After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.
-Milton Friedman in the Wall Street Journal, December 17, 1997, "Rx for Japan: Back to the Future."
I recently attended the 3-day annual meeting of the American Economic Association here in Chicago. The numbers were staggering: thousands of economists all at once, all in one place, talking about the world's money. One pundit called it "the poor man's Davos." Wandering through the corridors, it was like visiting a country whose arcane language you spoke, but did not hear that often and in such abundance. It was great fun, and very stimulating. With over 500 panel presentations it was almost impossible to choose which to attend.
A lot of the content was descriptive and analytical, rather than prescriptive. The academic practice of economics necessarily falls behind the sweep of current events. The starring country was China, but I could not find a single presentation on Iran, whose actions might actually affect world economic conditions more negatively than any other in 2012. The China analysis was however quite measured and realistic -- World Bank president Robert Zoellick and Harvard professor Larry Summers agreed that nothing lasts forever, not even Chinese growth. I did find it interesting that the panel on US-China economic relations did not include a single Chinese speaker -- where was Zhu Min of the IMF when we needed him?
The other star topic was, of course, the euro. On hand for the conference was Columbia professor Robert Mundell, known as a key proponent of the adoption of the euro, who discussed taking this concept a step further in order to create a global currency. After the euro crisis however, the prospect of a global currency has realistically moved much further into the future. The political hurdles are just too enormous. I had always thought that the next step after the euro might be a pan-Asian currency. However, the countries in Asia are even more diverse than the members of the European Union, in terms of economic development, religion, demographics, geography, culture, language, political systems, in short, everything. I also doubt that Japan, the world's third largest economy, will accept the Chinese yuan as coin of the realm. Even regional cooperation has been difficult to achieve, let alone global agreement.
There was definitely a strong whiff of nostalgia for the pre-Bretton Woods era, when gold was the monetary standard that linked most of the world. I am not in favor of a return to the gold standard for many reasons, but I began to think about other ways in which we could build convergence into the global financial system, reversing the divergence that has characterized the world post-2008.
Mundell is famous for his trilemma: a country can control interest rates, maintain a fixed exchange rate, and regulate capital flows, but not all three at the same time. If one abandons the goal of a fixed exchange rate or a global currency, what about the interest rate as a lever for convergence instead? As a thought experiment, what would happen if the central banks of the world, and the handful of people who run monetary policy, decided that they would all maintain the same interest rate?
Global Interest Rates- 2011--worldinterestrates.com
|Hong Kong SAR||0.5%|
|European Monetary Union||1%|
|Korea, Republic of||3.25%|
It is pretty clear within the first five seconds of thinking about the problem that a single global interest rate would not work. Risks and circumstances vary in each country. Removing the ability of central banks to use one of the best tools in their kit, interest rate adjustment, could make the next financial crisis even worse. However, that is essentially what has happened in the countries that now have ultra-low interest rates, such as the US, Japan, the UK, Canada and the EU -- all are 1% or lower. With inflation tracking higher than 1% in most of these countries, that means that debtors are favored over savers. Effectively, you have negative interest rates, because you are paying the money back with money that has depreciated in value over the length of the loan.
This lack of range of monetary motion has led to what economist Alan Blinder has called the Crazy Aunt problem. Since the central banks that have reached near zero interest rate bounds cannot cut rates further, they try out other unconventional means of control, opening up the closet and bringing out their Crazy Aunt who usually doesn't see the light of day. For example, QE (Quantitative Easing), or buying assets by the Fed. In fact, as the ZIRP (Zero Interest Rate Policy) countries lowered interest rates, they increased their balance sheets in almost reverse proportion. Banks never planned on becoming landlords, and the Fed never imagined that it would become an asset manager, but each has taken on these new roles. It might not end well.
I believe that there is a minimum level for interest rates below which policy distortions and long-term damage occur. The search for low interest rate loans has resulted in substantial speculation, particularly in the dollar and yen carry trades. Given Interest Rate Parity, an ideal state of equilibrium, investors would not prefer one country over the other and the carry trade would disappear. The Japanese experience of a near zero interest rate policy was a disaster, which resulted in the marooning of the Japanese economy for decades. I remember arguing with Japan's former central bank governor Toshihio Fukui that although lowering Japanese interest rates resulted in gains for Japanese companies, Japan's many savers, particularly in light of their stock market crash which resulted in huge retail losses, felt impoverished and would stop spending. I lost the argument, but I have always wondered what might have happened if Japan had gently raised rates and lowered sales taxes in the 90's.
We are in danger of repeating the Japanese experience. Federal Reserve Chairman Ben Bernanke has been criticized for ultra-low interest rates that could cause the United States to fall into a liquidity and growth trap. Felix Salmon's column in Reuters quotes the legendary Bill Gross of Pimco, writing in an op ed in the Financial Times last month:
"Bill Gross has a wonky column in the FT, saying that setting interest rates at zero doesn't boost economic growth:
With policy rates at or approaching zero yields and QE facing political limits in almost all developed economies, it is appropriate to question not only the effectiveness of historical conceptual models but entertain the possibility that they may, counterintuitively, be hazardous to an economy's health.
Certainly the record will show that countries with persistently low interest rates tend to have sluggish growth, and although the obvious causality there runs the other way -- central banks cut rates in response to slow growth -- it's never been clearer than it is now that such policies don't always work.
Gross's point is that zero rates, far from encouraging people to borrow more, actually encourage deleveraging instead, at both the short and the long end of the curve. Why wouldn't people want to borrow at ultra-low interest rates? In part, because no one wants to lend at ultra-low interest rates."
Many central banks have an inflation target -- they feel, for example, that 2% inflation is optimal for growth. So why not a floor for interest rates? In 2005 economists Menzie Chinn and Jeffrey Frankel wrote a prescient paper entitled "The Euro Area and World Interest Rates":
How has European monetary integration affected the determination of world interest rates? This question comprises a number of empirical and policy debates. The first question is: Is there a "world interest rate"? In other words, has the dismantling of the legal and regulatory impediments to capital controls, accompanied by decreases in transaction costs, resulted in an essentially integrated pool of financial capital? With the rapid evolution of financial markets in the Euro area, a re-examination is warranted.
So if the world decided to adopt a floor on interest rates, perhaps based upon (as suggested by Robert Mundell) a US government US dollar denominated bond at the highest credit rating at the 2% level, then the countries which would have to raise interest rates to meet the new floor would be the US, Canada, the EU, the UK, Hong Kong and several other non-EU member European countries.
In fact, interest rates are rising in the rest of the world. Emerging market countries have already begun to tighten. According to Central Bank News:
Indeed of the 87 central banks that Central Bank News monitors, 34 made net increases to their interest rates, while 32 held their rates net unchanged, and 21 made net reductions to their policy interest rates, many of these in the second half of the year (2011).
And here is the kicker: even if central bankers do not tighten, they must raise rates at some point. Fiscal deficits will increase each country's indebtedness, and the more debt you have, the higher the interest rate you must pay to borrow more money because your credit risk increases. Coming back to China, ironically China will ensure that US interest rates move upwards. They are steadily decreasing their reliance on US treasuries, and if the Chinese withdraw from the market over the next few years, then there will be fewer lenders and those who remain will want to be paid more.
Ben Bernanke has announced that there will be no interest rate hikes for this year, and the new 2012 Federal Reserve releases will contain interest rate forecasts for the first time. But will Bernanke be able to keep his promise? Is there a calculus such that businesses are willing to pay a certain rate of interest as long as it is stable and close to the historical average, and savers, as individuals or countries, have a minimum amount of return they desire in order to invest? The current low interest policy benefits banks -- their spreads are larger, and therefore their profits. It certainly doesn't benefit the large and growing community of retired people who live off the interest earned by their investments. Is there an equilibrium point for interest rates and inflation that creates sustainability and confidence, a world in which exchange rates follow rather than lead the discussion?
I end with a quote from Tom Hoenig, the recently retired head of the Federal Reserve Bank of Kansas City, long a dissident voice against the imposition of ultra-low interest rates during the recent crisis:
Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, discusses the economy at the Council on Foreign Relations on March 2, 2011, in New York. (Mark Lennihan, AP)
"You create certain fragilities in the economy that when you do have to reverse your position, in terms of interest rates, whenever that is, it becomes an increasing risk of shock to the economy, whether it's your concerns about the stock market tanking or values of land being affected," he said.
"When you artificially hold down interest rates or you artificially bring short-term tools to solve long-term problems, you get worse long-term problems."
-USA Today, July 1, 2011
The concern is if we hit another big crisis, unless there is a margin for tightening interest rates, we are forfeiting one of our most important tools -- conventional monetary policy. We leave ourselves open to trying new and novel methods of intervention. A crisis is a hard time to experiment. I recommend that we create of target interest rate of 2% and ask all other countries to do the same, and implement gradual tightening. If another crisis hits, we will have something familiar to work with, and we can leave that crazy aunt in the closet.
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