Institute for Research in Economic and Fiscal issues

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The ZIRP Trap: Why low interest rates are a tax on recovery

IREF Working Paper No. 201502: Philipp Bagus

Easy monetary policy and extensive bail-outs have been the two key responses with which central bankers have reacted to the 2008-2013 crisis. Who were the main beneficiaries of these policies? Who were the victims? Were there alternatives? And what can be done to solve the existing structural problems and leave the crisis behind us?

In this paper, Philipp Bagus analyzes monetary policy on both sides of the Atlantic and comes to the following conclusions:

1.
The main beneficiaries were the stakeholders in the banking industry – shareholders, blue-collar employees, and managers; civil servants, who succeeded in keeping their jobs and privileges, since the size of the government sector failed to be downsized; financial asset holders, especially those who owned shares and bonds issued by bad companies and public debtors kept afloat by the injections of liquidity.

2.
The main victims were small and medium-size enterprises, who found it hard to obtain loans from the banking sectors; and new entrepreneurs, crowded out by incumbent, poorly-performing companies that failed to go bankrupt and benefitted from direct and indirect subsidies.

3.
The alternative to extensive bail-outs and generous monetary policy would have been strict neutrality. Such an attitude would have indeed led to the collapse of a number of weak actors – including some banks and debt-burdened governments. Yet, the “crash” would have been short-lived, it would have forced a number of key actors to reduce their excessive indebtedness, it would have avoided the creation of further distortions, and it would have enhanced the creation of conditions much more favourable to entrepreneurship, competition and economic growth.

The monetary policy that has characterized these last years has also had other effects. For example, low interest rates have modified the time horizon of the typical company, which now aims at short-run targets. Following from that, the shortening of the time horizon also influences the role of credibility, reputation and individual responsibility. In other words, some of the pillars of capitalist prosperity have been dented. Moreover, this paper underscores that although the crisis originated, at least in part, from excessive spending by the government sector, the bail-out strategy pursued by central bankers has encouraged the ongoing expansion of the welfare state, and thus prepared the ground for further imbalances. In other words, ZIRP has been instrumental in keeping the crisis within limits, but its fundamental features remain to be addressed. The paper provides the first in-depth analysis of the theoretical consequences of ZIRP including its cultural and social ramifications.

Getting out of the ZIRP trap is going to be problematic, since it would likely lead to the crash that was feared in 2008, on top of which further distortions have been accumulating for the past seven years. The options on the table are limited. One is debt restructuring, a euphemism for partial default; a second one is (unexpected) inflation; a third possibility is a rise in taxation, with emphasis on a wealth tax. The author is inclined to believe that all these strategies will be pursued.

IREF Working Paper No. 201502: Philipp Bagus

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