We have just been through the decision of the Federal Reserve Board to delay increasing interest rates from its low level near zero. For seven years now the US economy has floated on 0.5 % rate. Quantitative Easing (QE) as it is called was unimaginable ten years ago. It is an aggressive version of what used to be called Open Market Operations. The central Bank enters the market and buys bonds of sound reputation (AAA grading) and thus puts out cash in the hope that the cash would be spent either directly by the bond seller or through higher lending by the bank which sells the bond and puts the cash in its reserves.
Traditionally such an operation would be a temporary move to be reversed later on when the situation warranted a tightening. But the crisis of 2008 was an unusually deep one. Normally a Keynesian policy of fiscal expansion with borrowed money would be the principal tool advocated by the textbook Keynesian model. But Keynesian theory for several reasons is perfect only for a closed economy with no access for the citizens to Capital markets abroad. The Government then cajoles or compels the Rentiers to buy its debt. With globalisation and open markets, citizens have freedom to invest their money anywhere and the Government is competing with other borrowers to attract the money. This requires the Government to show it is fiscally responsible and does not run unsustainable deficits.
Since the crisis, fiscal stimulus has been absent. Obama did have a package of $ 850 billion soon after he came to office but the high Debt-GDP ratio discouraged further action. Ben Bernanke, who was Chairman of the Fed at that time, had studied the Great Depression of the 1930’s. One criticism of the policy of the Fed at that time was that the Fed tightened monetary policy – raised interest rates which deepened the loss of output and employment. (USA did not get back to its pre- crisis level of GDP of 1929 till 1941; unemployment rose to 25 %.)
Ben Bernanke therefore decided not to repeat that mistake when his turn came as a Central Banker. He launched an extensive and aggressive bond buying program. The effect was to lower the interest rate down to near zero. The idea was to keep pumping money out till the economy revived and when it did to raise rates again. This active monetary policy was not in the Keynesian toolbox originally. Keynes was pessimistic about using monetary policy to revive the economy. The fear was that no matter how much money was poured in the Rentiers will not buy bonds. Interest rates would be stuck at a low rate (2% was thought to be the norm). This was called the liquidity trap. Since rates would not fall, monetary policy would not succeed in reviving the economy.
We have now had active monetary policy for seven years now. Bond buying stopped a while ago but the bonds purchased have not been sold back. That would depress bond prices i.e. raise interest rates. So has the policy revived the economy? The US economy has recovered as has the UK which also had QE. But we are uncertain about the precise transmission mechanism. One effect of low rates has been to let debtors service their debts – mortgages for homeowners and loans for businesses, for longer rather than to have to go bankrupt. Given the volume of money pushed out the prediction in theory would have been of rampant inflation. But the money has not fed itself into the US or UK economy and caused inflation. If anything inflation is way below the target of 2%.
So where has the money gone? Some has gone to Emerging Economies including India in search of high returns. Some is sitting idly in corporate treasuries since the opportunity cost of hoarding is very low. Some is with banks. There is little new direct investment taking place despite the low rates. ( Here Keynes has been proved right as he trusted ‘Animal spirits’ more than careful cost return calculus as the driver of investment decisions.)
The economy seems to have bounced off the bottom thanks to built-in stabilisers like unemployment benefits but it has taken eight years to reach back to its pre-crisis level of GDP. We will need to go back to our drawing boards and examine why and how the recovery took so long.
Economics is in this sense a science where answers constantly change since the real world is much more complex than models can handle. We just have to keep on doing better.