The Last Days of Pushing on a String

BlythMark Blyth over at the Harvard Business Review blog:

A metaphor attributed to John Maynard Keynes maintains that using monetary policy to fight a severe recession is like “pushing on a piece of string.” When the problem is inflation, pushing up interest rates (pulling on a string) is a pretty effective policy tool — ask anyone who lived through the Volcker recession of the early 1980s. But when rates are pushed down to stimulate economic activity the 'push' becomes less and less effective the closer to zero rates get.

The power of this “pushing on a string” metaphor is especially apparent today. The Federal Reserve's balance sheet shows that, since 2008, “deposits by depository institutions” (i.e. banks) have ballooned from about $30 billion to around $1.5 trillion. Why is all that money sitting at the Fed earning a meager 0.25% nominal interest when those same banks could make a lot more than that by lending it out?

The answer is simple: uncertainty about the future. Not uncertainty over Obamacare, or “regulation,” or any of the other bêtes noires of moment, but uncertainty over the lack of demand in an economy whose consumers and producers are paying back debt. After all, who opens a factory in the middle of a recession? But if we all think this way then investment expectations fall, which hits borrowing and lending activity, thereby bringing about the very recession that we all wanted to avoid in the first place.