MONETARY POLICY: No free lunch

06/10/2010 | William White

Ultra low policy rates in the West could have far-reaching ill effects, argues Bill White

Three years since the onset of the financial crisis and the global economy remains fragile. Why? Part of the answer lies in the excessively easy monetary and credit conditions over at least two decades, fostered by the belief that policy rate increases could not be used to moderate “bubbles” but that policy rate decreases could be used effectively to moderate “busts”.

As rates ratcheted down to ever lower levels, the imbalances and headwinds that now threaten sustainable growth grew ever larger and now threaten our collective future. Moreover, in spite of this chequered history, when the crisis hit in 2007 the policy response was “more of the same”.

The policy rate cuts in the Advanced Market Economies (AME’s) were unprecedented, and the Emerging Market Economies (EME’s) responded to upward pressure on their currencies, yet again, with more intervention and more monetary easing.

Where to from here? The policy prescriptions being suggested, particularly with respect to monetary policy in the AME’s, might best be described as “still more of the same”. The problem with these prescriptions is that they focus solely on the shorter term effects on domestic demand. Sadly, they are generally made without any serious consideration of their international effects, nor their longer run effects on aggregate demand and aggregate supply.

As to demand side effects, capital inflows into many EME’s are vehicles for importing both inflation and “imbalances” from the AME’s, tendencies often exacerbated by the EME’s own easy policies. As to the former, we are seeing rising inflation in India, China and Indonesia among others, and sharply rising commodity prices globally. As to the latter, global equity prices rebounded exceptionally strongly from the trough in March 2009. Moreover, property prices in EME’s, and those AME’s with relatively healthy banking systems, are now even higher than they were two years ago. As is now too well known, massive capital inflows and credit fuelled asset price increases often subsequently reverse with very serious consequences.

If the results of monetary stimulus in some countries seem rather unhealthy, in other countries there has been no response at all. Alan Greenspan’s “headwinds” have turned into “hurricanes” , with lenders unwilling to lend and borrowers unwilling to borrow. While low policy rates do seem to have been effective in recapitalizing banks, some significant downsides to this policy must be emphasized.

Low rates effectively penalize creditors at the expense of debtors; indeed, if the marginal propensity to spend is greater among the former than the latter, could the net result be to constrain spending rather than to encourage it? If the banks’ situation might be improving, what about the longer term impact on insurance companies and pension funds. Unable to meet statutory commitments, will they turn to still more risky behaviour in a “gamble for resurrection”? Will the availability of easy “carry trade” profits for banks only serve to convince them that there is no need to change their earlier, dangerous behaviour in a more fundamental way? Finally, what is the chance of a sharp reversal in bond rates inflicting heavy, perhaps catastrophic, losses on some market participants as in 1994?

Very low interest rates can also have pernicious effects on the supply side of the economy. Low interest rates give no incentive for the increased saving required to support capital accumulation and longer term growth. They encourage banks to “evergreen” loans, and markets to provide cheap funds to companies that ought to fail. Evidence from Japan indicates that “zombie” companies dragged down productivity growth in the economy as a whole, contributing materially to Japan’s dismal economic performance over the last twenty years. It is simply incredible to contend that Japan’s ongoing difficulties arose primarily from monetary policy not being easy enough in the distant past.

Finally, ultra low policy rates can have unpleasant implications for governments and central banks as well. If governments have fiscal problems, the temptation to shorten the maturity of their debt could prove irresistible. This raises the danger that the eventual need to “renormalize” rates might cause the burden of debt service, and the deficit itself, to increase so sharply that it would increase rather than reduce the fears of inflation. This could quickly result in very high inflation. At the very least, governments with fiscal problems will be increasingly inclined to pressure central banks not to raise rates. Unfortunately, if central banks are themselves exposed to market or credit risk, or fear that tightening could prove disruptive, they might not have much incentive to resist that pressure. This political road to both higher inflation and serious imbalances, a road paved with ultra low interest rates, would take longer. But it would still get us to a bad place in the end. 


William White is a former economic adviser and head of the Monetary and Economic Department at the Bank for International Settlements

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