Twenty years ago, a young economist destined to become a household name in Australia issued a warning to central banks around the world.
“[L]lowering rates or providing ample liquidity when problems materialize, but not raising rates as imbalances accumulate, can be rather insidious in the long run,” he said.
“They promote a form of moral hazard that can sow the seeds of instability and costly swings in the real economy.”
So said Philip Lowe, the future Reserve Bank Governor, in an article he co-wrote while on secondment to the Bank for International Settlements in Switzerland with the chief economist of the BRI, Claudio Borio.
The two men presented their report at a March 2002 conference organized by the BIS – dubbed “the bank of central banks” – on how risks could increase even in times of apparent calm.
Financial imbalances, such as asset bubbles, which could appear during periods of low inflation, were of particular concern. In certain circumstances, it would be appropriate for banks to take preventive measures “to preserve both financial and monetary stability”.
How central banks should act – and what they actually do – is at the heart of a fascinating if somewhat alarming new book by British economics commentator Edward Chancellor.
The Price of Time explores the history and role of interest rates. Central banks, much like the nursery rhyme about “an old lady who swallowed a fly,” seem accustomed to solving every market crisis in a way that breeds greater instability in the future.
Borio and Lowe’s warning that authorities should be alert to the dangers of speculation—and the moral hazard that arises when bad decision-makers get used to being rescued—is a constant theme that recurs throughout the book.
The work is also timely as an independent group is halfway through a review of the RBA and its operations, which is due to be completed in March.
That interest rates may rise in Australia, the United States, New Zealand and elsewhere does not diminish Chancellor’s case. As he notes, nominal rates may be below the record highs set during the Covid pandemic, but they are still well below inflation, leaving them negative in real terms.
One of the author’s favorite quotes is from Jeremy Stein, a Harvard University economist who served one term on the board of governors of America’s central bank, the Federal Reserve.
Firm market regulation was fine, but monetary policy “gets into all the cracks,” Stein said. Excessively low interest rates are inflating all sorts of asset bubbles as investors desperate for a return on their money grab property, stocks and, until recently, cryptocurrency.
“All these extraordinarily low interest rates [have] got into everything,” Chancellor told Guardian Australia. “And if we say we have the bubble of everything, it kind of follows that you’re going to have the bust of everything.”
It is perhaps surprising that the purpose and dangers of interest rates continue to confuse experts and the public. Most of us can intuitively understand that someone who lends money or another asset to someone else deserves a reward for the temporary transfer.
Ancient Mesopotamians “collected interest on loans before they discovered how to put wheels on carts,” Chancellor writes. Clay tablets dating back more than 4,000 years reveal that borrowers offered collateral – houses, land and slaves from the wife of a former borrower – as security for repayment.
While the history of interest over the millennia is fascinating, the main point of the book is to highlight the snowball challenges of the last quarter century.
In September 1998, Long-Term Capital Management, a giant US hedge fund with exposures estimated at $1 billion (A$1.5 billion), blew up. To avoid market contagion, the Fed cut its interest rate in what has become a model for subsequent central bank responses to stresses such as the global financial crisis and supply shocks from the Covid pandemic. .
“The total calculated cost of each crisis is higher than the previous ones,” said the Chancellor. And “their geographical scope is more extensive”.
However, it was China that prompted the author to question the genesis of market distortions and the role of interest rates.
By keeping interest rates artificially low for decades, but especially after the GFC in 2008, China implemented the biggest loan expansion in history. It alone has accounted for up to half of global investment since then, Chancellor said.
As the Guardian recently noted, property values in China are now double that of the United States and triple that of Europe. This is despite the fact that China’s annual economic output is only about three-quarters of that of these two regions.
Forests of new buildings destined to stand empty have sprung up, while increasingly expensive tunnels and high-speed railways to remote areas hint at the economic waste.
“Because interest rates reflect neither return on capital nor credit risk, the Chinese economy has suffered from the twin evils of capital misallocation and excessive leverage,” Chancellor wrote.
People may have overlooked the risks in China because of the state’s growing role in the economy and its grip on the banks. Or, “simply because China was able to get through the last crisis without too much apparent damage.”
The Chancellor isn’t used to making predictions, but China, he says, has embarked on “a highly unsustainable path”. The challenges facing Xi Jinping as the Chinese president attempts to rekindle confidence in a declining property market while navigating the economy despite continued Covid-related lockdowns are formidable.
And regarding this Borio-Lowe article, Chancellor says they were on the money: “If you look at housing booms and credit booms, and put them together, you get what [they call] costly recessions.
“It would be interesting to compare [Lowe] with this research he wrote,” he says, noting that the RBA under Lowe likely acted in a “contradictory” manner in its research with Borio on the dangers of allowing asset bubbles to inflate.
As for Lowe’s current position on the issue of too low interest rates – the cash rate remained at a record low of 0.1% for 18 months through May 2022 – a spokesperson provided a response. short: “We’re not in a position to help on this one. ”
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