Japan’s Bank Cuts: Are Low Interest Rates Really the Answer?

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Low rates in Japan and US have yet to boost economies (Toru Hanai/REUTERS)

If you can count on any central bank to cut interest rates at the drop of a hat, it’s the Bank of Japan.  On Tuesday morning, Bank of Japan surprised the world by cutting it’s already low-interest rates to effectively zero. The Japanese central bank is trying to boost its weak economy by making it cheaper for its businesses and citizens to borrow. It also hopes that the low-interest rates will cause the value of its currency, the yen, which has been rising recently, up 12% in the past six months alone, to fall. A weaker yen could boost exports by making Japanese goods cheaper to foreigners.

Low interest rates have for a while now been the accepted policy move to cure weak economies. Ever since the financial crisis, the US, too, has recently been pursuing an ultra-low-interest economy to pull us out of our money mess. And indeed, many forecasters think the US Federal Reserve will soon announce a new program to try to drive down long-term interest rates even farther. The problem is it might not work. Two years since the fall of Lehman sent the US economy into a tailspin, there is a growing amount of evidence that suggests low interest rates may not be the potent economic medicine that many economists think it is. Here’s why:

First of all, Japan has tried this before to limited success. The Bank of Japan had its interest rates set near 0% for much of the past decade, and yet its annual GDP growth hovered just about 0%. You could say that without low-interest rates Japan would have been in depression for all of that time, but low to no economic growth is not a sign of a successful policy. Japan’s economy did seem to recover in early 2009, but that was only after the country had raised interest rates and then lowered them again.

Second, the recent experience in the US suggests that low-interest rates do not necessarily have the effect economist normally expect. It is thought that low-interest rates because they make it cheaper to borrow will cause companies to borrow money to buy equipment, build plants, boost production or hire more workers. All those activities should boost the economy. In fact, that’s not what US companies are doing. They are borrowing money at ultra-low interest rates, but they are not spending that money on plants or equipment, and they are certainly not hiring. Instead they are sitting on the money. Or they are using it to retire old higher interest rate debts. Or they are buying their stock to boost their shares. And none of this appears to be boosting the economy.

Lastly, the focus on low-interest rates, and the high yen, are distracting Japanese policy makers for the real problem with their economy.

The conventional wisdom in Japan is that the country needs a weak yen to help its exporters compete in international markets. But this dependence on exports is an outgrowth of outdated thinking on Japan’s economy. There is really no reason Japan should be so reliant on exports. Unlike a small, open economy like Taiwan or Singapore, exports don’t account for that much of the economy – in fact, less than 20% of GDP. The problem is that the domestic economy doesn’t contribute enough to growth.

Japan, of course, is not alone. The US is using low-interest rates to boost its economy. As it the UK, and the rest of Europe. The problem may be a relative game. If everybody’s interest rates are low, at least in the developed world, then lowering your interest rates may not be a boost but just a futile race to the bottom. A growing number of US policy makers are starting to raise questions about the benefits of our low-interest rate policy. Some have called it a dangerous gamble. The biggest problem may be one of signaling. Companies do not build plants or hire workers unless they are confident the economy will improve and people will want to buy their goods. But low-interest rates have the opposite effect, sending a signal that the economy is still weak and will be for some time. How do we get out of this chicken and egg problem? Central bankers, it seems, have yet to figure that one out.