Why Did Fed Drop (short-term) Rates to 0%?

The Federal Reserve did something for the first time in its history. It dropped its fed funds overnight rate—the overnight rate it lends to banks—to between 0 and 0.25 percent. This meant in effect that it will print as much money as necessary to encourage financial institutions to begin to lend and/or invest again, which they are reluctant to do at present. But will it work without other stimulus programs?

Its FOMC press release highlighted the Fed’s concern for the economy: “The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

Why such a drastic measure? This is in spite of more than $1 trillion to date lent or invested in our largest financial institutions. It highlights a problem often debated by economists. How to get the most bang for the stimulus buck? Classical economists who hark back to the free market philosophy of Adam Smith believe that giving the largest financial institutions as much money as they need—either via a stimulus package, or more tax breaks—will encourage them to lend and invest in businesses.

But with consumer incomes and spending having declined more than 40 percent, there is little incentive for businesses to expand. The auto industry is just one example, with sales of both domestic and foreign cars down around 40 percent, as well. Industries are cutting jobs, not creating them at the moment.

It was the last, Great Depression that brought a new economic philosophy, named after British Lord John Maynard Keynes. And the Roosevelt Administration liked his ideas, since it wanted to stimulate consumption by directly creating jobs rather than waiting for the private economy to recover. Until then, the captains of industry and finance believed only the private sector should control resources, except during wartime. Any other economic model smelled of socialism.

But Lord Keynes, a British monetary expert thought differently in a famous essay:

“…there will be no means of escape from prolonged and perhaps interminable depression except by direct state intervention to promote and subsidize new investment. Formerly there was no expenditure out of the proceeds of borrowing that it was thought proper for the State to incur except for war. In the past therefore, we have not infrequently had to wait for a war to terminate a major depression. I hope that in the future we shall not adhere to this purist financial attitude, and that we shall be ready to spend on the enterprises of peace what the financial maxims of the past would only allow us to spend on the devastations of war.”

As a precursor to modern economic theory that took into account the psychological behavior of consumers and investors, Lord Keynes saw that emotions (and so confidence) helped to determine how humans behaved in both good and bad times.

We are currently in a recession that began last December and could last into 2009. And this has affected how consumers and businesses see the world. That is the reason why there is such an emphasis by the incoming Obama administration on job creation, as well as providing better health care and educational opportunities. It provides aid and relief to the consumers who power this economy—with their pocketbooks.

So though 0 interest loans help to grease the wheels, it is such job creation and training programs that puts money into consumers’ pockets and will ultimately bring the U.S. economy back. Without healthy consumers, what bank will lend or business expand?

© Harlan Green 2008