Zero interest rates, economic gloom
By Hossein Askari and Noureddine Krichene
The first decade of the 21st century is likely to be remembered for lax
monetary policy in major industrial countries, with interest rates at record
lows and credit expansion at unprecedented highs, and for the worst financial
crisis in the post-World War II period.
It will be remembered as a time when the financial system came close to a
general bankruptcy that could have wiped out thousands of banks, but banks were
saved at the cost of trillions of dollars to US and European taxpayers. The
cost of bank bailouts and gigantic stimulus pushed fiscal deficits to record
levels, and even in the aftermath of the turmoil, fiscal deficits are projected
to remain above 10% of gross domestic product (GDP) for another decade in the
United States, United Kingdom, and in
many other crisis-stricken countries. The financial crisis, in turn, fueled a
deep economic crisis, with unemployment that exceeds 10% in most industrial
countries.
How will governments cope with these deficits? Will they increase taxes? Will
foreigners finance the rising debt of the US, UK, and other countries? So many
uncertainties loom ahead. What can we learn from our mistakes?
During 2003-2004, the US federal funds rate was forced to 1% and kept at that
level for about a year. Consequently, the benchmark London Interbank Offered
Rate (LIBOR) hovered around 1% for about one year. Such low interest rates
created a highly speculative environment, a world casino, in financial markets
that ignited asset bubbles, and pushed credit mainly into subprime markets.
In the US, the credit/GDP ratio stood at its highest level at 35% in 2008. Such
a level of credit is difficult to service given that subprime markets, and
Ponzi borrowers, have zero capacity to service debt. Millions of borrowers have
enjoyed free wealth in the form of housing, luxury cars, and the like. Such
wealth has been paid for by over $1.5 trillion in write-downs and by
governments picking up toxic loans and bailing out homeowners through
unprecedented taxpayer subsidies.
Besides financial turmoil, low interest rates created large distortions in the
economy. They aggravated external current account deficits in many reserve
currency countries, led to negative national savings, and caused large currency
depreciation. Economic growth in many industrial countries was essentially
financed by foreign savings. After a long period of price stability during
1983-2001, commodity prices came under inflationary pressure during 2002-2008,
averaging annual price increases of about 23% a year.
Prices can be inflated through many channels, including credit, speculation,
exchange rate, income, and cost channels. For instance, during 2001-2006, US
housing prices were inflated essentially through credit and speculative
channels as opposed to income channels. Commodity prices were inflated through
credit and speculative channels. Oil prices ran up from $18 per barrel to $147.
Gold prices rose from $260 an ounce to over $1,200. The price of food such as
corn, rice, sugar and soybeans, rose by three to fourfold. The acceleration of
commodity price inflation during 2007-2008 to about 100% a year was a clear
sign of low real savings, indicated by food riots in many vulnerable countries.
Central banks acted as if asset bubbles were a sign of success and an
indication of economic prosperity. They were against pricking asset bubbles and
excluded asset price inflation from their measure of inflation, with inflation
measured by consumer core inflation, which also excluded food and energy
prices.
They were oblivious to deterioration of credit quality and the rising risk of
bank failures. Instead, they provided ample liquidity to fuel bubbles. The
response of central banks and governments to asset bubbles was outright
re-inflation to maintain asset prices at their bubble levels and prevent market
adjustment.
A deflation of asset prices would have ruined banks and forced borrowers to
default. Subsequently, central banks in the US, Europe and Japan have pushed
interest rates to near-zero bound and have injected trillions of dollars in
liquidity to banks and non banks regardless of the risks of financial
instability. Central banks have considered the appreciation of stock indices,
by about 65% since March 2009, as a sign of success, even though these gains
were financed by almost costless money and unemployment was rising.
Forcing interest rates to near-zero bound is a form of price control, which
will lead to distortions, speculation, and financial disorder. To maintain
interest rates at such low levels, the central bank has to keep pumping as much
liquidity as needed to prevent any rise in interest rates, regardless of the
dangers of speculative crashes and bank failures. Central banks cannot create
gold, oil, corn, or any other real goods. Their creation of money, ex-nihilo,
amounts to a pure redistribution of wealth to borrowers. A number of economists
have even called such practice a form of counterfeiting. This redistribution of
wealth is made through inflation by taxing cash holding and incomes.
Near-zero interest rates happen to also coincide with the wishes of a number of
governments facing the unpleasant arithmetic of financing monumental fiscal
deficits. Many central banks have decided to monetize government deficits and
reduce the cost of public debt. In the process, they now find themselves in a
situation where they could lose control of interest rates in the future.
The US Federal Reserve lost control of interest rates during 1930-1951 until
the 1951 accord with the US Treasury, which allowed it to modify interest rates
without the Treasury's objection.
The foundation of the policies of many Western central banks and governments
was to restore growth and employment through a combination of near-zero
interest rates and gigantic fiscal deficits. The dictate of central bankers is
simple. Low interest rates would increase demand for credit and, therefore,
real aggregate demand and employment. For politicians, large fiscal deficits
would, through the Keynesian multiplier, multiply real GDP and therefore
employment. It would appear that central bankers and politicians believe that
the same expansionary monetary policies that brought the ongoing financial
chaos and massive unemployment are the only policies that would restore
economic growth and employment.
Banks have been influenced by the bitter memories of capital losses, massive
write-downs, bailouts, and even waves of suicides or jailed financiers. They
were inundated by excess reserves, close to $1.5 trillion, which they could not
redeploy productively to prime borrowers. The only option was to shovel it, as
in the past, to subprime markets, with almost a zero chance of recovering
interest or principal.
Although, central bankers and politicians have tried to force banks into the
same misadventures as in the past, banks have hardly been responsive to this
pressure. Consequently, central bankers have decided to revive the
securitization of toxic assets. The Fed has bought close to $1 trillion of
mortgage securities and billions of consumer loans. It has thus injected large
amount of long-term liquidity that it cannot withdraw, and liquidity that could
become highly inflationary in the future.
Near-zero interest rates, combined with gigantic fiscal deficits, can hardly be
conducive to economic growth and employment. The years of 2001-2009 could have
been a decade of steady economic growth, as enjoyed during 1983-2000, had it
not been for the cheap money ideology of the Federal Reserve's Alan Greenspan
and Ben Bernanke.
Monetary prudence would have saved many Western countries trillions of dollars
in bank capital and fiscal losses. It would have saved millions of families
from losing jobs and incomes. Japan, a booming economy that weathered oil
shocks succumbed to near-zero interest rate policy and has not been able to
regain steady economic growth since 1992.
Although central bankers and politicians want to create demand and employment
through near-zero interest rates and attribute it to Keynes, such policy was
hardly proposed by Keynes. The economist proposed job creation through digging
holes and refilling them, financed by government deficits. Another way to
create demand is through cash-for-clunkers programs. These prescriptions for
creating demand are less distortive than near-zero interest rates.
Simple economic growth theory attributes growth to capital accumulation and
real savings. The accounting definition for savings is real GDP minus private
and public consumption. The economic definition has a number of forms. One
definition of savings is wage funds, namely food, energy, clothing, and other
consumer goods, made available for workers to be employed in the production of
capital goods such as housing, machinery, roads, and schools, necessary for
economic growth.
Near-zero interest rates penalize savers and reduce their incomes. Combined
with excessive credit and fiscal deficits, near-zero interest rates can reduce
savings and boost consumption. Sluggish growth, a decline in investment,
inflation, and widening external deficits are indicators of falling real
savings and erosion of capital.
A number of industrial countries experienced stagflation during most of the
1970s. Rising commodity prices, especially in energy and food, could be
considered as an indicator of low real savings, caused by persistent fiscal
deficits and accommodative monetary policies. Policymakers allowed money market
rates to rise dramatically to 19% in the US, 13% in Japan, 18% in the UK. The
LIBOR rose to 19%. Such a rise in interest rates contributed to curbing
inflation and enhancing real savings.
Most noticeably, commodity prices fell dramatically and exhibited long-term
stability during 1983-2000. For instance, oil prices fell sharply from $41 per
barrel, and remained at $15-18 for about two decades. In the same vein, food
prices fell and remained stable until 2001. Gold prices fell from $850 an
ounce, could not recover, and remained at an average of $260.
Such commodity price declines, followed by stability, was conducive to a
long-term non-inflationary economic growth during 1983-2000. Money interest
rates, averaging 7%, contributed to savings and productive investment.
In contrast, the world economy in 2008-2009 was marked by near-zero money
market rates in major industrial countries. Although having collapsed with
de-leveraging of speculative funds, commodity prices rebounded in 2009 and
exhibited a strong upward trend. Commodity price inflation as in 1976-1982 and
2001-2008 can be seen as detrimental to economic growth and can be a sign of
low real savings. In short, the prospects for steady economic growth, as during
1983-2000, are highly unlikely.
Economic policies in the major industrial countries are politically dictated by
cheap monetary policies and excessive fiscal expansion. Besides frightening
fiscal deficits, near-zero interest rates are considered to be the key for
restoring lasting economic growth. Instead, lasting economic growth requires
balanced fiscal and monetary policy.
Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist at the International Monetary Fund and a former advisor, Islamic
Development Bank, Jeddah.
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