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Lower rates can't rescue a deleveraging
The squeeze begins
After decades of rising debt, the burden becomes too big. Incomes fall while debt repayments rise, borrowers are squeezed, and credit dries up. Scrambling to fill the hole, borrowers sell assets, and the rush to sell floods the market. The stock market collapses, real estate tanks, and banks get into trouble.
The self-feeding spiral
Falling asset prices cut the value of the collateral borrowers can put up, which makes them even less creditworthy. People feel poor, credit rapidly disappears, and less spending means less income, less wealth, less credit, and less borrowing. The whole thing feeds on itself.
Rates hit zero
In a recession, lowering interest rates stimulates borrowing. In a deleveraging, rates are already low and soon hit 0%, so the stimulation ends. They did in the United States during the 1930s and again in 2008. Lenders realize the debts have become too large to ever be fully paid back, borrowers have lost both their ability to repay and the value of their collateral, and they feel crippled by debt. They don't even want more.
Why can't interest rates go below zero?
Holding physical cash pays zero, so in theory depositors would withdraw cash rather than accept a negative rate. Economists call the point where rate cuts stop working the effective lower bound.
Some central banks still tested slightly negative rates, including Denmark's in 2012, the European Central Bank's in 2014, and the Bank of Japan's in 2016.
How did the Fed act after hitting zero?
In December 2008 the Federal Reserve cut its target to a range of zero to 0.25 percent. It then turned to large-scale asset purchases, known as quantitative easing, starting with mortgage-backed securities and later adding Treasury bonds.
The Fed's balance sheet grew from under $1 trillion in 2007 to about $4.5 trillion by 2014.
Why do forced asset sales feed on themselves?
When many borrowers sell at once, the buyers best able to value an asset are often in the same trouble as the sellers, so assets go to outsiders at depressed prices. Lower prices cut the value of collateral across the market, which triggers more demands for repayment and more sales.
Andrei Shleifer and Robert Vishny laid out this logic in a 1992 paper on liquidation values and debt capacity.
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