There's a great analogy in Thursday's Mises Daily by Llewellyn H. Rockwell Jr demonstrating how low interest rates alone will do little to "fix" the global economic crisis.
To understand the implications, imagine if a fine restaurant advertised a five-course meal and French wine for all comers — at $1 each. Would the customers be exuberant? You bet. They would be wild with anticipation, choosing to stand in a line and hang out at the restaurant rather than do other things with their time.
The restaurant would be packed and happy, though of course it couldn't sustain this in the long run, but the fun is great while it lasts. At some point, reality kicks in. The manager notes that there are no more tables and maybe no more food. The employees are exhausted. Moreover, the balance sheets don't line up: they are losing money on every meal they serve. At some point, the manager is going to have to announce the bad news and everyone is going to have to go home.
This is roughly what happened with the current boom and bust. Policy makers, however, seem to be under the assumption that they can keep the boom going on forever simply by dropping the interest rate ever lower. This is something like a restaurant owner thinking that he can continue to have people wait in line even though he has no tables or food or servers remaining. It is a physical and economic impossibility for him to make good on his promises.
At some point in this process, people begin to drift away and go on to other things. The manager can continue to advertise $1 meals in the hope of stimulating his business but this is simply illusion. No one is buying it; even if they did, the restaurant can't make the balance sheets work out. We can venture a prediction here that this restaurant will not be stimulated. It will enter into a prolonged period of inactivity until nothing is left.
Policy makers can lower interest rates as much as they like but at the end of the day, the only way they can maintain a rate below that of the market (the rate based on the pool of real savings plus risk, time and so on) is through increases in the quantity of money. They have to produce additional quantities of money and offer it on the money market (to banks) to maintain any downward pressure on rates at all - with the consequence being price inflation. This whole process is nothing more than wealth redistribution as each unit of the money supply is diluted and the new money is not distributed evenly; it inevitably reaches certain people first - the bankers, government, etc. These people can then buy more out of an unchanged supply of real goods which in turn increases money prices - the prices the rest of the population now pays with their depreciated dollar savings.
Increasing the quantity of money does nothing to benefit the economy as a whole but does benefit some; namely governmental officials, policy makers and bankers at the expense of everyone else, especially the poor and people on fixed incomes. Not only that but it deceives firms by distorting a very important price signal, encouraging malinvestment and sowing the seeds of the next crisis. Steve Horwitz provides an excellent summary, noting that by lowering the interest rate, it gives firms "...the impression that the public is now more patient and more willing to wait for consumption goods. Had the expansion of loanable funds been financed by genuine savings, the lower interest rate would be sending an accurate signal about the public’s wishes. However, when the expansion is caused by an excess supply of money rather than a shift in the public’s time preferences, the tight relationship between market rates of interest and underlying time preferences is broken."
If these Mercantilist policies of monetary inflation are maintained the question is not if we're going to have another recession after this one, but when.
