The Menace of Sub-Zero Interest-Rate Policy

The Menace of Sub-Zero Interest-Rate Policy by  for Mises

Sub-zero interest rate policy as Europe and Japan have practiced for many years menaces global economic prosperity. Yet Congress and the White House are strangely silent on the issue; even a prophetic messenger would not arouse them.

Two monetary episodes – one historical and counterfactual, the other contemporary and real – highlight the nature of the danger.

First, history: throughout the heyday of the gold standard from the mid-1860s to 1914, short term money market rates in London rarely fell below 1-2% p.a. and then only briefly. Typically, these short rates were highly volatile day-to-day, but few cared.

The medium and long-term rates were much steadier, their level reflecting a massive amount of decentralized information in the market-place stemming from individual borrowing and lending decisions. Perceptions of the likely average short-term rate over the long-run set a floor to long-term rates (as speculators could borrow at the long rate and roll-over lending at the short).

Walter Bagehot famously observed that “John Bull can stand many things, but he cannot stand interest rates of 2 per cent” (meaning lower rates would make him mad – in today’s sense of irrational exuberance or desperate search for yield). The gold standard worked in a way which respected that wisdom.

If short-term rates fell towards zero, there would be a heavy “drain of gold” as the public converted deposits and notes into the yellow metal; a growing shortage of gold reserves (in the banking system) would force a tightening of monetary conditions. This mechanism depended on the natural scarcity of gold and its unique attractions. “High-powered money” under fiat money regimes has never enjoyed these properties.

The implicit floor to nominal interest rates was no barrier to the invisible hands achieving economic recovery from recession. This occurred in the context of stable prices in the very long run, not permanent inflation as preached by the architects and officials of today’s 2 per cent inflation standard. Crucially goods prices fell to a below-average level during the weak phase of the business cycle and were widely expected to rise back to normal or above in the expansion phase.

What do today’s central bankers think of Bagehot’s wisdom about John Bull?

They deny that asset inflation exists. And they would not request their research departments, filled up with neo-Keynesian economists, to conduct the following counterfactual analysis.

If central banks had all respected a 1-2% floor to interest rates through the last decade how would economic recovery have taken place and what would have been the nature of the expansion?

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