Federal Reserve Chairman Ben Bernanke was right when he recently said that monetary policy "cannot be a panacea" for the economy. But he was wrong in insisting that short-term interest rates must remain at near zero.

In fact, the Fed's interest policy is pernicious. It's crippling the economy, retarding consumption, deterring lending, encouraging nonproductive investment, hindering job-producing investment and undermining confidence.

Bernanke's rationale, which reflects the prevailing view among economists, policymakers and Fed governors, is that near-zero rates provide economic stimulus because higher asset prices filter down to increased consumption, and therefore investment and job creation.

But it's not working that way. In fact, the anemic nature of the recovery compared with those following previous recessions demonstrates the need for an urgent re-examination of the Fed's policy.

How does the near-zero rate damage the economy?

  • It is causing a massive transfer of wealth, as much as $600 billion a year. The money comes from individuals and institutions whose portfolio incomes are crippled by the rock-bottom returns. The greatest beneficiary is the financial sector. This is supposed to increase lending and spur job-producing investments. But there are few signs this is happening because the beneficiaries of the Fed's wealth transfer aren't following the playbook. Instead they have used the wealth to reward shareholders and enrich the incomes of already highly paid executives.
  • The negligible returns on savings stresses savers, pension plans, retirement accounts, endowments, foundations, trusts, pension plans and insurance companies and companies with cash, delaying the restoration of confidence — a key to recovery.
  • Instead of producing jobs at home, funds have flowed offshore and into commodities creating asset price bubbles around the world destabilizing currencies and even countries.
  • It deters lending to job-producing middle-market companies and small businesses by producing a steep yield curve on government and high-quality credits. Why would banks and investors lend to the little guy when they can earn tidy profits without effort, expense or risk by lending to the big guys?

In human terms, the Fed's policy means dairy farmers in Iowa are forgoing equipment purchases to save for retirement, charities in Manhattan are reducing services as foundations cut grants, and local governments are laying off teachers to cover pension plan deficits.
It's especially frustrating that supporters of the Fed policy have a stark example of its failure staring them in the face: Japan.

Following the bursting of its credit bubble in 1990, Japan brought its equivalent of the Fed rate down to a then-unprecedented 0.25%.

The country proceeded to suffer a lost decade of economic stagnation that has never really ended.

It is accepted wisdom among economists that this happened because the Bank of Japan didn't bring rates down fast enough. In fact, Japan got caught in a cycle in which zero rates led to anemic private consumption, dysfunctional investments and ineffective stimulus programs while running up massive government debt.

To avoid this trap, the Fed should begin raising short-term rates. That will reverse the massive wealth transfer and bolster confidence.

Banks will be forced to look for lending opportunities beyond high-quality credits and investors will seek out productive investments at home, creating economic efficiencies and job growth.

Raising rates would actually increase consumption, stimulate job-creating investments, help restore confidence — and help get the sputtering recovery into a higher gear.

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