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Where will the global central bank economy lead?

UNITED STATES, WASHINGTON (OBSERVATORY) — Given the stagnation in developed countries, the ingenuity of central banks in easing monetary policy is not at all what is needed. What is needed is to recognize the ineffectiveness of government efforts to stimulate demand through fiscal policies and other means.

The central banks of the world and the scientists who follow them annually recall Jackson Hole. However, the theme of this year’s meeting, “Monetary Policy Issues,” can lead to dangerous complacency, former US Treasury Secretary Lawrence Summers and Harvard employee Anna Stansberry write in their column on Project Syndicate.

Simply put, changing inflation targets, communication strategies or balance sheets is not an entirely adequate response to the challenges that major economies are now facing. Rather, 10 years of inflation below the target level in the entire developed world and the complete failure of the Bank of Japan’s active efforts to increase inflation make us think that what used to be an axiom is now a lie: central banks cannot always set inflation levels through monetary policy.

Europe and Japan found themselves in the so-called monetary black hole – a liquidity trap with minimal opportunities for expansionary monetary policy. The US is left to go through one recession, and they will suffer the same fate, given that they will not have the opportunity to lower interest rates when the next recession occurs. And given ten-year rates in the range of 1.5% and negative real forward rates, we can conclude that the possibilities for quantitative easing and forecasting for additional incentives are very limited.

These events support the concept of stagnation: the problem is much deeper than is commonly believed. The deficit and the level of public debt are much higher, nominal and real interest rates are much lower, and nominal GDP growth is much slower. This suggests a certain set of factors affecting the reduction in aggregate demand, the effect of which is only partially mitigated by fiscal policy.

Discussions of traditional politics are rooted in Keynesian traditions if macroeconomic problems are seen as reflecting problems that slow down market equilibrium. The combination of low inflation, lower neutral real interest rates and lower bounds on nominal interest rates will hinder full employment recovery. And all that can be done to lower real interest rates is constructive. And with flexibility in interest rates, stagnation can be overcome. The immediate problem is to raise real rates, so first of all you need to look for solutions for central banks and monetary policy.

However, it is necessary to be skeptical about the fact that everything is so simple. A universal trend among central banks is to perceive the coincidence of very low real interest rates and inflation as a decrease in the neutral real interest rate and use the traditional monetary policy framework with a modified neutral real rate.

However, more negative explanations are possible. There is reason to believe that the ability of lower interest rates to stimulate the economy has been weakened.

The share of durable goods sectors susceptible to interest rates in GDP declined. The importance of the effect of savings increased amid falling interest rates, the negative impact of lower interest rates on disposable income increased as government debt grew. The reduction in interest rates under these conditions undermines the capital of financial intermediaries and their creditworthiness. With the globalization of the economic cycle, the exchange rate is not so important for monetary policy. Given the negative real interest rates, it is unlikely that the cost of capital will become an important obstacle to investment.

To begin, consider the case when a decrease in interest rates has both a positive and a negative effect on demand. Reducing interest rates from a certain level may limit rather than increase demand. In this case, monetary policy cannot provide full employment and cannot increase inflation. If demand is constantly lagging, according to the Phillips curve, inflation will fall rather than grow.

Even if cuts in interest rates on all counts increase demand, there is good reason to worry if the effect is weak. It may happen that any short-term benefit from demand is offset by the adverse effects of lower rates on subsequent productivity for macroeconomic or microeconomic reasons.

From a macroeconomic point of view, low interest rates contribute to an increase in leverage and asset bubbles, they reduce the cost of borrowing, stimulating investors to obtain profitability. In almost every report on the 2008 financial crisis, a certain role is given to the consequences of the very low interest rates that were observed in the early 2000s. In a broader sense, bubble researchers always emphasize the role of easy money and excessively large liquidity.

From the point of view of microeconomics, low rates undermine the health of financial intermediaries, reducing their profitability, and hamper the efficient distribution of capital. They allow the weakest firms to fulfill debt service obligations and can impede competition by favoring existing firms. There is something unhealthy in the economy in which corporations can profitably take loans and invest, even with a payback project.

This suggests that lower interest rates will not just be insufficient, but not productive in response to stagnation.

This wording is closely related to the recent criticism of economist Thomas Palley: negative interest rates will not help fix Keynesian unemployment. The authors of the post-Keynesian tradition have long emphasized: the role of individual frictions in economic fluctuations should be understated relative to the fundamental lack of aggregate demand.

If the reduction in interest rates is insufficient or ineffective, the ingenuity of central banks in easing monetary policy in the face of stagnation is something that is clearly not needed. The inability of governments to stimulate demand through fiscal policies and other means must be recognized.

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