Tuesday, July 9, 2013

Rajan on the Uncertainties of Ultra-Low Interest Rate Policies

When it comes to worrying about future financial dangers, Raghuram Rajan has a track record. Back in 2005, he presented a paper at a high-profile conference of central bankers called, "Has Financial Development Made the World Riskier?" He answered "yes," and took a lot of criticism for a few years--before the financial crash and Great Recession from 2007-2009 largely proved him right.

Rajan has now given the first Andrew Crockett Memorial Lecture at the Bank of International Settlements, titled "A step in the dark: unconventional monetary policy after the crisis." With economic predictions, as with stock market forecasters, it's always wise to note that past performance is no guarantee of future success. But it's always worth learning about how Rajan sees the world. He writes:  

"Two competing narratives of the sources of the crisis, and attendant remedies, are emerging. The first, and the better known diagnosis, is that demand has collapsed because of the high debt build up prior to the crisis. ... But there is another narrative. And that is that the fundamental growth capacity in industrial countries has been shifting down for decades now, masked for a while by debt-fuelled demand. More such demand, or asking for reckless spending from emerging markets, will not put us back on a sustainable path to growth. Instead, industrial democracies need to improve the environment for growth. The first narrative is the standard Keynesian one, modified for a debt crisis. It is the one most government officials and central bankers, as well as Wall Street economists, subscribe to, and needs little elaboration. The second narrative, in my view, offers a deeper and more persuasive view of the blight that afflicts our times."

Rajan argues that the extraordinary steps taken by the Federal Reserve and other central banks in the heat of the financial crisis and recession was brave and correct. However, he points out that the policies of ultra-low interest rates since the end of the crisis have not restored the economy to health, and worries about some of the risks and problems that are being stored up.

"Hindsight is 20–20. It now seems obvious that central banks should have done what they did then, but in many ways, the central banks were making it up as they went. Fortunately for the world, much of what they did was exactly right. They eased access to liquidity through innovative programs such as TALF, TAF, TARP, SMP, and LTRO. By lending long term without asking too many questions of the  collateral they received, by buying assets beyond usual limits, and by focusing on repairing markets, they restored liquidity to a world financial system that would otherwise have been insolvent based on prevailing market asset prices. In this matter, central bankers are deservedly heroes in a world that has precious few of them. ... Be that as it may, the second stage of the rescue was to stimulate growth with ultra-low interest  rates. And thus far, the central banks have been far less successful."

For all the hot-tempered rhetoric about the actions of the Federal Reserve since about 2009, the truth is that economists don't have strong theory or evidence on how these policies should work. Rajan writes: 
"Churchill could well have said on the subject of unconventional monetary policy, “Never in the field of economic policy has so much been spent, with so little evidence, by so few”. Unconventional monetary policy has truly been a step in the dark."

Rajan offers some discussion of the potential issues with a policy of sustained ultra-low interest rates. For example:

  •  "[F]inancial risk taking may stay just that, without translating into real investment. For instance, the price of junk debt or homes may be bid up unduly, increasing the risk of a crash, without new capital goods being bought or homes being built. ... As just one example, the IMF’s Global Financial Stability Report (Spring 2013) points to the re-emergence of covenant lite loans as evidence that greater risk tolerance may be morphing into risk insouciance.
  • "[A]ccommodative policies may reduce the cost of capital for firms so much that they prefer labor-saving capital investment to hiring labor. ...  Excessive labor-saving capital investment may defeat the very purpose of unconventional policies, that is, greater employment. Relatedly, by changing asset prices and distorting price signals, unconventional monetary policy may cause overinvestment in areas where asset prices or credit are particularly sensitive to low interest rates and unanchored by factors such as international competition. For instance, the economy may get too many buildings and too few machines, a consequence that is all too recent to forget."
  • "The spillovers from easy global liquidity conditions to cross-border gross banking flows, exchange rate appreciation, stock market appreciation, and asset price and credit booms in capital receiving countries – and eventual overextension, current account deficits, and asset price busts has been documented elsewhere, both for pre-crisis Europe and post-crisis emerging markets."
  • Politicians may avoid taking necessary reforms, because they unwisely believe that central bankers have all the tools necessary to bring long-term economic health.
  • "Exiting central bankers have to be prepared to “enter” again if the consequences of exit are too
    abrupt. Will exit occur smoothly, or in fits and starts, or abruptly? This is yet another aspect of
    unconventional monetary policies that we know little about."