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The Dilemma of Central Banking

Once upon a time, Keynesians' focus on the short term and neoclassical theorists' attention to the long term had little trouble coexisting within the same broader monetary-policy framework. But in an age of persistently low and negative interest rates, the rules of the game have changed.

BEIJING – Low interest rates – both nominal and real – have been a persistent feature of advanced economies since the 1980s. How long, many now wonder, can the trend last?

In 2015, the “Geneva Report” on the topic by the International Center for Monetary and Banking Studies and the Center for Economic Policy Research argued that interest rates would stay low for long, but most likely not indefinitely. But with more than $13 trillion worth of negative-yielding bonds outstanding in the world economy, many more scholars and investors have started to think that rates could stay low forever. If so, central bankers will face a critical dilemma: in the event of a growth slowdown, should they keep their limited powder dry, or use it preemptively?

The answer lies outside monetary policy and beyond national borders. To see why, it is useful to revisit the basic concept of interest, which has always been a source of controversy in economic theory. As the Austrian economist Eugen von Böhm-Bawerk pointed out in his 1890 book, Capital and Interest, “the theory [of interest] exhibits a motley collection of the most conflicting opinions, no one of them strong enough to conquer, and no one of them willing to admit defeat.” The situation today is not much different. Explanations for the current era of low interest rates come from either of two seemingly contradictory schools of thoughts: neoclassical theory and Keynesian theory.