Six years ago, the US Federal Reserve hit rock bottom. It had been cutting the federal funds rate, the interest rate it uses to steer the economy, more or less frantically in an unsuccessful attempt to get ahead of the recession and financial crisis.
It eventually reached the point where it could cut no more, because interest rates can not go below zero. On Dec. 16, 2008, the Fed set its interest target between zero and 0.25 percent, where it remains to this day.
The fact that we have spent six years at the so-called zero lower bound is amazing and depressing. What is even more amazing and depressing, if you ask me, is how slow our economic discourse has been to catch up with the new reality.
Everything changes when the economy is at rock bottom — or, to use the term of art, in a liquidity trap (don’t ask). However, for the longest time, nobody with the power to shape policy would believe it.
What do I mean by saying that everything changes? As I wrote way back when, 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 does not 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 would push inflation up.
“Structural reform,” which usually means making it easier to cut wages, is more likely to destroy jobs than create them.
This might all sound wild and radical, but it is not. In fact, it is what mainstream economic analysis says will happen once interest rates hit zero, and it is also what history tells us. If you paid attention to the lessons of post-bubble Japan, or for that matter the US economy in the 1930s, you were more or less ready for the looking-glass world of economic policy we have lived in since 2008.
However, 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 lamppost: for support, not for illumination.
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 again and again that budget deficits were our most pressing economic problem, that interest rates would soar any day now unless we imposed harsh fiscal austerity.
I could have told you that this was foolish, and in fact I did, and sure enough, the predicted interest rate spike never happened — but demands that we cut government spending now, now, now have cost millions of jobs and deeply damaged our infrastructure.
We were also told repeatedly that printing money — not what the Fed was actually doing, but never mind — would lead to “currency debasement and inflation.”
The Fed, to its credit, stood up to this pressure, but other central banks did not. The European Central Bank, in particular, raised rates in 2011 to head off a nonexistent inflationary threat. It eventually reversed course, but has never gotten things back on track.
At this point European inflation is far below the official target of 2 percent, and the continent is flirting with outright deflation.
Are these bad calls just water under the bridge? Isn’t the era of rock-bottom economics just about over? Do not count on it.
It is true that with the US unemployment rate dropping, most analysts expect the Fed to raise interest rates sometime next year. However, inflation is low, wages are weak and the Fed seems to realize that raising rates too soon would be disastrous.
Meanwhile, Europe looks further than ever from economic liftoff, while Japan is still struggling to escape from deflation. Oh, and China, which is starting to remind some of us of Japan in the late 1980s, could join the rock-bottom club sooner than you think.
So the counterintuitive 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 do not; one of the most striking aspects of economic debate in recent years has been the extent to which those whose economic doctrines have failed the reality test refuse to admit error, let alone learn from it.
The intellectual leaders of the new majority in the US Congress still insist that we are living in an Ayn Rand novel; German officials still insist that the problem is that debtors have not suffered enough.
This bodes ill for the future. What people in power do not know, or worse what they think they know but is not so, can very definitely hurt us.
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