Central Banking Goes Negative

NEW HAVEN – In what could well be a final act of desperation, central banks are abdicating effective control of the economies they have been entrusted to manage. First came zero interest rates, then quantitative easing, and now negative interest rates – one futile attempt begetting another. Just as the first two gambits failed to gain meaningful economic traction in chronically weak recoveries, the shift to negative rates will only compound the risks of financial instability and set the stage for the next crisis.

The adoption of negative interest rates – initially launched in Europe in 2014 and now embraced in Japan – represents a major turning point for central banking. Previously, emphasis had been placed on boosting aggregate demand – primarily by lowering the cost of borrowing, but also by spurring wealth effects from appreciating financial assets. But now, by imposing penalties on excess reserves left on deposit with central banks, negative interest rates drive stimulus through the supply side of the credit equation – in effect, urging banks to make new loans regardless of the demand for such funds.

This misses the essence of what is ailing a post-crisis world. As Nomura economist Richard Koo has argued about Japan, the focus should be on the demand side of crisis-battered economies, where growth is impaired by a debt-rejection syndrome that invariably takes hold in the aftermath of a “balance sheet recession.”

Such impairment is global in scope. It’s not just Japan, where the purportedly powerful impetus of Abenomics has failed to dislodge a struggling economy from 24 years of 0.8% inflation-adjusted GDP growth. It’s also the US, where consumer demand – the epicenter of America’s Great Recession – remains stuck in an eight-year quagmire of just 1.5% average real growth. Even worse is the eurozone, where real GDP growth has averaged just 0.1% over the 2008-2015 period.