Now that the Jackson Hole confab, where the world’s central bankers gather annually to discuss their craft, has ended, our attention turns to one basic question: With interest rates this low, do central banks have any power to change the course of growth and inflation?

Europe and Japan are currently caught in a “liquidity trap “, term originating in the 1930's by Keynes. In layman’s terms, this means that even if the central bank were to lower rates further, the demand for funds by business and consumers would not increase. Dropping the cost of money does not lead to economic expansion.In the case of Japan, this situation has characterized their economy for more than two decades. With negative central bank rates in both regions, economic performance continues to remain anemic. German industrial data now indicate that the EU is in recession. Although rates in the US are positive, there has been widespread fear that the Fed will be forced to adopt zero-bound interest rates and reactivate another round of quantitative easing to stave off an impending recession.

In a recent article, Lawrence Summers and Anna Stansbury,argue that “there are strong reasons to believe that the capacity of lower interest rates to stimulate the economy has been attenuated – or even gone into reverse”. If the Bank of England were to drop its rate from 0.75% to 0.50% or the ECB were drop its rate from minus 0.40% to minus 0.50%, would that make a difference to growth? Very doubtful. The Fed’s decision to make a “mid-cycle” adjustment to the funds rate of a ¼ pt. drop will hardly be noticed throughout the economy. Why the pessimism regarding the effectiveness of monetary policy? Summers and Stansbury offer two perspectives on how to look at this question.

At the macro level, we have seen how low interest rates promote leverage and greater risk-taking, especially as borrowers seek higher-yielding assets. Here, the concern is with asset bubbles which ultimately lead to market crashes. We have not (as yet) experienced a crisis in the financial markets since 2008. However, there have been countless warnings that easy money and ample liquidity will bring the equity and bond markets to their knees. Summers and Stansbury, however, seem less concerned with this possibility than what may happen at the micro level.

At the micro-economic level, they argue that low rates hurt financial corporations’ profits and affect the efficient allocation of capital by allowing weak companies to undertake greater debt obligation. In their words, “there is something unhealthy about an economy in which corporations can profitably borrow and invest even if the project in question pays a zero return”. Put slightly differently, there is a real possibility that banks will not make credit available to borrowers regardless of how low rates fall. Rates no longer determine a project’s viability. As Milton Friedman argued decades ago, low rates are a sign of economic stagnation or even decline which ultimately impairs credit creation and future growth. Be careful what you wish for.

Summers and Stanbury argue that “what is needed is admissions of impotence, in order to spur efforts by governments to promote demand through fiscal policies and other means.”. This is a cry for governments to open the spending gates to stimulate growth, along the lines of the classic Keynesian model for economic expansion. 

Recent developments in Germany are encouraging when it comes to fiscal expansion. The German government just successfully issued a 30-year zero-coupon bond which immediately traded at a negative yield. More importantly, the bond was issued at a time when the German federal and state governments are running balanced budgets. Perhaps, the country is preparing for fiscal expansion, taking the opportunity to raise money at no cost.