Zero interest hurting U.S. economy

Sebastien Buttet is professor of economics at Cleveland State University. Panos Mourdoukoutas is chair of the economics department at the C. W. Post Campus of Long Island University. They co-edit the financial blog BubbleBustInvesting.com

Despite the slight uptick in the unemployment rate to 9 percent in April, the economic impact of the Federal Reserve's second round of "quantitative easing" is largely positive. Since the program to purchase Treasury bonds to keep interest rates low and stimulate the economy was announced last August, the stock market has gained 30 percent and the unemployment rate declined by a full percentage point.

But the Fed's ultra-low interest rates are not without unintended -- and unwelcome -- long-run economic consequences.

Just take a look at Bethpage. For decades, residents enjoyed walking to the nearby beautiful garden nursery. But in 2007, at the peak of the real estate bubble, the nursery was turned into a multiple-unit retail outlet. Its developers didn't seem to mind that scores of nearby retail outlets were vacant; they had the land and they had the financing. Four years later, the new outlet is vacant, too.

To analyze the impact of ultra-low interest rates on the economy, it's useful to consider that there are two very different kinds of entrepreneurship. Demand-side entrepreneurship -- the good kind, which leads to long-run bull markets -- begins with consumer needs that have yet to be fulfilled and comes up with viable business concepts to bridge these gaps.

This means that the consumer is the center of the business universe, the guide of its "animal spirits." Economic resources, including capital, are raised after a business opportunity has been identified and explored. The Fed, with its low interest-rate policy, provides a welcome nudge to entrepreneurs' animal spirits. It stimulates but does not guide them.

By contrast, supply-side entrepreneurship begins with economic resources that are amassed before a business opportunity is identified and explored. Lured by the seemingly large financial gains observed everywhere around them, investors can't resist the urge to follow the herd and borrow heavily, often using faulty assumptions to evaluate the profitability of their enterprise or overestimating the true demand for their products. The bursting of the recent real estate bubble is a prime example of misguided animal spirits.

The Fed's policies can affect which kind of entrepreneurship prevails. But when do policies of lower interest rates provide a needed nudge to stimulate entrepreneurs for wealth creation, and when do they misguide them?

The answer depends on the level from which interest rates begin to fall and how long they stay low.

The dramatic fall in interest rates from just under 20 percent in the 1970s triggered a 2-decade-long burst of entrepreneurial activity and economic expansion, starting with investments in the personal computer and biotechnology industries in the mid-'80s and further innovations in the telecommunication industries in the mid-'90s -- the good type of entrepreneurship.

But if interest rates stay too low for too long, they stimulate supply-side entrepreneurship and misguide the animal spirits for consumers and investors alike. For consumers, too-low interest rates encourage excessive spending with borrowed money, leading eventually to market saturation and hurting future economic growth. For investors, too-low interest rates encourage reckless investing, as they chase after every asset whose valuation seems to defy gravity.

Mark Twain once said that "history does not repeat itself, but it does rhyme." Federal Reserve Chairman Ben Bernanke's zero-interest-rate policies -- backed by two rounds of quantitative easing -- have been successful at restoring the value of stocks and commodities by chasing investors away from safe assets. But this trend may not be sustainable. And if the last decade provides any guidance, the Fed's zero-interest-rate policies may well misguide the animal spirits, leading to another round of manias, panics and crashes.