Low interest rates aren’t working

In most walks of life, it’s pretty obvious that if what you’re doing isn’t working, you should try something else. In the world of central banking, however, the strategy has been to do more of what isn’t working, providing trillions of dollars and euros of liquidity via quantitative easing and even sending official interest rates in some countries into negative territory.

But what if low interest rates are the problem, not the solution? What if the continuous central- bank efforts to add more stimulus end up suggesting that the economic outlook is so bleak that nobody in their right mind would take advantage of the largesse?

In December, the Federal Reserve raised its benchmark interest rate for the first time since 2006 and suggested that the move would be followed by four more increases this year. Instead, it’ s almost the middle of the year, and the futures market is betting the Fed is more likely to remain inactive for the next six months than raise again. “This mismatch between what we’re saying and what we’re doing is arguably caus- i ng distortions in global financial market pricing, causing unnecessary confusion for future Fed policy and eroding credibility,” St. Louis Fed President James Bullard said last week.

One big problem with artificially engineering low borrowing costs is that capital can end up trapped in so-called zombie companies. What the economist Joseph Schumpeter called “creative destruction” is less likely when money is free. That prevents economic Darwinism from weeding out the weak.

Citigroup’s Gregory Marks published a research note last week slamming central bankers for acting like doctors allowed to “perform experimental procedures on everyone who walks through hospital doors.” He cited Rudolf von Havenstein, who was president of the German central bank when the country was gripped by hyperinflation between 1921 and 1923, in large part because he printed money with no regard for the inflationary consequences. His name has become synonymous with muddled monetary thinking ( one of the funniest market Twitter feeds around bears his name).

“We should be invoking Havenstein to identify the present flaw in institutional thinking around current monetary policy, specifically negative rates,” Marks wrote. “In other words, the lesson here is that, unfortunately, people believed in the efficacy of a completely irrational policy because it was put in place by a qualified and experienced policymaker — this instead of questioning the common sense merit of its possible outcome.

And in a research report published earlier this month with the title “The ECB Must Change Course,” Deutsche Bank’s chief international economist, Torsten Slok, argued that the eurozone central bank should prepare to reverse its policy stance. “The longer policy prevents the necessary catharsis, the more it contributes to the growth of populist or extremist politics,” Slok argues. “Normalizing rates would be seen as a positive signal by consumers and corporate investors. The longer the ECB persists with unconventional monetary policy, the greater the damage to the European project will be.”

If central banks ( and indeed financial markets) are telling the world that money will be free for the foreseeable future, what incentive do consumers or companies have to borrow today to consume or invest, rather than waiting a while to see if demand picks up? Suppose instead there was a co- ordinated announcement that interest rates in the world’s major economies would rise to, say, two per cent in three months’ time. Might that not grease the wheels of industry, prompting companies to borrow to invest?

In December, when the Fed raised rates, I argued that it shouldn’t have. Based on economic orthodoxy, I stand by that call. But I’m willing to entertain the possibility that it’s time to rip up the textbooks and try some financial heterodoxy. If lower borrowing costs haven’t revived growth or extinguished the threat of deflation, maybe it’s time to give higher interest rates a chance.

THE CENTRALBANK MESSAGE IS THAT MONEY WILL CONTINUE TO BE FREE.