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European Central Bank Lowers Interest Rates, Trumping "Zero Lower Bound" Theory
Posted By Salim Furth, Ph.D On November 12, 2013 @ 3:32 pm In Economics | Comments Disabled
The European Central Bank (ECB) lowered a key interest rate  to 0.25 percent on Thursday. This is a big deal, since it demonstrates that the ECB has the ability and the will to stabilize euro inflation, which has fallen below the ECB’s target and become a drag on real growth.
Keynesian economists have been claiming for years  that interest rates had become useless as a policy tool, that they were at the “zero lower bound.” If interest rates are stuck at zero (“the liquidity trap”), then increased savings does not lead to increased investment, consumption becomes more economically valuable than savings, and government borrowing no longer crowds out private investment in the short term.
So when the ECB lowered rates on Thursday, it proved that rates had not been at the lower bound and that the ECB was not permanently unwilling to lower interest rates. Economist Scott Sumner called the move a nail in the coffin of Keynesianism .
There is more evidence that the reliance on liquidity trap theory was a mistake. Eric Swanson and John Williams showed that while overnight interest rates in the U.S. were near zero and unresponsive to economic news, longer-term rates remained responsive  through most of the crisis. Menzie Chinn countered  that the 2009 stimulus should have boosted interest rates even more, but even his data show that interest rates only declined after the stimulus was withdrawn.
Lorenzo Bini Smaghi shows (Figure 4)  that business interest rates are very highly correlated with economic growth. That’s not surprising—the credit crunch has been a salient feature of the crisis, and as Bini Smaghi argues, poor growth has much more to do with poor pre-crisis policy than with monetary management. But it’s an indication of the importance of the market for business loans, even in depressed economies.
Heritage Foundation research  on European stimulus and austerity also shows that fiscal policy has had typical effects during the past several years: Spending still crowds out the private economy, taxes still stifle economic growth. According to Keynesians, multipliers should be much larger than usual.
Keynesian analysis of the crisis is built on the idea that the normal market for business loans and investment is irrelevant to the economy’s recovery. In old Keynesianism, that arose from a belief that savings was not generally available for investments. In New Keynesianism, the old paradox is revived only when the market for business loans is oversaturated with money so that more saving does not translate into more investment (a liquidity trap). But the evidence shows that the business loan market remains an important handmaiden of growth even in depressed economies.
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URL to article: http://blog.heritage.org/2013/11/12/ecb-lowers-interest-rates-trumping-zero-lower-bound-theory/
URLs in this post:
 Image: http://blog.heritage.org/wp-content/uploads/European_Central_Bank131112.jpg
 lowered a key interest rate: http://www.reuters.com/article/2013/11/07/us-ecb-rates-idUSBRE9A600O20131107
 Keynesian economists have been claiming for years: http://krugman.blogs.nytimes.com/2013/10/15/five-on-the-floor/
 a nail in the coffin of Keynesianism: http://www.themoneyillusion.com/?p=24616
 longer-term rates remained responsive: http://www.heritage.org/research/reports/2013/05/monetary-policy-and-zero-lower-bound-interest-rates
 Menzie Chinn countered: http://www.econbrowser.com/archives/2013/05/crowding_out_wa_4.html
 Lorenzo Bini Smaghi shows (Figure 4): http://www.voxeu.org/article/austerity-and-stupidity
 Heritage Foundation research: http://www.heritage.org/research/reports/2013/10/europes-fiscal-crisis-revealed-indepth-analysis-of-spending-austerity-and-growth
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