Schrager: A zombie economy could be America’s future

Over the next decade, the U.S. economy will face two big challenges: higher interest rates and AI-generated disruption. Each invites the same solution: policies to keep rates below their market level.

The strategy, also known as yield-curve control, is tempting, and it may even provide an immediate boost to the economy. But messing with rates would be a mistake. Japan’s experience shows that the long-term costs of keeping rates artificially low far outweigh the short-term benefits.

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It’s easy to see the hardship caused by higher interest rates. In the U.S., rates on long-term bonds (ones that mature in 10 years or more) have trended up since the pandemic. This means consumers pay more for their debt and mortgages. Businesses pay more for loans. The government pays more to service its debt. A lot of the U.S. economy is built around the historically low rates of the last several decades, so the longer rates stay high, the more disruption it will cause.

AI poses another challenge. Even in the best-case scenario — artificial intelligence transforms the economy, making Americans richer and more productive — AI will involve lots of disruption. Higher interest rates will mean that firms which are barely hanging on will face a higher cost of capital to keep their businesses viable and their people employed.

So the government will want to do whatever it can to bring down long-term interest rates. Conventional monetary policy tends to influence short-term rates; longer-term rates are set by the markets. And many market forces point to higher rates for longer.

The government can influence long-term rates through policies such as quantitative easing, where the central bank buys long-term bonds. The government can also lower rates by requiring pension funds or banks to buy lots of bonds. But it is a risky plan.

Japan offers a cautionary tale. It faced a slowing economy following the boom years of the 1980s. To keep its economy afloat, it kept long-term interest rates low with a mix of financial repression and QE. Japan muddled through decades of low growth and high debt with a good standard of living and not much job loss. It became the poster child for why nations can run up as much debt as they’d like.

But there is a cost to keeping rates artificially low for too long. Japan is full of what’s known as “zombie companies”: firms that aren’t profitable and don’t have a viable business model, but can stay afloat with cheap debt. Eventually, however, when inflation returned and interest rates around the world increased, Japan had to let its rates rise too.

Those zombie companies are now going out of business, as many family-run firms declare bankruptcy. The zombie companies made Japan’s economy less efficient and slower-growing, and left generations of Japanese working at unprofitable businesses.

It will be tempting for the U.S. and Europe to engage in some financial repression in the coming years. Not only will it make America’s addiction to debt seem manageable, it will help ease the transition to an AI economy. Cheap debt will allow more zombie companies to survive.

President Donald Trump’s administration is already hinting at the possibility. Trump certainly wants lower short-term rates, and Treasury Secretary Scott Bessent has been vocal about his desire to lower long-term rates too. How the administration might do so, however, is unclear — Bessent has also said he is skeptical of doing more QE.

He is right to be. If the Japanese experience isn’t an adequate warning, he can look closer to home. Some of America’s current economic problems are the result of past forays into yield-curve control. The Federal Reserve’s QE during the pandemic is still causing problems in the housing market — it artificially lowered mortgage rates, which then went up when inflation returned. Meanwhile, the Treasury is losing money on its bond portfolio, and the bond market is experiencing dislocations as the Fed reduces its large post-pandemic balance sheet.

All this is the result of only a few years of trying to control the yield curve. If it becomes normal policy, expect worse distortions and more threats to Fed independence. Japan’s policies, followed for decades, created thousands of zombie companies. The danger for the U.S. is that financial repression, pursued on a large scale, would create a zombie economy.