Welcome To The ZIRP

by dday

The Federal Reserve cut their key interest rate as low as they can go - virtually to zero, although the bank rate is more like .5%. The investors loved it! Well, today they did, anyway. But this is the final tool in the shed for the Fed, and a zero interest rate policy (or ZIRP!) hasn't shown much success elsewhere in the world:

There's a bit of room left to go, since the rate isn't actually zero, but essentially, the Fed has run out of ability to use standard monetary policy. It's broken and it doesn't work anymore. Deflationary expectations have set in, and folks figure that a dollar a year from now will be worth more than dollar now, so even borrowing at zero or .5% doesn't seem like that good a deal.

As Bloomberg pointed out, the Bank of Japan kept rates at zero for five years, and it did squat. So the Fed has announced that it will use non-standard measures like buying up government backed housing bonds, and is considering buying long term treasuries, whose rates simply aren't dropping, even as people accept negative returns to buy short term securities. (They are doing so because the Fed was paying 1% interest on reserves, and treasuries can be used as reserves, which is why the Fed dropped the amount they pay on reserves to .25%.) [...]

Deflation can always be fixed, in the worst case scenario, the government could just send everyone a gift card for $50,000 which expires in 3 months and tell them to use it or lose it. But it can't be fixed by giving money to banks who won't lend it to the real economy, and even pushing down long bond rates really isn't going to matter as long as there are deflationary expectations.

So, expect the Fed to spend a LOT of money and get very little in return until someone uses some of the money to buy a clue. In the meantime, remember, you're probably going to have to pay this money back, no matter how little it does, unless the government manages to make itself go bankrupt. In theory the US need never go bankrupt, but a lot more of this, and it may turn out to be the lesser evil.

Paul Krugman calls it the liquidity trap - the Federal Reserve can't implement a rate change to facilitate lending at all, and the banks aren't being forced to lend, and the quantity of money is meaningless because bonds are worth essentially just as much. The Fed is also planning quantitative easing, basically increasing the money supply. But when money is the same as bonds, what's the difference? As Ian says, we're exploding the deficit and getting little in return.

The other worry is deflation; consumer prices fell at a record rate last month, which means that retailers can't sell enough to make a profit, which means they cut jobs, which means less people have money, and prices have to drop to sell anything, etc. Nasty business. While Kevin Drum notes that the drop in prices is entirely due to cheaper oil, taking that out of the equation there was virtually no change in inflation, which is unsustainable.

The textbook tells us to engage massive fiscal spending, as nobody is equipped to spend at all right now except for government. But Robert Reich is absolutely correct, IMO, that spending won't be enough.

Keynesianism is based on two highly-questionable assumptions in today's world. The first is that American consumers will eventually regain the purchasing power needed to keep the economy going full tilt. That seems doubtful. Median incomes dropped during the last recovery, adjusted for inflation, and even at the start weren't much higher than they were in the 1970s. Consumers kept spending by borrowing against their homes. But that's over. The second assumption seems even more doubtful: that, even if middle-class Americans had the money to continue the old pattern of spending, they could do so forever. Yet the social and environmental costs would soon overwhelm us. Even if climate change were not an imminent threat to the planet, the rest of the world will not allow American consumers to continue to use up a quarter of the planet's natural resources and generate an even larger share of its toxic wastes and pollutants.

The current deep recession is a nightmare for people who have lost their jobs, homes, and savings; and it's part of a continuing nightmare for the very poor. That's why we have to do all we can to get the economy back on track. But many other Americans are discovering they can exist surprisingly well buying fewer of the things they never really needed to begin with. What we most lack, or are in danger of losing, are the things we use in common -- clean air, clean water, public parks, good schools, and public transportation, as well as social safety nets to catch those of us who fall.

That's why it's not enough to spend, spend, spend, until the housing market comes back or everyone gets excited about the latest iGadget again. Indeed we need to create a new economy that is not based so heavily on unsustainable consumer spending. President-elect Obama has the right idea in talking about a green economy - not only would the money spent go into something of value, like the commons, but the emphasis on green technologies could spur innovation and perhaps generate something we can export for a change. Right now America is the number one exporter of raw materials in the world - we make precious little, give away our material wealth and do nothing but consume. When you strip away the CDOs and the CDSes and the subprime lenders, THAT's the problem. We're a bubble-based economy out of necessity. Without re-industrializing America, without making products the rest of the world wants, that will never change.

James Boyce has more, and believe me, I gave you the GOOD news.