by Mario Rizzo
What has been disappointing about the recent stimulus vs. austerity debate is the recycling of arguments that have been gone over many times before in many newspapers and blogs. The debate has become tiresome and unenlightening.
The major feature of the debate that is responsible for the lack of enlightenment is, well, its unrelenting macro-aggregate character. The main variables are excess demand for goods, excess supply of financial assets, total government spending, deficit to GDP ratios, government debt to GDP ratios, the confidence of economic agents in government bonds (as measured by yields), and so forth.
Is there anything important going on beneath the surface – factors that have a more direct causal relationship to the decisions of real economic agents?
Now a breath of fresh air!
I recently came across some articles on the dangers of prolonged very low interest rates. They appear in The Economist, American Economic Association’s Papers and Proceedings (“The Credit Crisis” by Douglas Diamond and Raghuram Rajan), the Annual Report of the Bank for International Settlements, a summary blog post by Rajan, and most recently a Financial Times article by Rajan, “Bernanke Must End the Era of Ultra Low Rates.” All of these are well-worth studying.
What is particularly interesting about this work is that it shows that important distortions can be produced by excessively low interest rates before either “full employment” is reached or the price level begins to rise at all. Below are some of my own observations based on reading the above articles and papers.
1. Let us remember that the housing-market bubble occurred without any major episode of price-level inflation. The collapse of innovative derivative securities was also not the result of price-level inflation. Therefore, right at the outset we should be suspicious of those who concentrate their attention on unemployment, inflation, and government debt.
2. One of the most important distortions of prolonged periods of very low interest rates is the increase of incentives to bear risk. This is sometimes described as the search for yield. Modern finance theory suggests that the optimal tradeoff between expected return and risk shifts in the direction of greater risk when expected returns fall. (Tyler Cowen has a good discussion of this in a business cycle context in his book, Risk and Business Cycles.)
3. Unfortunately, the precise extent and nature of this additional risk is not easy to identify ex ante. The more unprecedented economic conditions are, the less relevant is recent experience. Increased leverage makes for increased uncertainty.
4. While the effect of Fed policy is initially on short-term interest rates, the effect spreads to longer-term rates. There are a number of mechanisms by which this occurs. However, if short-term interest rates are expected to be low for a substantial period, banks will finance longer-term loans with short-term debt. The profits generated by the spread between very low short rates and higher long rates will encourage this.
5. In general, one danger of this banking activity is that a more future-oriented real capital (or production) structure will be encouraged by the fall in long rates but be quite vulnerable to the rise in short-rates under the control of the Fed. This is a case where the plans of the savers and providers of loanable funds are not in fundamental (or long-run) coordination with those who supply or create the real capital structure.
However, at this particular point in the business cycle the danger is more that there will not be sufficiently rapid re-allocation of resources away from the unsustainable sectors.
6. In the long-run view, the present period of ultra low interest rates is part of the process by which moral hazard is created. If banks know that when they get into trouble by responding in a boom to low interest rates, they will be rescued by another recessionary period of low interest rates, it is difficult to see why they should stop engaging in problematic behavior.
The current period of low interest rates needs to be reversed, in my view, before the traditional macroeconomic warning signs of trouble appear. The problem will not show itself in the grand aggregates until it is too late.