by Andreas Hoffmann and Gunther Schnabl*
With central bank balance sheets and government debt levels exploding, discomfort about future inflation arises. A discussion about the appropriate exit strategy from low-interest rate policies has started. The standpoints of central banks are different. The ECB seems more decisively in favour of an early exit. The Federal Reserve discusses the technical aspects rather than an early timing (see Mario’s earlier blog entry). The Bank of Japan is said not to exit earlier than in five years. What situation are we facing? A return to monetary policies that are neutral to inflation and bubbles is unlikely for four reasons:
(1) Policy markers in industrial countries tend to use monetary policies asymmetrically. This asymmetry started in the 1980s in Japan. To promote growth of the export-led economy the Bank of Japan lowered interest rates in periods of appreciation, but did not raise them proportionally when the yen depreciated (for more). Finally interest rates fell to zero in the aftermath of the 1997/98 Asian crisis. Greenspan and Bernanke have followed a similar pattern with respect to stock markets (more). While they cut interest rates decisively during crisis, they hesitantly raised them in boom periods. Thus, the US interest rate level fell towards zero in the current crisis. In Europe as well, the interest rate reached a historical low in the latest slump.
(2) Even though it makes sense that central banks “give increased accommodation and extend thereby their circulation in order to prevent panics” (Hayek 1967: 108), the described structural fall of the interest rate level lowers the marginal productivity of investment (see Mario’s entry) and depresses growth. Thus lifting interest rates becomes difficult, as bad investment would be dismantled and/or bubbles burst (more).
(3) As long as interest rates can be lowered, the state budget remains stable. However, as soon as the zero-interest rate bound is reached, fiscal stimulus is intensified and government debt may skyrocket, as in Japan since the late 1990s. The higher the level of government debt, the higher will be the pressure on the central bank to keep the interest rate low. Japan is a „good“ example. As gross government debt has increased to more than 200 percent of GDP, the interest rate has to remain close to zero to keep the debt service under control.
(4) This raises the question of whether the institutional independence of central banks can resist the pressure of governments to monetize the debt. The Bank of Japan has been de facto downgraded to a branch of the government since the 1990s. In the US fiscal and monetary policies are coordinated. The personal mobility between central bank, financial markets and government seems to blur the institutional separation. Also in Europe, an appreciation pressure on the euro will make it difficult to defend a restrictive course in monetary policy.
Thus, the political will is at the core for a decisive exit from easy monies and structural distortions. But both voters and politicians seem reluctant. They may rather prefer to laminate reforms with expansionary fiscal and monetary policies. From this perspective inflationary tendencies and new bubbles seem likely, while long-term growth will further slow down.
*Gunther Schnabl is professor of economic policy and international economics at Leipzig University (Germany). Andreas Hoffmann is a doctoral candidate at his chair and currently visiting New York University.
For more see: Hoffmann, A. and Schnabl, G. 2009: A Vicious Cycle of Manias, Crashes and Asymmetric Policy Responses – An Overinvestment View.