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Will Central Bankers Bring Stagnation?

Central Bankers
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EDITOR NOTE: Austerity versus accommodation. One is painful but leads to shorter-term recovery. The other brings relative comfort but risks long-term stagnation. Generally speaking, Americans crave comfort, perhaps to a fault. Long gone are the stoic (or even Spartan) principles that fueled pioneer expansion (as problematic a history as that was), “rugged individualism,” and eventually, American growth. Government and the Fed understand this, and they’re very accommodating toward driving the cultural sloth that has become “America.” As a result, they may drive us toward economic sloth as well.

“Our country continues to face a difficult and challenging time….People have lost loved ones. Many millions have lost their jobs. There is great uncertainty about the future. At the Federal Reserve, we are strongly committed to using our tools to do whatever we can, for as long as it takes…to ensure that the recovery will be as strong as possible, and to limit lasting damage to the economy” –Jerome Powell, Chairman of the Federal Reserve, June 10, 2020

America is hurting. From a pandemic to a recession and mass unemployment to social unrest over the sadly still-present systemic racism in our institutions, our country’s future feels extraordinarily uncertain. Jerome Powell speaks to this above, and he is leading the Federal Reserve in taking an active role to try and mitigate the uncertainty. Perhaps the most important way in which the Fed is trying to mitigate uncertainty is through committing to near-zero interest rates for the foreseeable future. In his speech last week, Powell noted that there is no time horizon in which the Fed sees itself moving rates higher than zero and forecast 2022 as the earliest possible date for a rate hike. If the Federal Reserve persists with zero (or negative) interest rates for the foreseeable future, the American economy will be condemned to stagnation—like Europe and Japan before it—as capital flows away from productive investment and toward ever increasing debt payments.

Why would the Fed take this path? In short, this is the crisis playbook. The Fed appears to believe that zero or negative interest rates will stimulate the economy by encouraging consumers to spend now—as opposed to saving—and that increased spending will spark an economic recovery from the recession we find ourselves in. For this to work, the Fed is putting its faith in the textbook, straight-line relationship between interest rates and savings holding despite mounting evidence against it.

Long periods of zero and negative interest rates have been tried before—notably in Europe and Japan—and the results have been not just disappointing, but devastating. The evidence suggests that instead of ensuring a strong recovery and limiting lasting economic damage, zero or negative interest rates almost surely lead to a slow recovery and inflict significant long-term economic damage.

In Japan, the Bank of Japan moved to zero interest rates in the late 1990s and has barely budged since.

Japan has not, however, had the strong, growing economy that this was intended to foster. Instead, it has experienced persistently low rates of growth on a declining trend, only touching the previously common 2 percent growth threshold twice in the nearly three decades since it brought rates down to near zero.

The Japanese stock market hasn’t recovered either. Since interest rates hit the floor, its market has been range bound at a level below where it was prior to dropping interest rates.

The use of zero interest rates may have been necessary as a crisis-fighting tool when first introduced, but the persistent use of zero interest rates for the decades following have not led to any form of meaningful or sustainable growth—either in the real economy or in financial assets. Japan could be an anomaly, however, or other factors could be at play. It has an aging population, relies on manufacturing in an age increasingly dominated by services and technology, and has little to no natural resources to speak of, all of which may have weighed on growth. Let’s look at Europe as a second case study.

In Europe, we see the same exact story playing out as in Japan. Zero and negative interest rates were instituted later in Europe than in Japan—the European Central Bank did not dramatically lower interest rates until Europe was in the midst of the financial crisis of 2008, and it did not go to zero until the euro crisis in the early parts of last decade.

Originally Posted on Mises Institute

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