Why the FED’s Zero Interest Rate Policy Hurts the Economy

Michael S. Rozeff
The LRC Blog
Thursday, June 21, 2012

Never before has the FED (or any central bank with the possible exception of Japan’s) announced that it would hold the short-term overnight rate to near ZERO percent for another 1.5 years. It’s already been at close to 0% since late 2008. By 2014, the FED’s target date, this will make 6 years of such a low Fed Funds rate and all other related short-term rates, with concomitant depressing effects on long-term rates. This is absolutely extraordinary.

David Ranson points out that the countries whose central banks have not done a ZIRP (Canada and Germany) have recovered faster than the countries whose central banks have done the zero interest rate policy (Japan and the U.S.). Why does a zero interest rate policy (ZIRP) hurt the economy? There are several strong reasons.

 

In the first place, ZIRP is a bank bailout policy. It supplies banks liberally with reserves. This keeps alive zombie banks and other financial institutions that should fail. It allows banks to continue policies that should be abandoned. This is a drag on wealth creation.

Second, ZIRP causes the government sector to enlarge. The federal government is more likely than the private sector to take advantage of low short-term rates in order to borrow and finance itself, as the private sector typically uses longer-term sources. Under ZIRP, Japan’s government built out uneconomic roads and transport systems. This spending didn’t stimulate economic growth, since scarce capital went to uneconomic projects. The U.S. fights uneconomic wars and wastes its capital that way, for example. It continues to subsidize the housing sector. All such activity is a drag on wealth creation.

In all cases of government borrowing and spending, there is another offset which is that business firms and taxpayers both adjust their investment and spending downwards because they know that the future burden of taxes will rise in order to pay off debt. Higher taxes discourage wealth creation.

ZIRP reduces nominal interest rates while monetary inflation keeps on going or rises. This produces negative real rates of return. Savers are stuck between a rock and a hard place. Their real income from saving goes down. When they look at stocks and bonds, they find that the prospective returns are low, because their prices have been bid up due to interest rates having been kept low.  This discourages saving and thus investment in risky enterprises. It encourages both consumption and investment in goods whose storage keeps up with inflation and preserves wealth. These do not produce economic growth. The latter depends on WEALTH CREATION, which means the discovery of and investment in profitable forms of activity.

• A d v e r t i s e m e n t

ZIRP means that a centrally-planned and centrally-administered interest rate has replaced or substantially influenced or displaced the free market. The market for loanable funds is distorted. In the short to medium term, people expect the low interest rates to persist, but in the long term they figure that the policy will eventually end and interest rates rebound to normal levels. This has got to affect what they invest in and how they finance those investments. Many investors will be expecting stocks and bonds eventually to decline. Others will be selling them over time against that eventuality. But yet others will be buying because interest rates are so low. The resulting confusion means that asset prices provide very noisy and uncertain signals of long-term value. This is going to distort the investment decisions made by company managers. Overall, it will discourage private sector investment and wealth creation. This is another reason why ZIRP tends to enlarge government borrowing and spending relative to private sector borrowing and investment.

All central banking control over monetary policy is central planning. All of it is a dagger in the heart of a capitalistic or free market economy. ZIRP is a larger and exaggerated case of this disease because it involves such a huge expansion in the central bank’s balance sheet; but ZIRP has peculiar negative effects of its own.

For ZIRP to go on for 6 years is unbelievable in a country that supposedly stands for free markets. ZIRP is making evident that the FED has a hugecredibility gap.

 

This article was posted: Thursday, June 21, 2012 at 9:12 am

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