These are times of shattered illusions. The attacks of Sept. 11 destroyed our sense of invulnerability, and now the mythology of the "New Economy" is receding before the reality of declining jobs and profits. To this list may soon be added the Federal Reserve's presumed power, which--during the reign of Alan Greenspan as Fed chairman--has grown to immense proportions in the popular imagination. People began thinking that the Fed had achieved what "fine tuning" (a concept discredited in the 1970s) had promised. By well-timed changes in interest rates, the Fed can steer the economy along a path of low inflation, high employment and rapid growth.
It is doubtful whether Greenspan ever bought this line. He has seen too many business cycles to harbor a false sense of control. But the success of his stewardship has inspired unrealistic expectations, even among economists, about the power of monetary policy--changes in interest rates and money supply orchestrated by the Fed and other government central banks. We may soon be disabused of this pleasing faith.
The Fed has cut interest rates nine times this year. The Fed funds rate has dropped from 6.5 percent in January to 2.5 percent, the lowest level since 1962. Yet the economy was still deteriorating even before Sept. 11. To state the obvious: even with the usual "lags," the Fed's cuts weren't powerful enough to offset the ill effects of faltering investment, employment and confidence.
Japan is exhibit A in the limits of monetary policy. In 1999 the Bank of Japan lowered its official interest rate to zero. It is still zero, though the BOJ temporarily raised it back to a whopping 0.25 percent (that's a quarter of 1 percent). All the while, Japan's economy sputtered. It is now in recession. Low interest rates are supposed to spur more lending and borrowing. But in Japan, total bank lending has declined for 45 consecutive months, reports The Japan Daily Digest. Some economists describe this situation as a "liquidity trap," a phrase coined by John Maynard Keynes. The academic jargon is a veil for ignorance. It evades the harder and more relevant question: why aren't there willing borrowers and lenders?
In Japan, government overregulation and bad banking practices have left devastating legacies. So much of the economy has been protected from competition by regulation, subsidies and cartels that it's hard for new companies and industries to get started. This shrinks the pool of potential borrowers. Meanwhile, Japan's banks still suffer from all the poor loans they made in the "bubble economy" of the late 1980s and early 1990s. Saddled with massive losses, they aren't eager to make new loans. Consumers aren't eager to borrow, either, because years of economic stagnation--now compounded by fears of joblessness--have fed their pessimism.
The point is that even zero interest rates can't reinvigorate the economy if other conditions are sufficiently …