Why banks aren't lending: the unintended consequences of a zero interest rate policy.

• Author: McKinnon, Ronald

Since the credit crunch and global downturn in 2008, governments everywhere have responded to the shortfall in aggregate demand in a standard textbook Keynesian fashion. To degrees, they have adopted fiscal stimuli: ramping up government expenditures and cutting taxes. Central banks followed the lead of the U.S. Federal Reserve by driving short-term interest rates toward zero; almost exactly zero for overnight interbank rates in the United States, Japan, and Canada, and generally less than 1 percent in Europe into the fall of 2009.

In a statement on September 23, 2009, the Fed repeated that it would keep its benchmark overnight interest rate at virtually zero for an "extended period." But are these near-zero interest rates the appropriate policy response?

In late 2009, with partial recovery, or at least a noticeable slowing, of the global downturn, a rather heated debate on exit strategies has emerged. The G20 finance ministers agreed on "'the need for a transparent and credible process for withdrawing the extraordinary fiscal, monetary, and financial sector support as recovery becomes firmly secured." But how and when to start withdrawing the support remains controversial.

One group sees unsustainable fiscal deficits and the extraordinary overhang of excess bank reserves as a portent of a monetary explosion and looming inflation. Indeed some commodity markets--notably gold and oil seem to be frothy, and the dollar is weak again. They argue for withdrawing the stimulus.

Countering this, a second group points to high and possibly still rising unemployment in the United States and Europe, coupled with excess capacity, as an effective barrier to any near-term outbreak of inflation in 2009--or even 2010. In the aggregate, they see potential supply still looking much higher than demand. This group worries that any withdrawal of stimulus now would be premature--much as in the Great Depression, when U.S. fiscal and monetary retrenchment in 1937 cut short a nascent economic recovery after 1933.

How best can we sort out these competing arguments? By disaggregating the U.S. stimulus package into its relevant components, one can identify some elements that can and should be exited immediately without undermining--and perhaps even strengthening--the expansionary impact of the whole regime. Here I focus on monetary policy; because the world is still largely on a dollar standard, what the Fed does strongly influences other central banks around the world.

The key point is that the Fed should raise short-term interest rates from near zero to modest levels--say 2 percent. Long ten- or thirty-year bond rates would be largely unaffected or could even fall. But in the current zero-interest liquidity trap, such a modest increase in short rates has distinct advantages.

First, in the huge but still constricted wholesale interbank market...