Jackson Hole 2012: Mystery as to why zero interest rate policies are not working more effectively

Going into the 2012 Jackson Hole economic conference, the question was has the printing press reached its limits or as economists would phrase it:  why aren't zero interest rate policies working more effectively.

The answer provided by the conference was that it is a mystery why the policies aren't more effective, but despite this mystery the central banks were going to continue to pursue zero interest rate policies.

Regular readers suspect there is no mystery.  They recall that Walter Bagehot, the individual who in the 1870s wrote the book on modern central banking, Lombard Street, specifically stated that interest rates should not be lowered below 2%.

Here is an individual who lived during a time when a financial crisis was a frequent occurrence.  Not only did he state that interest rates should not be below 2%, he did not make any exceptions to this rule.

In fact, Mr. Bagehot went further than say 2% was the lower bound.  He said that the financial system cannot stand interest rates below 2%.

Evidence that Mr. Bagehot knew what he was talking about is everywhere.

For example, zero interest rate policies have triggered the Pension Death Spiral where the need to make up for the lack of earnings in pension funds is depriving companies of the funds they need to reinvest in maintaining or growing the real economy.

For example, consumer demand has dropped as consumers who are retired attempt to stretch their savings and consumers who are still working are saving more in anticipation of the greater quantity of savings they will need in retirement (there is no reason for them to assume that their savings will generate any income).

For example, all of the businesses in finance that depend on a spread between the return on their assets versus the cost of their liabilities are seeing their business model crash and burn.

As the Telegraph's Jeremy Warner observed prior to the beginning of the 2012 conference,

Central bankers may have averted outright disaster, but they are powerless to do more....

Please note the use of the word 'may' as it is not clear that central bank policy did avert outright disaster.  A disaster that central banks played a significant role in creating.

Faith in central banks as guarantors of macro-economic stability has been shaken to breaking point by the events of recent years, a crisis which they utterly failed to see coming, still less were able to prevent....

Actually, in the US, the Fed could have prevented the crisis.

Regular readers remember that the Fed has responsibility for bank supervision.  Its failure in a supervisory capacity contributed as much or more to the crisis.

Please recall how until the financial crisis hit and the US banks needed to be bailed out Fed officials said that modern finance had transferred risk out of the banking system and to investors who were better able to hold the risk.

The financial crisis showed that Fed officials didn't know what they were talking about.

If nothing else, the event serves to highlight that five years after the crisis began, monetary policy is still struggling to deliver meaningful solutions....

Since the beginning of the financial crisis, your humble blogger has been saying that monetary policy is never going to fix what is a solvency problem.  This confirms my observation.

Central banks stand widely accused of having failed. Is this fair? Not entirely. Just as they were much too highly rated before the crisis hit, they have now become somewhat oversold. 

Part of what went wrong in public policy in the lead-up to the credit crunch is that too much trust was vested in central banks, which were widely credited with almost superhuman powers. This led to a feeling of false security and a blissful disregard of what the bankers, the politicians and the wider economy were up to. 

Whatever happened, it was thought, monetary policy could always be relied on to come riding to the rescue....

Clearly, the financial crisis has shown that this is not true.

But the question is, why don't central bankers admit they are powerless and that the policies they are pursuing may be creating more problems than they solve?

If the crisis has taught us anything, it is that it is unwise to place too much faith in central banks. The most they can hope to do is paper over the cracks....

It is only certain types of cracks that central banks can paper over and solvency is not one of these types.

To think they can somehow magic away all our problems is to descend into the fantasies of the past.

After the conference, Reuters reported

Policymakers in Europe and the United States facing weak growth and painfully high unemployment are struggling with the issue of whether additional monetary stimulus could do more harm than good....

Mr. Bagehot would say more harm.

"What is holding the economy back? Why is it that we've had such incredibly accommodative monetary policy for so long (but) we've had so little growth? I think it remains a puzzle," said Donald Kohn, who is now a senior fellow at the Brookings Institution think tank in Washington....

It is not a puzzle.  It is confirmation that Mr. Bagehot was right.

Adam Posen, who finished his final day as a member of the Bank of England's monetary policy on Friday and is a powerful advocate for more forceful central bank action, asked the same question as Kohn: "Why has all this lower short-term interest rates failed to make the economy go go go?" 

But he scornfully blamed "defeatism" by central banks concerned about interfering in the proper functioning of markets and damaging their credibility....

As predicted by Mr. Bagehot, the fact is that low interest rate policies interfere in the proper functioning of markets.  Interference that causes more harm than good.

A hotly debated paper presented on Saturday discussed the damage done to U.S. households by the collapse in the housing market, raising the question of what monetary policy could do to help people whose assets have been wiped out and who were now saving like crazy to rebuild them....

Please note that the problem of saving to rebuild net worth is made harder by low interest rate policies as savings do not generate income.

Kohn was not convinced that various headwinds fully explained why growth had been weak for so long, and wondered whether the unusually low level of interest rates was impacting economic activity in a way that was not understood. 

"We keep trying to bring spending from the future into the present with lower and lower interest rates. ... There is a lot we don't understand about what is going on," he said....

Perhaps Mr. Bagehot's 2% interest rate rule should be followed until such time as the economics profession can definitively understand what goes on at interest rates below 2%!

"I think it is kind of the elephant in the room for this conference - whether the U.S. economy went through some sort of structural shift associated with this very large financial crisis," said St. Louis Federal Reserve President James Bullard, who has publicly questioned the need for more Fed action. 

"It sure looks like the economy was on one trend pre-crisis and it is on a very different trend post-crisis," he added. "I think the longer this goes on the stronger the evidence will be that we're on a different trend (and) ... it does have policy implications," he said.

The lower post-crisis trend appears to confirm that Mr. Bagehot is right about never lowering interest rates below 2%.