GDP growth has averaged just 0.1% over the 2008-2015 period.
All of this speaks to the impotence of central banks to jump-start aggregate demand in balance-sheet-constrained economies that have fallen into 1930s-style “liquidity traps.” As Paul Krugman noted nearly 20 years ago, Japan exemplifies the modern-day incarnation of this dilemma. When its equity and property bubbles burst in the early 1990s, the keiretsu system — “main banks” and their tightly connected nonbank corporates — imploded under the deadweight of excess leverage.
But the same was true for over-extended, saving-short American consumers — to say nothing of a eurozone that was basically a levered play on overly inflated growth expectations in its peripheral economies — Portugal, Italy, Ireland, Greece, and Spain. In all of these cases, balance-sheet repair pre-empted a resurgence of aggregate demand, and monetary stimulus was largely ineffective in sparking classic cyclical rebounds.
This could be the greatest failure of modern central banking. Yet denial runs deep. then-Federal Reserve Chair Alan Greenspan’s “mission accomplished” speech in early 2004 is an important case in point. Greenspan took credit for using super-easy monetary policy to clean up the mess after the dot-com bubble burst in 2000, while insisting that the Fed should feel vindicated for not leaning against the speculative madness of the late 1990s.
That left Greenspan’s successor on a very slippery slope. Quickly out of ammunition when the Great Crisis hit in late 2008, then-Fed Chair Ben Bernanke embraced the new miracle drug of quantitative easing — a powerful antidote for markets in distress but ultimately an ineffective tool to plug the hole in consumer balance sheets and spark meaningful revival in aggregate demand....MORE