One of the first casualties of a financial crisis is the truth. During times of stress, central bankers embrace a time-honored
tradition: they issue anodyne statements that are economical with the truth.
Central bankers are also prone to seize upon standard `solutions' that
have been congealed into a crust of dogma by endless repetition and obeisance.
Today, we are witnessing a well-rehearsed repeat performance.
With the onset of the financial crisis and the collapse of aggregate demand
in the US, the Federal Reserve reached for the standard textbook solution
to stimulate demand. Indeed, the Fed pushed short-term interest rates
toward zero—a zone in which they have been trapped ever since.
The textbooks tell us that these `low' interest rates should have
stimulated investment and given aggregate demand a big boost. The economy
should be in a boom phase. But it is barely holding its head above water.
Why hasn't the economy responded in a textbook fashion to the near-zero,
interest-rate elixir?
In the monetary sphere, the Fed has, in a standard Keynesian
manner, flooded the economy with high-powered base money since the onset of the
crisis in late 2008. But with the crisis, the money multiplier collapsed and has
remained depressed. In consequence, broad money measures, such as
M2, have barely budged during the post-crisis period and the economy has
continued to disappoint.
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