The world has moved into a low-interest rate trap. Since the mid-1980s, asymmetric monetary policy patterns--that is, sharp interest rate cuts during crises and hesitant interest rate increases during the post-crisis recoveries--have pushed interest rates toward zero (Hoffmann and Schnabl 2011) (see Figure l). (1) With short-term interest rates having reached the zero bound, unconventional monetary policies (i.e., extensive government and corporate bond purchases) have nudged long-term interest rates further downward.
The ultra-low interest rate policies encouraged financial market exuberance, which led to painful financial meltdowns, during which exploding debt of financial institutions was transformed into public debt to ensure financial stability. By pushing long-term interest rates downward, central banks are keeping growing general government debt levels (see Figure 1) sustainable and are discouraging efforts to reduce government spending. Inflated central bank balance sheets, which contain growing amounts of government bonds, erode the credibility of central banks.
Meanwhile, the exit from the low, zero, and negative interest rate policies is strongly dependent on the public debt levels, because eveiy increase in interest rates threatens to cause a meltdown in the financial system and (thereby) to block the budgets of highly indebted countries (see Figure 1). For this very reason--while pretending to pursue inflation targets--the central banks in the core of the international monetary system either continue their extensive bond purchase programs (Bank of Japan, European Central Bank) or have moved very hesitantly toward the exit from ultra-loose monetary policies and financial repression (U.S. Fed, Bank of England).
The literature on the exit from the low interest rate environment is scarce. Summers (2014) argues that, given aging societies and a declining marginal efficiency of investment, the key interest rates set by the central banks reflect the gradual decline of the equilibrium interest rate in the industrialized countries. Given these assumptions an exit from the ultra-expansionary monetary policies is not necessary.
Reinhart and Sbrancia (2015) argue on die basis of historical experience that low nominal interest rates help to contain debt servicing costs and to reduce the real value of government debt. Thus, financial repression is seen as a pre-step for the exit from excessive monetary expansion. McKinnon (1993) has developed a blueprint for the exit from financial repression in emerging market economies based on the reconstitution of market forces, which has proven to be highly successful in many East Asian as well as Central and Eastern European countries, and in particular in China.
Low-Growth Effects of Financial Repression
McKinnon (1973) showed the negative growth effects of the financial repression imposed on the capital markets of emerging market economies in the 1950s and 1960s. (2) Uncontrolled government expenditure financed by the expansion of the real stock of money undermined via repressed financial markets the efficiency of investment. With state-controlled interest rates the allocation of capital had become disconnected from market principles. (3) Similarly, since the mid-1980s the asymmetric monetary policy patterns of the large central banks have disturbed the allocation function of capital markets by driving a wedge between the returns of financial assets and physical capital stock.
Since the mid-1980s asymmetric monetary policies have subsidized investment in financial assets. During upswings, low central bank interest rates have inflated asset prices, whereas during crises the decline of asset prices has been countered with even further interest rate cuts and unconventional monetary policy measures (Hoffmann and Schnabl 2011). (4) As a result, since the mid-1980s asset prices--as represented in Figure 2 by the share prices in the four largest industrialized countries--have increased dramatically, leading to substantial speculation gains. Since 1985--despite substantial swings--the average increase in share prices per year has been close to 7 percent.
In contrast, investment in physical capital was discouraged because no public insurance mechanism was provided for risk linked to investment in innovation and attempts to increase the efficiency of die production process. The ultra-expansionary monetary policies have disturbed--like in the emerging market economies formerly plagued by financial repression--die adoption of best-practice technologies (5) by undermining the allocation function of interest rates, which separates between investment projects with high and low expected returns. This has clouded growth perspectives and therefore profit opportunities of most enterprises.
Whereas interest rate cuts during boom phases encouraged investment projects with lower returns, during the crisis further interest rate cuts prevented the dismantling of investment projects with low marginal efficiency. (6) On the global level, this resulted in an increasing number of zombie enterprises and zombie banks, which are kept alive by the low-cost liquidity provision of central banks (see Peek and Rosengreen 2005 as well as Cabellera, Hoshi, and Kashyap 2008 on Japan). (7) Kornai (1986) dubbed this phenomenon "soft budget constraints" for the former centrally planned economies of central and eastern Europe. Unemployment was regarded as politically undesirable; thus, state-owned enterprises were subsidized with costless credit by state-controlled banks. The banks were kept alive with the help of the printing press of the central bank.
With resources remaining bound in low-return investment projects, a restraint has been put on efficiency-increasing innovation. In the neoclassical growth model, given a declining marginal efficiency of investment, output converges toward a steady state (Solow 1956, Swan 1956). Beyond that point, growth is only possible, if innovation takes place (Solow 1957). If, however, financial repression undermines die innovation process by binding resources in inefficient investment projects and reducing the incentive for household savings, (8) then investments, productivity gains, and growth will slow. This is shown in Figures 3 and 4 for the United States, United Kingdom, Japan, and Germany.
Distribution Effects and Political Instability
The negative growth effects have been paired with far-reaching redistribution effects of the very expansionary monetary policies. (9) First, if central banks depress government bond yields, the public sector gains at the cost of the private sector, which holds these assets. Second, the financial sector gains relative to the rest of the economy because currency units newly issued by the central bank are transferred first to the financial institutions, which can spend the newly issued currency units first. Each previously created currency unit held by other economic agents can purchase a smaller portion of goods, services, or assets (such as stocks and real estate) (Cantillon 1931).
Third, die higher income class (which owns the largest share of stocks and real estate) gains relative to the middle class (which tends to save in low-risk asset classes) because the excessive money creation inflates asset prices (see Figure 3), while it depresses returns on bank deposits and government bonds.
Fourth, young people lose relative to older people because productivity gains converging toward zero put a restriction on real wage increases. This burden is overproportionally shifted to newcomers in the labor markets, because older contracts allow for a stronger wage negotiation power. Given productivity gains close to zero, the wage level (and the social security benefits) of the...