federal reserve bank of dallas

7/31/2019 Federal Reserve Bank of Dallas

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Federal Reserve Bank of Dallas

Globalization and Monetary Policy Institute

Working Paper No. 126http://www.dallasfed.org/assets/documents/institute/wpapers/2012/0126.pdf

Ultra Easy Monetary Policy and the Law of Unintended Consequences*

William R. White

August 2012

Abstract

In this paper, an attempt is made to evaluate the desirability of ultra easy monetary policy byweighing up the balance of the desirable short run effects and the undesirable longer runeffects the unintended consequences. The conclusion is that there are limits to whatcentral banks can do. One reason for believing this is that monetary stimulus, operating

through traditional (flow) channels, might now be less effective in stimulating aggregatedemand than previously. Further, cumulative (stock) effects provide negative feedbackmechanisms that over time also weaken both supply and demand. It is also the case thatultra easy monetary policies can eventually threaten the health of financial institutions andthe functioning of financial markets, threaten the independence of central banks, and canencourage imprudent behavior on the part of governments. None of these unintendedconsequences is desirable. Since monetary policy is not a free lunch, governments musttherefore use much more vigorously the policy levers they still control to support strong,sustainable and balanced growth at the global level.

JEL codes: E52, E58

* William R. White is currently the chairman of the Economic Development and Review Committee at the

OECD in Paris. He was previously Economic Advisor and Head of the Monetary and Economic

Department at the Bank for International Settlements in Basel, Switzerland. +41(0)79-834-90-66.

[email protected]. The views in this paper are those of the author and do not necessarily reflect the

views of organizations with which the author has been or still is associated, the Federal Reserve Bank of

Dallas or the Federal Reserve System.


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2

UltraEasyMonetaryPolicyandtheLawofUnintendedConsequences2

ByWilliamWhite

A. IntroductionThecentralbanksoftheadvancedmarketeconomies(AMEs)

3haveembarkedupononeofthe

greatesteconomicexperimentsofalltime ultraeasymonetarypolicy.Intheaftermathofthe

economicand financial crisiswhichbegan in the summerof2007, they loweredpolicy rates

effectivelytothezerolowerbound(ZLB).Inaddition,theytookvariousactionswhichnotonly

causedtheirbalancesheetstoswellenormously,butalsoincreasedtheriskinessoftheassets

theychosetopurchase.Theiractionsalsohadtheeffectofputtingdownwardpressureontheir

exchangeratesagainstthecurrenciesofEmergingMarketEconomies(EMEs).Sincevirtuallyall

EMEs tended to resist thispressure4, their foreign exchange reserves rose to record levels,

helpingtolowerlongtermratesinAMEsaswell.Moreover,domesticmonetaryconditionsin

theEMEswereeasedaswell.Thesizeandglobalscopeofthesediscretionarypoliciesmakes

themhistoricallyunprecedented.EvenduringtheGreatDepressionofthe1930s,policyrates

andlongertermratesinthemostaffectedcountries(liketheUS)wereneverreducedtosuch

lowlevels5.

In the immediate aftermath of thebankruptcy of Lehman Brothers in September 2008, the

exceptional measures introduced by the central banks of major AMEs were rightly and

2Theviewsexpressedherearepersonal.Theydonotnecessarilyrepresenttheviewsoforganizationswithwhich

theauthorhasbeenorstillisassociated.3Itisimportanttonotethat,inspiteofmanysimilaritiesinthepoliciesofvariousAMEcentralbanks,therehave

alsobeenimportantdifferences.SeeWhite(2011),4ThisphenomenonwasnotinfactconfinedtoEMEs.AnumberofsmallerAMEs,likeSwitzerland,havealso

resistedupwardpressureontheirexchangerates.5SeeBankforInternationalSettlements(2012)Graph1V.8

This long run is a misleading guide tocurrentaffairs. In the long runwearealldead. Economists set themselves too

easy,toouselessatask if intempestuous

seasons theycanonly tell thatwhen the

stormislongpasttheseaisflatagain.

JohnMaynardKeynes

Noverydeepknowledgeofeconomicsisusually needed for grasping the

immediate effectsof ameasure;but the

task of economics is to foretell the

remoter effects, and so to allow us to

avoid such acts as attempt to remedy a

present illbysowingtheseedsofamuchgreaterillforthefuture.

LudwigvonMises


3/45

3

successfullydirected to restoring financial stability. Interbankmarkets inparticularhaddried

up,andtherewereseriousconcernsaboutafinancialimplosionthatcouldhavehadimportant

implicationsfortherealeconomy.Subsequently,however,asthefinancialsystemseemedto

stabilize,thejustificationforcentralbankeasingbecamemorefirmlyrootedinthebeliefthat

suchpolicieswererequiredtorestoreaggregatedemand6afterthesharpeconomicdownturn

of2009. Inpart,thiswasaresponsetotheprevailingorthodoxythatmonetarypolicy inthe

1930shad

not

been

easy

enough

and

that

this

error

had

contributed

materially

to

the

severity

of the Great Depression in the United States.7 However, it was also due to the growing

reluctance to usemore fiscal stimulus to support demand, given growingmarket concerns

abouttheextenttowhichsovereigndebthadbuiltupduringtheeconomicdownturn.Thefact

thatmonetarypolicywas increasingly seen as the only game in town implied that central

banks in some AMEs intensified their easing even as the economic recovery seemed to

strengthen through 2010 and early 2011. Subsequent fears about a further economic

downturn,reopeningtheissueofpotentialfinancialinstability8,gavefurtherimpetustoultra

easymonetarypolicy.

FromaKeynesianperspective,basedessentiallyonaoneperiodmodelofthedeterminantsof

aggregatedemand,itseemedclearlyappropriatetotrytosupportthelevelofspending. After

the recession of 2009, the economies of the AMEs seemed to be operating well below

potential,andinflationarypressuresremainedsubdued.Indeed,variousauthorsusedplausible

versions of the Taylor rule to assert that the real policy rate required to reestablish a full

employmentequilibrium(andpreventdeflation)wassignificantlynegative.Suchfindingswere

usedtojustifytheuseofnonstandardmonetarymeasureswhennominalpolicyrateshitthe

ZLB.

Thereis,

however,

an

alternative

perspective

that

focuses

on

how

such

policies

can

also

lead

to

unintendedconsequencesover longer timeperiods.This strandof thoughtalsogoesback to

thepreWarperiod,whenmany businesscycletheorists9focusedonthecumulativeeffectsof

bankcreatedcredit onthesupplysideoftheeconomy. Inparticular,theAustrianschoolof

thought, spearheadedbyvonMisesandHayek,warned that creditdrivenexpansionswould

6SeeinparticularBernanke(2010).ThereasonsforconductingQE2seemtodiffersubstantiallyfromthereasons

forconductingQE1.7Bernanke(2002)8ThecatalystforthesefearswasasharpslowdowninEurope.Thiswasdrivenbyconcernsaboutsovereigndebtin

anumberofcountriesintheeurozone,andassociatedconcernsaboutthesolvencyofbanksthathadbecome

overexposed

to

both

private

and

sovereign

borrowers.

Also

of

importance

were

fears

of

the

fiscal

cliff

in

the

US.

Thisinvolvedexistinglegislationwhich,unlessrevised, wouldcuttheUSdeficitbyabout4percentofGDP

beginninginJanuary2013.Asdiscussedbelow,thisprospecthadachillingeffectoncorporateinvestmentand

hiringwellbeforethatdate.9Foranoverview,seeHaberler(1939). Laidler(1999)hasaparticularlyenlighteningchapteronAustriantheory,

andthemaindifferencesbetweentheAustriansandKeynesians.Hethennotes(p.49)Itwouldbedifficult,inthe

wholehistoryofeconomicthought,tofindcoexistingtwobodiesofdoctrinewhichsogrosslycontradictone

another.


4/45

4

eventuallyleadtoacostlymisallocationofrealresources(malinvestments)thatwouldendin

crisis.BasedonhisexperienceduringtheJapanesecrisisofthe1990s,Koo(2003)pointedout

that an overhang of corporate investment and corporate debt could also lead to the same

result(abalancesheetrecession).

Researchers at the Bank for International Settlements have suggested that amuch broader

spectrum of credit driven imbalances10, financial aswell as real, could potentially lead to

boombustprocessesthatmightthreatenbothpricestabilityandfinancialstability11.ThisBIS

wayofthinkingabouteconomicandfinancialcrises,treatingthemassystemicbreakdownsthat

could be triggered anywhere in an overstretched system, also hasmuch in common with

insightsprovidedby interdisciplinaryworkoncomplexadaptive systems.Thiswork indicates

thatsuchsystems,builtupasaresultofcumulativeprocesses,canhavehighlyunpredictable

dynamics and can demonstrate significant non linearities12. The insights of George Soros,

reflectingdecadesofactivemarketparticipation,areofasimilarnature.13

Asatestimonytothiscomplexity,ithasbeensuggestedthatthethreattopricestabilitycould

alsomanifest

itself

in

various

ways.

Leijonhufvud

(2012)

contends

that

the

end

results

of

such

creditdrivenprocessescouldbeeitherhyperinflationordeflation14,with theoutcomebeing

essentially indeterminate prior to its realization. Indeed, Reinhart and Rogoff (2009) and

Bernholz (2006) indicate that there are ample historical precedents for both possible

outcomes.15

As to the likelihood that creditdrivenprocesseswilleventually lead to financial

instability, ReinhartandRogoff(2009)notethatthis isacommonoutcome,thoughtheyalso

10Animbalanceisdefinedroughlyasasustainedandsubstantialdeviationfromhistoricalnorms,forwhich

thereisnocompellinganalyticalexplanation.11

See

in

particular

the

many

works

authored

or

coauthored

by

Claudio

Borio,

including

Borio

and

White

(2003).

SeealsoWhite(2006).TheoriginsofthiswayofthinkinggobacktotheworkofAlexanderLamfalussyandpossibly

evenbefore.SeeClement(2010)ontheoriginsofthewordmacroprudential,whosefirstrecordeduse atthe

BISwasin1979.12

Thereisalonghistory(althoughnevermainstream)oftreatingtheeconomyasacomplex,adaptivesystem.It

goesbacktoVeblenandevenbefore.However,thisapproachreceivedsignificantimpetuswiththefoundingof

theSantaFeInstituteintheearly1990s.SeeWaldrop(1992).Forsomerecentapplicationsofthistypeofthinking

seeBeinhocker(2006)andHaldane(2012). Fromthisperspective,aneconomysharescertaindynamic

characteristicswithothercomplexsystems.Buchanan(2002)suggeststhefollowing.First,crisesoccuronaregular

basisincomplexsystems.Theyalsoconformtoa PowerLawlinkingthefrequencyofcrisestotheinverseoftheir

magnitude.Second, predictingthetimingofindividualcrisesisimpossible.Third, there isnorelationship

betweenthesizeofthetriggeringeventandthemagnitudeofthesubsequentcrisis.Thiswayofthinkinghelps

explainwhytheGreatModerationcouldhavebeenfollowedbysuchgreatturbulence,andwhymajoreconomic

criseshave

generally

emerged

suddenly

and

with

no

clear

warning.

13Soroshaswrittenprolificallyonthesethemesovermanyyears.Forarecentsummaryofhisviews,seeSoros

(2010)14

Inearlierpublications,Leijonhufvudreferredtothecorridorofstabilityinmacroeconomies.Outsidethis

corridor,hesuggeststhatforcesprevailwhichencourage anever wideningdivergencefromequilibrium.Seealso

White(2008)15

Thishelpsexplainthecoexistencetodayoftwoschoolsofthoughtamonginvestorsaboutfutureprice

developments.


5/45

5

note that theprocessmorecommonlybeginswitha recession feedingbackon the financial

systemthantheotherwayaround16. ReinhartandReinhart(2010)documenttheseverityand

durabilityofdownturnscharacterizedbyfinancialcrisis,implyingthatthiscomplicationwould

seemmore likely to shift thebalanceofmacroeconomicoutcomes towardsdeflation rather

thaninflation.

Inthispaper,anattemptismadetoevaluatethedesirabilityofultraeasymonetarypolicyby

weighing up the balance of the desirable short run effects and the undesirable longer run

effectstheunintendedconsequences.InSectionB, itissuggestedthattherearegroundsto

believethatmonetarystimulusoperatingthroughtraditional (flow)channelsmightnowbe

lesseffective in stimulatingaggregatedemand than is commonlyasserted. InSectionC, it is

further contended that cumulative (stock) effects provide negative feedbackmechanisms

that also weaken growth over time. Assets purchased with created credit, both real and

financial assets,eventuallyyield returns that are inadequate to service thedebts associated

withtheirpurchase.Inthefaceofsuchstockeffects,stimulativepoliciesthathaveworkedin

thepasteventuallylosetheireffectiveness.

It is also argued in SectionC that,over time,easymonetarypolicies threaten thehealthof

financial institutions and the functioning of financial markets, which are increasingly

intertwined.Thisprovidesanothernegative feedback loop to threatengrowth.Further, such

policiesthreatentheindependenceofcentralbanks,andcanencourageimprudentbehavior

on thepartofgovernments. Ineffect,easymonetarypoliciescan lead tomoralhazardona

grand scale17.Further,onceon such apath, exitbecomesextremelydifficult. Finally,easy

monetarypolicyalsohasdistributionaleffects,favoringdebtorsovercreditorsandthesenior

management of banks in particular. None of these unintended consequences could be

remotelydescribed

as

desirable.

Theforceoftheseargumentsmightseemto leadtotheconclusionthatcontinuingwithultra

easymonetarypolicyisathoroughlybadidea.However,aneffectivecounterargumentisthat

such policies avert near term economic disaster and, in effect, buy time to pursue other

policiesthatcouldhavemoredesirableoutcomes. Amongthesepoliciesmightbesuggested18

moreinternationalpolicycoordinationandhigherfixedinvestment(bothpublicandprivate)in

AMEs.Thesepolicieswouldcontributetostrongeraggregatedemandatthegloballevel.This

wouldpleaseKeynes.Aswell,explicitdebt reduction,accompaniedby structural reforms to

redressotherimbalancesandincreasepotentialgrowth,wouldmakeremainingdebtsmore

easilyserviceable.ThiswouldpleaseHayek.Indeed,itcouldbesuggestedthatacombinationof

16SeeReinhartandRogoff(2009)p.145. Severefinancialcrisesrarelyoccurinisolation.Ratherthanbeingthe

triggerofrecession,theyaremoreoftenanamplificationmechanism.17

ThisisdiscussedfurtherinWhite(2004)18

White(2012b)


6/45

6

all these policiesmust be vigorously pursued ifwe are to have any hope of achieving the

strong,sustainedandbalancedgrowthdesiredbytheG20.Wedonotliveinaneitheror

world.

Thedangerremains,ofcourse,thatultraeasymonetarypolicywillbewronglyjudgedasbeing

sufficient to achieve these ends. In that case, the bought timewould in fact have been

wasted19.Inthiscase,theargumentspresentedinthispaperthenlogicallyimplythatmonetary

policyshouldbetightened,regardlessofthecurrentstateoftheeconomy,becausethenear

term expected benefits of ultra easymonetary policies are outweighed by the longer term

expectedcosts.Undoubtedlythiswouldbeverypainful,but(bydefinition)lesspainfulthanthe

alternativeofnotdoingso.JohnKennethGalbraithtoucheduponasimilarpracticalconundrum

someyearsagowhenhesaid20

Politicsisnottheartofthepossible.

Itischoosingbetweentheunpalatableandthedisastrous.

ThismightwellbewherethecentralbanksoftheAMEsarenowheaded,absentthevigorous

pursuitbygovernmentsofthealternativepoliciessuggestedabove.

B.WillUltraEasyMonetaryPolicyStimulatetheRealEconomy?Stimulative monetary policies are commonly referred to as Keynesian. However, it is

importanttonotethatKeyneshimselfwasnotconvincedoftheeffectivenessofeasymoneyin

restoring realgrowth in the faceofaDeepSlump.This isoneof theprincipal insightsof the

GeneralTheory.21

Incurrentcircumstances,twoquestionsmustbeaddressed.First,willultra

easymonetary conditionsbeeffectively transmitted to the realeconomy?Second,assuming

theanswer

to

the

first

question

is

yes,

will

private

sector

spending

respond

in

such

away

as

to

stimulatetherealeconomyandreduceunemployment? It issuggested inthispaperthatthe

answertobothquestionsisno.

a) UltraEasyMonetaryPolicyandtheTransmissionMechanismWhen thecrisis first started in the summerof2007 the responseofAME centralbankswas

quite diverse. Some, like the ECB, remained focused on resisting inflationwhichwas rising

under the influence of higher prices for food and energy.Others, like the Federal Reserve,

loweredpolicy rates swiftly andby unprecedented amounts.However,by the end of 2008,

19GovernorShirakawaoftheBankofJapanhasmadethisargumentparticularlyforcefully.SeeShirakawa(2012a

and2012b). ItalsoresonatesstronglyinbothEuropeandtheUnitedStates.Theirrespectivecentralbankheads

haverepeatedlycalledongovernmentstotakethenecessarymeasurestodealwithfiscalandotherproblemsthat

areultimatelygovernmentresponsibilities.SeealsoIssing(2012)p3andFisher(2012).Bothhavestressed

repeatedlythatthatthereareclearlimitstowhatcentralbankscando.20

Galbraith(1993).21

SeeKeynes (1936)


7/45

7

againstthebackdropofthefailureofLehmanBrothersanddeclininginflation,virtuallyallAME

central banks were in easing mode and policy rates were reduced virtually to zero. This

responseshowedclearlythecapacityofcentralbankstoact.Atthesametime,havinglowered

policyratestoorneartheZLB,theseactionsalsoimpliedaseriouslimitationonthefurtheruse

oftraditionalmonetarypolicyinstruments.Further,astimeworeon,doubtsbegantoemerge

abouttheeffectivenessofsomeofthetraditionalchannelsoftransmissionofmonetarypolicy.

An important source of concern was whether lower policy rates would be effectively

transmittedalongtheyieldcurvetolongermaturities.Duetothepotentiallyinteractingeffects

ofrisingtermandcreditspreads,longratesmightfalllessthannormally(orindeedmighteven

rise) in response to lower policy rates. This phenomenon has already beenwitnessed in a

numberofperipheralcountriesintheeurozonearea.Afteryearsofdeclininglongratesdriven

by convergence trades, prospects of continuing slow growth (or even recession) in these

countriesraisedconcernsaboutthecontinuedcapacityoftheirgovernmentstoservicerising

debt levels.TheEuropeanCentralBanktook variousstepstosupportthepricesofsovereign

bonds in the various countries affected, but these measures have not thus far proved

successful.22

Incontrast,forsovereignsdeemednottohavecounterpartyrisk,therehasbeennoevidence

of suchproblems. Indeed, long term sovereign rates in theUS,Germany, Japan and theUK

followedpolicyratesdownandarenowatunprecedented low levels.However,therecanbe

noguaranteethatthisstateofaffairswillcontinue.Onedisquietingfactisthattheselongrates

havebeentrendingdown,inbothnominalandrealterms,foralmostadecadeandthereisno

agreementastowhythishasoccurred.23

Manycommentatorshavethusraisedthepossibility

of a bondmarket bubble thatwill inevitably burst24. Further, long term sovereign rates in

favoredcountries

could

yet

rise

due

to

growing

counterparty

fears.

In

all

the

large

countries

notedabove,therequiredswing intheprimarybalanceneededjusttostabilizedebttoGNE

ratios(athighlevels),isverylarge25. Suchmassivereductionsingovernmentdeficitscouldbe

22TheECBdirectlypurchasedsuchbondsin2010and2011underitsSMP program.Morerecentlyithasextended

LTROfacilities,withsomeofthefundsprovidedbeingusedbybankstopurchasebondsissuedbytheirnational

sovereigns.CriticsofthesepoliciescontendthattheECBcouldlowerthesebondspreadsifitweretoannouncea

targetforsuchspreadsandmakecredibleitswilltoimposeit.Forvariousreasons,botheconomicandpolitical,

theECB

has

thus

far

chosen

not

to

do

this.

However,

it

remains

an

open

issue.

23Forafulleranalysisofthepotentialcontributingfactors,seeTurner(2011)

24Perhapsthebestknownmarketparticipanttoexpress thisviewwasBillGrossofPimco,thoughhehas

subsequentlychangedhismind.25

Forcalculationsindicatinghowlargetheneededswingmightbe,seeCecchettietal(2010).Theircalculations

indicatetheprimarysurplusmustswingby15percentagepointsofGDPintheUnitedKingdomandJapan,and11

percentagepointsintheUnitedStates.Generallyspeaking,theadjustmentsrequiredinlargecontinental

Europeaneconomiesaresmaller.


8/45

8

hard toachieve inpractice. In theUSand Japan, inparticular,theabsenceofpoliticalwillto

confrontevidentproblemshasalreadyledtodowngradesbyratingagencies26.

Asforprivatesectorcounterpartyspreads,mortgagerates inanumberofcountrieshavenot

followedpolicyratesdowntothenormalextent.IntheUnitedStatesinparticular,astheFed

Funds rate fell sharply from 2008 onwards, the 30 year FNMA rate declined much less

markedly27. In part, widening mortgage spreads reflect increased concentration in the

mortgagegrantingbusinesssincethecrisisbegan,andalso increasedcostsduetoregulation.

However,italsoreflectsthe globallossoftrustinfinancialinstitutions,whichhasledtohigher

wholesale funding costs. Inaddition, costsof fundshave risen inmanycountriesdue to the

failureofdepositratestofullyreflectdeclinesinpolicyrates28.Afullerdiscussionoftheeffects

oflowinterestratesonthefinancialindustryisreservedforlater

Spreads for corporate issueshave also fallen less thanmightnormallyhavebeen expected,

even iftheabsolutedeclinehasbeenverysubstantial.Nevertheless,thesespreadscouldrise

again if the economywere toweaken or even if economic uncertaintieswere to continue.

Paradoxically,arise

in

corporate

spreads

might

even

be

more

likely

should

governments

pursue

credibleplansforfiscaltightening29.Theseplansmightwellinvolvetaxincreasesandspending

cutsthatcouldhavematerialimplicationsforbothforwardearningsandcompaniesnetworth.

Thiscouldconceivablyincreaseriskpremiaoncorporatebonds.A further concern is that the reductions in real rates seen to date, associated with lower

nominalborrowingratesandseeminglystable inflationaryexpectations,mightatsomepoint

beoffsetbyfallinginflationaryexpectations.Inthelimit,expectationsofdeflationcouldnotbe

ruledout.This infactwasan importantpartofthedebt/deflationprocess firstdescribedby

IrvingFisher in1936.Theconventionalcounterargumentisthatsuchtendenciescanbeoffset

by articulation of explicit inflation targets to stabilize inflationary expectations. Evenmore

powerful,acentralbankcouldcommittoaprice leveltarget,implyingthatanypricedeclines

wouldhavesubsequentlytobeoffsetbypriceincreases30.

However,thereareatleasttwodifficultieswithsuchtargetingproposals.Thefirstismakingthe

target credible when the monetary authorities room for maneuver has already been

26TherecentratingsdowngradeoftheUS wasnotduetoanychangeintheobjectiveeconomiccircumstances.

Rather,itreflectedanassessmentthatadysfunctionalCongresswasincreasinglyunlikelytomakethe

compromisesnecessarytoachieveameaningfulreductionoftheUSdeficit.27

Moreover,

average

effective

rate

on

outstanding

US

mortgages

fell

even

less;

homeowners

with

negative

effectiveequitywereunabletorefinancetheirmortgagesatlowerrates,asinearliercycles.28

OnthisgeneralquestionoftheincreasedcostoffinancialintermediationseeLowe(2012).29

SeeDugger(2011).DuggerintroducestheconceptofFiscalAdjustmentCost(FAC)discounting.Hecontendsthat

companiesarealreadyassessingtheeffectsoffiscalconstraintontheirownbalancesheetsandearnings.Ineffect

theybegintotreatlongtermfiscalshortfallsaspresentvalueoffbalancesheet(corporate)liabilities.30

Thisisverysimilartotheprocessthatworkedunderthegoldstandard.Fallingpriceswereexpectedtoreverse,

thusloweringtheexanterealinterestrateandencouragingpricestorise.


9/45

9

constrained31

by the zero lower bound problem (ZLB). The second objection is evenmore

fundamental;namely,thepossibilitythat inflationaryexpectationsarenotbasedprimarilyon

central bankers statements of good intent. Historical performance concerning inflation,

changing perceptions about the central banks capacity and willingness to act, and other

considerationscouldallplaya role.Theempiricalevidenceon this issue isnotcompelling in

eitherdirection32.

Lower interest rates arenot theonly channel throughwhichmonetary conditions inAMEs

mightbeeased further.Whethervia lower interestratesorsomeothercentralbankactions,

reflationary forces could be imparted to the real economy through nominal exchange rate

depreciation33andtheresultingincreaseincompetitiveness

34.However,animportantproblem

withthisproposedsolutionisthatitworksbestforasinglecountry.Incontrast,virtuallyallthe

AMEsareneartheZLBanddesirousoffindingotherchannelstostimulatetherealeconomy.

Evidently,thisstillleavesthepossibilityofabroadernominaldepreciationofthecurrenciesof

AMEsvisavisthecurrenciesofEMEs. Indeed,giventhetradesurplusesofmanyEMEs(not

leastoilproducers),andalsotheinfluenceoftheBalassaSamuelsoneffect,arealappreciation

oftheircurrenciesmightbethoughtinevitable.

The problem restswith the unwillingness ofmany EMEs to accept nominal exchange rate

appreciation;thesocalledfearoffloating.Tothisend,theyhaveengagedovermanyyearsin

large scale foreignexchange intervention andeasierdomesticmonetarypolicies thanwould

otherwise have been the case.More recently, the rhetoric concerning currencywars has

sharpenedconsiderably,andanumberofcountriesturnedforatimetocapitalcontrols35.The

principal concernabout these trends inEMEs is that theymight lead toamore inflationary

domesticoutcome36.

Another channel throughwhichmonetarypolicy is said towork is throughhigherprices for

assets,inparticularhousesandequities. Ineffect,higherpricesaresaidtoaddtowealthand

this in turn spurs consumption. Before turning (below) to the latter link in this chain of

causation,considertheformerone.Inthosecountriesinwhichthecrisisraisedconcernabout

thehealthof thebanking system (eg;US,UK, Ireland,Greece, Spain)housepricesbegan to

31ForanelegantdescriptionofthisproblemseeYamaguchi(1999).Eventoday,theBankofJapanrefusestoseta

targetforinflation,butratherespousesalessambitiousgoal32

SeeGalatiandMelick(2004).AlsoGalati,HeemiejerandMoessner(2011)whichprovidesasurveyofrecent

theoryandtheavailableempiricalevidence.33

Svenson

(2003)

34Howlongnominaldepreciationresultsinarealdepreciationisanotherhighlydebatedissue.Inflationwould

presumablybelessofaproblemincountrieswithhighlevelsofexcesscapacity.ExperienceofdepreciationinLatin

Americancountriesoverdecadesindicatesthisneednotalwaysbethecase.35

Interestingly,theIMFnowseemsmorewillingthanhithertotoacceptbothlargescaleinterventioninforeign

exchangemarketsandcapitalcontrols.SeeOstryetal(2010)36

RecenteffortsinChinatoraisedomesticwagesinordertospurdomesticconsumptionworkinthesame

direction.


10/45

10

declinesharplyearlyinthecrisis.Lowerpolicyrateswerenotsufficienttoreversethistrend.In

contrast, in countrieswhere thehealthof thebanking systemwasnever a serious concern,

housepricesdidcontinuetoriseaspolicyrateswere lowered.Thishasraisedconcernsofan

eventualandaggravatedcollapse.

As forequityprices, stock indices in theAMEsdid recovery substantially afterpolicyeasing

began.However, it isalsonotablethatthese increasesbegantomoderate in thesummerof

2010andagaininthemiddleof2011.Ineachcase,theannouncementofsomenonstandard

policymeasurethencausedstockpricestoriseonceagain.Morebroadly,however,thevery

fact that a number of central banks felt the need to have recourse to such non standard

measures indicates that standard measures had failed to produce the stimulative effect

desired.Thedurabilityof real gains supportedby theexpansionof nominal instruments

alsoseemshighlyquestionable.

Finally, an evaluation is needed of the effectiveness of themany non standardmonetary

policymeasuresthathavebeentakenbycentralbanksinlargeAMEs,pursuanttoreachingthe

ZLB37.The

highly

experimental

nature

of

these

measures

is

attested

to

by

various

differences

observedinwhatdifferentcentralbankshaveactuallydone.AsdescribedbyFahretal(2011)

thereareimportantdifferencesbetweenthepracticesoftheFedandtheECB.

Perhapsmost important, the Fed seems to have treated its non standardmeasures as a

substitute for standard monetary policy at the ZLB. In contrast, the ECB treats them as

measures to restore market functioning so that the normal channels of the transmission

mechanism policy can work properly. Second, while the Fed made increasingly firm pre

commitments(thoughstillconditional)tokeepthepolicyratelowforanextendedperiod,the

ECB consciouslymadeno suchpre commitmentThird,whereas the Fedhaspurchased the

liabilitiesofnon financialcorporationsaswellasthoseofTreasuryandFederalagencies, the

ECBhaslentexclusivelytobanksandsovereigns.

Fourth,whiletheECBconductedonlyrepos, in

order tofacilitateexitfromnonstandardmeasures,theFedmadeoutrightpurchases.

Manyof thenon standardmeasures taken todate arebroadly similar to thoseundertaken

earlierby theBankof Japan. It is instructive therefore that the Japanese authorities remain

highly skeptical of their effectiveness38

in stimulating demand. Perhaps themost important

reason for this is that thedemand forbank reserves tends to rise tomatch the increase in

supply; inshort, loangrowthdoesnotseemtobemuchaffected. If, inexpandingthereserve

base,the

central

bank

also

absorbs

collateral

needed

to

liquefy

private

markets,

that

too

could

beanegativeinfluence.Thistopicisreturnedtobelow.

37ForanearlyanalysisseeBorioandDisyatat(2009)

38Shirakawa(2012a,2012b)


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11

Itisofcoursetruethatstillmoreaggressiveunconventionalmeasurescouldbeintroducedthat

mighthavetheeffectdesired.Indeed,inchastisingtheBankofJapanforitstimidity,Bernanke

(2000)and(2003)explicitlysuggestedtargetsfor longterm interestrates,depreciationofthe

currency,ahigherinflationtarget(say3to4percent)andfiscalexpansionentirelyfinancedby

the central bank. Unfortunately, for each of these policy suggestions there is a convincing

counterargument.

Explicittargetsforlongrateshardlyseemrequiredwithlongratesalreadyatrecordlows.Asfor

thedifficultiesofachievingacurrencydepreciation,thesehavebeendiscussedabove. Recent

suggestions for a higher inflation target39

have also generated wide spread criticism,

particularly since inflation in AMEs has stayed stubbornly and unexpectedly high to date.

Finally,fiscalexpansionentirelyfundedbymonetarycreationcould,givenAMEsovereigndebt

levelsgenerallythoughtofasunsustainable,easilyraisefearsoffiscaldominanceandmuch

higherinflation.Perhapstheclearestindicationoftheforceofthesecounterargumentsisthat

Chairman Bernanke, having proposed these policies almost a decade ago, has not found it

appropriate to reassert themmore recently, in spiteof theongoingand (again)unexpected

weaknessoftheUSrecovery40.

b) Would privatesectordemandrespondtoeasiermonetaryconditions?Conventionalthinking isthat lower interestrateswillencouragehouseholdstosave less(and

consume more) and will encourage companies to investmore. In both cases, spending is

broughtforwardfromthefuture,becausethediscountratehasbeenreduced.Evenabstracting

fromthe influenceofcumulativestockconsiderations(bothrealandfinancial)onspending41,

thisconventionalthinkingcanbechallengedinanumberofways.

Aconsideration

that

applies

to

both

household

and

company

spending

is

the

message

given

by

ultra easymonetary policy. To the extent that suchmeasures are unprecedented, indeed

smackingofdesperation,theycouldactuallydepressconfidenceandthewilltospend.Keynes

referencestoanimalspiritsintheGeneralTheorywouldseemappropriatehere.Indeed,the

greater the respectheldby thepublic for the centralbank inquestion, themore likely this

outcomemightbe.Higherrespectwouldincreasethelikelihoodthatthepublicwouldbelieve

thatthecentralbankhadidentifiedproblemsthattheythemselveshadnotforeseen.

39SeeBlanchardetal(2011)

40Ball(2012)ratherattributestoadifferentcausetheunwillingnessofBernanketopursuehisearlierpolicy

prescriptions.BallsuggeststhatgroupthinkandashypersonalitypreventedBernankefromspeakingout

forcefullyatanFOMCbriefingin2003.Atthismeeting,hisearliersuggestionswereessentiallyruledoutbythe

Fedstaff. IthinkithighlyimplausiblethatthesecharactertraitswouldhaveseriouslyconditionedBernankes

behavioroverthenextnineyears,particularlyafterhebecametheChairmanoftheFOMC.41

Tobedealtwithinthenextsectionofthepaper.


12/45

12

Anumberofotherconsiderationsmightaffecthouseholdspending inparticular.Perhaps the

mostimportanthastodowiththeassumedpositiverelationshipbetweentheinterestrateand

the desired rate of saving.While it is conventional wisdom that lower interest rates will

stimulateconsumption,Bailey (1992)andothershave longargued thateven thesignof this

relationship isambiguous.Suppose that savershaveapredeterminedgoal for theminimum

amount of savings theywish to accumulate over time. Thiswould correspond to someone

wishingto

purchase

an

annuity

of

acertain

size

upon

retirement,

at

adesired

age.

Evidently,

a

lowerinterestratealwaysimpliesaslowerrateofaccumulation.But,ifinfacttheaccumulation

ratebecomessolowthatitthreatenstheminimumaccumulationgoal,theonlyrecourse(other

thanpostponingretirement)willbetosavemoreinthefirstplace42.Aswillbediscussedbelow,

asimilarlogicaffectsthebehaviorofthosefinancialinstitutions(likeinsurancecompanies)who

havecommittedtoprovidingannuitiesorwhoofferdefinedbenefitpensions.

The distributional (income) implications of interest rate changes for aggregate household

spending also receive too little attention. Very low rates imply less household disposable

incomeforcreditorsandmoredisposableincomefordebtors.Shouldthemarginalpropensity

to consume of creditors (say older, credit constrained people living off accumulated assets)

exceedthatofdebtors,theneteffectofredistributioncouldbeto lowerhouseholdspending

rather than raise it43. This argument has in the past been invoked occasionally by central

bankers inEMEs. More recently,Lardy (2012)andRogoff (2011 )havebothrecommended

endingfinancialrepressioninChinaasawaytoraisehouseholdconsumption.Thecoreoftheir

argumentisthathigherinterestrateswouldraisedisposableincomeandconsumptioninturn.

Finally,theargumentthathigherwealth(generatedbylowerratescausingrisingassetprices)

will leadtomoreconsumerspending alsoneedsseriousreevaluation.Whilenotdenyingthe

empiricalrobustness

of

this

relationship

in

the

past,

the

argument

suffers

from

aserious

analytical flaw. Lower interest rates cannot generate wealth, if an increase in wealth is

appropriatelydefined as the capacity tohave ahigher future standardof living44. From this

perspective, higher equity prices constitute wealth only if based on higher expected

productivity and higher future earnings. This could be a byproduct of lower interest rates

stimulatingspending,butthisissimplytoassumethehypothesismeanttobeundertest.

As for higher house prices raising future living standards, the argument ignores the higher

futurecostoflivinginahouse.Rather,whathigherhousepricesdoproduceismorecollateral

againstwhichloanscanbetakenouttosustainspending.Inthiscase,however,theloanmust

42Strictlyspeakingthisconclusionfollowsonlyiftherateofgrowthofproductivity(andeconomicpotential)has

alsofallen.Thustheremustbeanincreaseinsavingtoreconstitutelostwealth.43

AsWalterBagehotputitoveracenturyagoJohnBullcanstandmanythings,buthecannotstandtwoper

cent.44

SeeBailey(1992)andMerton(2006)


13/45

13

be repaidat the costof future consumption45.No wealthhas in factbeencreated. Inany

event, asnoted above,houseprices inmany countrieshave continued to falldespite lower

policyrates46.Thisimpliesthattheneedforpaybackcannolongerbeavoidedbystillfurther

borrowing.

Anumberofcounterargumentscanalsobemadetothehypothesisthatultraeasymonetary

policywillraisecorporate investment. Firstnotethefactthat investment,asaproportionof

GDP, has been trending down inmostAMEs in recent years. This has occurred in spite of

generally solid corporate profits, healthy balance sheets, large cash reserves and very low

interestratesoveranumberofyears.Anumberofreasonshavebeensuggestedtoexplainthe

lackofinvestmentresponsetothesepropitiousfinancialconditions.

Thefirsthasbeenanenvironmentofevergrowinguncertaintyaboutanumberof important

issues; future domestic demand in light of uncertainty aboutjob prospects, future foreign

demandgivenuncertaintyaboutexchangeratesandprotectionism,anduncertaintyastohow

theburdenoffiscalrestraintandpossiblesovereigndebtreductionmightaffectthecorporate

sector.A

second

set

of

concerns

is

closely

related.

In

many

AMEs

anti

business

rhetoric

is

becomingmorecommonandthepoliticalmomentumseemstobeshiftingtowardsextremism.

Moreover,growingconcernsaboutrising income inequality(returnedtobelow)andconcerns

abouttheethicalstandardsofthebankingcommunitycouldalltooeasilybeconverted intoa

broaderantibusinessagenda47.

Athirdreasonforcontinuinglowinvestmentseemstohavebeenaseculartrend onthepartof

corporatemanagementsinAMEstomaximizecashflow.Theincentiveforthisshorttermism

couldbe that it allows for largerpayouts forboth salariesanddividends,also raisingequity

pricesand

the

value

of

management

options

in

the

bargain.

Evidently,

however,

such

behavior

comesattheexpenseofbothfixedcapitalinvestmentandthefuturehealthofthefirmitself.

If

low interest ratesencourage firmstoborrowmoremoney,which theycanuse for thesame

shorttermpurposes,thenpresumablythelongertermdamagewillbeevenworse.

Ithasevenbeensuggestedthatlowinterestrateshavethemselvescontributedtolowerfixed

investment inAMEs.One channelwouldbe viahigher commodityprices (as a resultof the

public sector investment boom in China),which raises costs in AMEs and reduces profits.

Perhapsmore importantly,manycorporations stillhavesignificantobligations in the formof

definedbenefitpensionplans.Ramaswamy (2012)presentsachillingquantitativeanalysisof

the effectsof interest rate changesonpublicpension funds anddefinedbenefit funds. The

45SeeMuellbauer(2007)andWhite(2006b)

46SomeestimatesindicatethatUShouseholdersequityintheirhousesfellfromapeakofabout$10trillionto$6

trillionattheendof2011.47

Forananalysisofantibusinessattitudesinthe1930s,undertheRooseveltadministration,seePowell(2003)

andSmiley(2000).


14/45

14

essenceoftheargumentisthatlowerinterestratesreducetheassetrevenuesofpensionfunds

andraisethepresentvalueoffuture liabilities.Fundingshortfallseventuallyhavetobemade

upbythesponsoringcompany,reducingprofitsandfundsavailableforinvestment.

ArecentreportbytheconsultingfirmMercerindicatesthatthe1500leadingcompaniesinthe

UShadapensiondeficitof$689billionasofJuly2012;i.e.,theyareonly70percentfunded.In

theUK, the Pension Protection Fund recently estimated that almost 85 percent of defined

benefitplanswereunderfunded,withacumulativeshortfallofover$400billion48.Moreover,

proposedchangestopensionrules,incountriesusingIFRSaccountingstandards,seemlikelyto

maketheimpactoflowratesoncompanieswithsuchpensionfundssignificantlyworse49.

To summarize, there are significant grounds forbelieving that the various channels through

whichmonetarypolicymightnormallyoperateareat leastpartiallyblocked.Moreover,there

are also grounds forbelief thatneitherhouseholdnor corporate spending would react as

vigorously as in the past, even if the traditional transmission channels were functioning

properly.Notetoothattheissueofdebtstocks,otherimbalances,andthepossibilityofa

creditcrunch

affecting

the

real

economy

have

not

yet

even

been

mentioned.

These

influenceswillalsoweighonboththecapacitytospendandthewilltospend,furtheroffsetting

theinfluenceofultraeasymonetarypolicies.Aswell,suchpolicescanhaveotherunintended

consequenceswhichmightalsotendtogrowovertime.

C. CouldUltraEasyMoneyHaveUnintendedConsequences?Theunexpectedbeginningofthefinancialandeconomiccrisis

50,anditsunexpectedresistance

topolicymeasurestakentodate,leadstoasimpleconclusion.Thevarietyofeconomicmodels

usedbymodernacademicsandbypolicymakersgivefewinsightsastohowtheeconomyreally

works51.Ifweacceptthisignoranceasanundesirablereality,thenitwouldalsoseemhardto

deny thepossibility that thepolicyactions taken in recentyearsmightalsohaveunintended

consequences. Indeed, itmustbenoted thatmanypreWarbusinesscycle theorists focused

theirattentiononpreciselythispossibility.

Perhaps a goodjumping off point for such analysesmight be the pioneeringwork of Knut

Wicksel. Hemade thedistinctionbetweenthenaturalrateof interest,whichequalizedex

48Evenasofmid2010,whenbondyieldsweresignificantlyhigherthaninearly2012,therewereestimatesthat

sustainedlowratesimpliedthathalfofUKcompaniesarebust.SeeJohnson(2010).49

Under

proposals

outstanding

as

of

June

2012,

companies

will

no

longer

be

able

to

defer

recognition

of

actuarial

gainsandlosses.Currently,theycandosousingthesocalledcorridormethod.Inaddition,companieswillno

longerbeabletoassumealowerratefordiscountingliabilitiesthantheassumedrate(oftenunreasonablyhigh)

atwhichassetsaccumulate.50

TheWEO,publishedbytheIMFinthespringof2008,predictedrealgrowthintheadvancedeconomiesin2009

of3.8percentofGDP.Theactualoutcomewas 3.7 percent, aforecasterrorof7.5 percentagepointsofGDP.

Theywerebynomeansaloneinmissingthisdramaticturnaround.51

FormoreonthisseeWhite(2010)


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15

antesavingandinvestmentplans,andthefinancialrateofinterest,setbythebankingsector.

Differences between the twowere thought by him to lead to undesired pricemovements

and/or to economic imbalances, the importance ofwhichwould depend on the size and

durationofthedifferencesbetweenthetworates

Werewetoadoptthisanalyticalframework,policymakerstodaywouldseemtohaveserious

causeforconcern. Thenaturalrateofinterest(real)fortheglobaleconomyasawholecan

beproxiedby thepotential rateofgrowthof theglobaleconomy,asestimatedby the IMF.

Reflectingglobalizationandtechnologytransfer,thismeasurehasbeenrisingsteadilyforthe

lasttwentyyears. Incontrast,ifoneproxiesthefinancialrateofinterest(real)byanaverageof

availablebreakeven rates (say for tenyearTIPS), thismeasurehasbeen falling for the last

twentyyears.Moreover,atthegloballevel,thenaturalrateofinterestroseabovethefinancial

rate in1997, and thegaphasessentiallybeenwideningever since52. From thisperspective,

underlyinginflationarypressuresand/orimbalanceshavealreadybeencumulatingformany

years. Since recent ultra easymonetary policy initiatives are effectively stillmore of the

same, there would then seem to be a prima facie case for raising concerns about the

unintendedconsequencesofmonetaryeasing.

Without asserting the correctness of any particular view, the approach taken below is to

identifytheconcernsraisedbythemacrotheoristsquotedaboveandthentoevaluatewhether

currentcircumstanceswouldseemtoindicatethattheirviewsmightbejustified.Theconcerns

associatedwithrapidcreditandmonetarygrowthwould includerising inflation,misallocation

of real resources (notonly increditupswingsbut indownswingsaswell),and theeffectsof

imbalanceswhichcouldleadtoprotractedrecessionsandevendebtdeflation.

a) ThelikelihoodofrisinginflationPerhapsthefirstquestiontobeaddressedishowinflationwasavoidedintheAMEsduringthe

manyyearsthatfinancialrateswerewellbelownaturalratesandcreditgrowthwasvery

rapid53? One possible answer is that a growing commitment by central banks to the

maintenance of low inflation succeeded in anchoring inflationary expectations. This

explanation,however,ishardtoreconcilewiththeobjectivefactofrapidmonetaryandcredit

expansionengineeredbycentralbanksoverthatperiod.

Amoreplausible(oratleastcomplementary)explanation wouldbethemajorincreaseinthe

rate

of

growth

of

potential

in

the

EMEs,

accompanied

by

a

series

of

investment

busts

in

a

numberof countries;Germany after reunification, Japanafter the bubble,SouthEastAsia

52SeeBIS(2007)andHanoun(2012)Graph4.Hanounalsoprovidesevidence(Graph5)that,forthelastdecadeat

least,theglobalpolicyratehasgenerallybeenwellbelowtheratesuggestedbyaglobalTaylorrule.Fora

descriptionofthechangesincentralbankbalancesheets,seeBankforInternationalSettlements(2012),p40.53

AlternativeexplanationsfortheGreatModerationarediscussedatlengthinBorioandWhite(2003)


16/45

16

after theAsiancrisis,and theUSaftertheTMTcrashoftheearly2000s. Ineffect,asecular

increaseinglobalsupplywasmetbyadecreaseinglobaldemandwiththepredictableresultof

reducing inflation54.Thisprovidedthecontext inwhicheasymonetarypoliciescouldbemore

easilypursued.

Looking forward, the likelihoodof rising inflation in theAMEswould seem tobe limited. In

mostcountriesthereappearstobeasignificantdegreeofexcesscapacity,andSectionBabove

impliesthatultraeasymonetarypolicyisunlikelytoremedythisproblemquickly.Nevertheless,

some sourcesofconcern remain. In somecountries, like theUK,exchange ratedepreciation

couldhavean impactoninflation.Crisisrelatedreductions inthe levelofpotentialcouldalso

provegreater than iscurrentlyexpected,55leaving room forpolicymistakes.Finally,asudden

shift in inflationary expectations, perhaps linked to furthermeasures to extend ultra easy

monetarypolicies,cannotnotbecompletely ruledout.While inflationexpectationsshowno

trends(awayfromdesiredlevels)inrecentyears,theydoseemtohavebecomemorevolatile.

AperhapsmorepressingproblemisthepossibilityofsharplyhigherinflationinEMEs.Inpart

dueto

their

fear

of

floating,

many

EMEs

seem

to

be

operating

near

full

capacity,

and

monetary conditions are generally very loose. Aswell, the rate of growth of potential now

seemstobeslowingafterprevioussharpincreases56.Thiscouldinturn,viathehigherpriceof

imports, leadto inflationacceleratingunexpectedly intheAMEsaswell. Ineffect,thiswould

bea reversalof the seculardisinflationary impulses sentbyEMEs to theAMEs inprevious

years.SinceAMEcentralbanksunderestimatedtheimportanceofthepositivesupplyshocksin

earlier years, it is not unlikely that theywould also fail to recognize the implications of its

reversal.

While suchan inflationaryoutcomemightbejudgeduseful in resistingdebt/deflationof the

Fisher type, rising inflation alongwith stagnantdemand inAMEswould clearly implyother

serious problems for the central banks of AMEs. On the one hand, raising policy rates to

confront rising inflationcouldexacerbatecontinuingproblemsof slackdemandand financial

instability.Ontheotherhand,failingtoraisepolicyratescouldcauseinflationaryexpectations

torise.Further,weredifferentcentralbankstoresponddifferently,astheydidin2008,there

mightalsobeunwelcomeeffectsonexchangerates.

54Amoredetailed analysisisavailableinWhite(2008).SeealsoIssing(2012)p10.

55TheOECDestimatesthatthelevelofpotentialintheOECDcountriesfellaftertheonslaughtofthecrisisby

about3percentonaverage.Theystress,however,thattheseestimatesarehighlyimprecise.56

AsEMEsbegintoindustrialize,theyinitiallyhavethebenefitofrapidurbanization(asagriculturalproductivity

rises)andtheinternationaltransferoftechnology.Overtimebothofthesecatchupfactorssupportinggrowth

becomelessimportant.


17/45

17

b) MisallocationsofrealresourcesNewbooks,articles in thepopularpressandeven rapvideos indicate thattheKeynesHayek

debateoftheearly1930s isonagain.Itremainshighlyrelevanttothe issueofwhetherultra

easy monetary policies might have unintended consequences. Keynes was fundamentally

interestedindemandsidepoliciesthatwouldreviveeconomiesinaDeepSlump.Incontrast,

HayekandothermembersoftheAustrianschoolwerefundamentallyinterestedinsupplyside

issues.They rather focusedonhow theeconomygot intoaDeepSlump in the firstplace,

consciousofthepossibilitythatremedies(moreofthesame)mightactuallymakethingsworse

overtime.

TheAustrian conclusionwas that credit createdby the banking system, rather than the on

lendingofgenuinesavings ,would indeedspurspendingbutwouldalsocreatemisallocations

of real resources (malinvestments). These supply side misallocations would eventually

culminate in an economic crisis. Moreover, similar to Wicksel, they concluded that the

magnitudeofthecrisiswouldbecloselyrelatedtotheamountofexcesscreditcreatedinthe

previousupswing.

Jorda,

Schularick

and

Taylor

(2012),

using

data

from

14

AMEs

dating

back

to

the1870s,provideconvincingempiricalevidence thatthe intuitionofWickselandHayekon

thispointwasessentiallycorrect57.Asimilarconclusionarisesfromthehistoricaldatausedby

ReinhartandReinhart (2010),and from recentUSdatabasedondifferences in localmarket

economicconditions58.

Thisconclusiondoesnot,however,logicallyruleoutthepossibilitythatHayekandKeyneswere

bothright. Itissimplyafactthattheeconomydoeshavebothademandsideandasupply

side. It isalsoafactthatpolicyactionsdohavebothneartermand longerterm implications.

Thus,demandsidestimulusmightwellworktostimulate theeconomy inthenearterm,but

suchstimulusmightcomewithalongertermprice. Evaluationoftheneartermbenefitsand

longertermcostsofmonetarystimulusis,infact,thecentralthemeofthispaper.

Inpractice,Keynesianthinkinghasalmostcompletelydominatedthepolicyagendaformostof

thepostWarperiod.Thus,thepredominantconsiderationforpolicymakers59

hasbeenthenear

termeffectsofmonetaryeasingonaggregatedemand,andtheassociatedimpactoninflation.

Over the last twodecadesor so,with inflationnear target levelsoreven threatening to fall

57See

also

Reinhart

and

Reinhart

(2011)

58MianandSufi(2011)relatethemagnitudeoflocaldownturnsintheUS(primarilyinthenontradedsector)to

thedegreeofhouseholdborrowingthatbuiltupinthesamelocalityduringtheboom.59

VirtuallyallAMEcentralbanksgiveprideofplacetoafirstpillar;namelytheirestimateoftheoutputgapand

itseffectoninflationviaanaugmentedPhillipscurve.FirsttheBundesbank,butnowalsotheECB,haveasecond,

monetarypillarwhichrelateslowfrequencymovementsinmonetaryaggregatestolongerterminflationary

trends.Thisisstillverydifferentfromlookingatcreditdevelopmentsfortheirpossibleunintended

consequences,particularlyonthesupplysideoftheeconomy.


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18

belowtarget,policymakerssaw littleneedtoraise interestrates incyclicalupturns.Similarly,

thereseemednoimpedimenttovigorousmonetaryeasingindownturns.

Even within the Keynesian framework, however, these policies might now be thought

questionable.Asnotedjustabove,thedisinflationarytrendsobserved in theglobaleconomy

were in large part the result of positive supply shocks, rather than solely due to deficient

demand.Theyshouldinprinciplehaveelicitedadifferentandtighterresponse60.Viewedfrom

an Austrian perspective, the policy errorwas even graver. Below the surface of the Great

Moderation, such policies encouraged financial exuberance61

which allowed significant

malinvestmentstobuildupinbothphasesofsuccessivecreditcycles.62

Thesedevelopments

aredocumentedbelow.

1) MisallocationsinthecreditupswingIn a comprehensive review of pre War theories of business cycles, Haberler (1939)

distinguishedbetweentwo formsof malinvestmentthatarise intheupswingofthecredit

cycle:verticalandhorizontal. Verticalmalinvestmentsimplyanintertemporalmisallocation.It

occurs when easy and cheap access to credit causes an inordinate shift towards capital

investments,andparticularlyto longer livedcapital investments.Forthesamereason,saving

rateswouldbereducedanddebtsallowedtoaccumulate. Thesewouldeventuallyconstrain

futurespending63justatthetimetheincreasedsupplypotentialwascomingonline. Horizontal

malinvestmentsareinvestmentsinparticularsectorsthateventuallyleadtoexcesscapacity.

Inbothkindsofmalinvestment,theeventualoutturnisacollapseinprofits.Thisresultsinthe

forced termination of further investment in projects already well advanced, less new

investment in general, and an investment collapse in those particular sectors that had

expandedthe

most

during

the

credit

upswing.

Looking

at

developments

over

the

last

decade

or

so,itisveryeasytofindevidenceofsuchprocessesatwork.

60Thereisacuriousasymmetryhere.Ithasbeenwellacceptedfordecadesthatnegativesupplyshocks,for

exampleincreasesinenergypricespushingupinflation,neednotcausepolicyratestorise. Thelogicwasthatfirst

round shiftsinthepricelevelcouldbetoleratediftheyhadnosecondroundeffectsonwagesandinflation.

Incontrast,positivesupplyshocksdidinpracticeseemtoleadtolowerratesthanotherwise.Onthisissue,see

Beckworth(2008).Perhapsthecluetotheasymmetryisthat,inbothcases,policyrateswinduplowerthan

otherwisewhichtendstobebotheasyandpopular.61

Issing(2012)notes(p3)thatacombinationofinflationtargetingandsupplysideshockscanturnpolicyintoan

independentsource

of

instability(It)

fuels

financial

exuberance

and

financial

exuberance

in

turn

creates

financial

imbalances.62

OnreturningfromavisittotheUSinthelate1920s,Hayekforetoldadeepslump.Onbeingtoldthiswas

impossible,becauseUSpriceswereessentialstable,Hayekapparentlyrespondedthatthiswaspreciselythe

evidenceofanunderlyingproblem. Increasesinproductivityshouldhavebeenpushingpricesdown,butcredit

expansionwasholdingthembackup.63

Ineffect,savingswouldproveinadequatetopurchaseallofthegoodsandservicesprovidedbytheincreased

investmentgeneratedartificiallybycreditreceivedfromthebankingsystem.


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19

First, consider verticalmalinvestments. In theyearsofeasy credit conditionspreceding the

onsetofthecrisis,investmentinthehousingstockinvirtuallyeveryAMErosesharply64.House

prices rosemarkedly,asdidhousing starts inmost cases.The fact that thesedevelopments

wereunsustainable isnowalltooevident. Incountries liketheUS,theUK,Spainand Ireland,

thehousingdownturnisalreadywelladvanced,housepricescontinuetofall,andconstruction

activityhasslowedmarkedly.Insomeothercountries(Canada,Sweden,Denmark,Norwayetc.)

houseprices

have

continued

to

rise

and

construction

activity

remains

elevated.

Nevertheless,

concernsaboutoverbuildinginthesecountriesarebeingexpressedevermoreforcefully65.

Similarly, inmanyEMEs relativelyeasy credit conditionshave also led to sharp increases in

constructionactivityandinhouseprices.Inmanycases,notleastChinaandBrazil,activityhas

focusedontheproductionofhighendpropertieswhichremainvacantaftertheirpurchase.

Giventhisoverhangofinventory,itisnothardtobelievethatadownturnwillproveinevitable.

Since housing is long lived, cannot be readilyused for other purposes, and is generally not

internationallytradable,theeffectsofthisparticularkindofmalinvestmentcouldbefeltfora

longtime.

Anotherexampleofverticalmalinvestmentswouldbethemassive increases in infrastructure

investment, largelyprivatelyfinanced,whichoccurredgloballypriortotheonsetofthecrisis.

Indeed,inmid2008,theEconomistmagazinecalledthisinfrastructureinvestmentthebiggest

boominhistory66.Whilethisprivatesectorboomcametoahaltwiththeonsetofthecrisis,it

wasreplacedinpartbypublicsectorspendingoninfrastructure.Thishasbeenmostmarkedin

China,whereoverallspendingoninvestmentsince2008hashoverednear50percentofGDP.

Neithertheprivatesectornorpublicsectorphasesofthisinvestmentboomwouldhavebeen

possiblewithoutreadyaccesstorelativelycheapcredit.Indeed,intheChinesecase,thecentral

authoritieslargely

avoided

fiscal

expansion

by

explicitly

ordering

Chinese

banks

to

provide

the

loansrequiredbylowerlevelsofgovernmenttomeettheirspendinggoals.

Large scale spending on infrastructure is not in itself a bad thing. Inmany circumstances,

particularly inEMEs, the social rateof returnmightbeexpected towellexceed the costof

financing.However, there is accumulating empirical evidence thatmany large infrastructure

projects cost far more to build than originally estimated and produce far fewer benefits.

Flyvbjerg(2009)givesmanyexamplesof largeprojects inAMEsthatwouldneverhavebeen

builtifexpostestimatesofbenefitsandcostshadbeenavailable.HecitestheChannelTunnel,

64AmongtheAMEs,onlyGermany,SwitzerlandandJapanfailedtoreflectthesedevelopments.Inpart,thiswas

becauseallthreecountrieswerestillrecoveringfromtheirown,earlier,housepricebubbles.65

SuchconcernshavebeenexpressedinthevariouscountryreviewsorganizedbytheEconomicandDevelopment

ReviewCommitteeoftheOECD.Australia,NewZealand,Canada,theScandinaviancountriesandanumberof

othersallseemtobeexposedinthisregard.66

TheEconomist(2008)


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20

theDanishGreatBeltTunnel,theBigDiginBostonandtheMillenniumDomeamongahost

ofothers.

Flyvbjerg notes as well three global trends that increase the likelihood of infrastructure

investmentsbecomingmalinvestments.The first isthetrendtowardsmorerapidspending,

drivenby the exigenciesof spendingquicklyduring adownturn. This raises the riskofboth

wasteandcorruption.Thesecond istherisingproportionofglobal infrastructurespending in

EMEs,giventhepresumptionthatgovernanceofsuchprojectsmightbeevenworse than in

AMEs67. In China, for example, the dominant influence of the Communist Party on both

borrowers and lenders ishard to reconcilewithobjective assessmentof thenetbenefitsof

suggestedprojects.68

Third, infrastructureprojectseverywhereare increasinglydependenton

IT and communications systems,where large projects have an evenmore dismal record of

accomplishmentthanprojectsinothersectors.

Athirdexampleofverticalmaladjustment,promptedbyeasycreditconditions,hasbeenthe

massivebuildupofexportcapacityinmanycountriesinSouthEastAsia.Lowinterestratesin

theimporting

AMEs

ensured

high

levels

of

consumption

and

ready

markets.

Conversely,

in

the

exporting countries, low interest rates encouraged investment to satisfy those demands.

Government commitment to export led growth strategies also implied resisting upward

exchangeratepressures,andencouragedeasiermonetarypolicyinturn.Today,manyofthese

exportingcountriesremainheavilyreliantonsalestoAMEs69

whosedebtsaresuchthatthey

cannolongeraffordto borrowtofinancesuchsales.

A fourth and final example of vertical maladjustment is provided by the sharp drop in

household saving ratesovermany years in anumberofAMEs,mostnotably in the English

speaking countries. Inmany of these countries, house priceswere rising rapidly during the

periodofrapidlyexpandingcredit.Somehouseholdslikelybelieved(wrongly)thattheywerein

factwealthierasaresult,andspentmoreaccordingly. Insomecountries,mostnotablythe

UnitedStates,higherhousepricesalsoprovidedmorecollateraltosupportfurtherborrowing.

Sinceintheearlyyearsofthiscenturythereweresignificantfearsof inadequatedemandand

potentially even deflation, this borrowingwaswelcomedby policymakers as intertemporal

optimization. However, at the time, little or no attention was paid to the fact that such

67Flyvbjergultimatelyblamesbadgovernanceforthesebadoutcomes.Ineffect,thoseputtingtogetherprojects

consciouslyunderestimatecostsandoverestimatebenefits.Theydothistomaketheirprojectsmore

competitivewith

others

in

the

search

for

funding,

especially

from

governments.

68SeeMcGregor(2010)forabroaderdiscussion.Foramorespecificexample,Chinaisintentonbuildingover

20000kilometersofhighspeedrailtacktolinkupitsmajorcities.Atthesametime,thereistobeamassive

expansionofairportservicetothesamedestinations.Noteaswell,thatmanyprestigeprojectsfavoredbylocal

governmentsaredesignedtooutdotheprojectsofotherlocalgovernments.Thisarecipeforovercapacity.69

Thisisnottodenysuccessfuleffortsbyanumberofcountries,includingChina,toexpandmarketsinother

EMEs.Ofcoursethisstillleavesthebroaderquestionoftherobustnessofthetotalityofthosemarkets inthe

eventofaseriousdownturnintheAMEs.


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21

optimizationwouldbydefinition require payback and could act as a serious constrainton

growthinthefuture70.

Theneed for payback ismost clearlyevident in sharp increases inhouseholddebt service

ratiosinmanycountries71.TheseincludetheEnglishspeakingcountriesnotedabove,butalsoa

number of peripheral countries in Europe aswell. Further, perhaps linked to the fear of

floating phenomena discussed above, many EMEs now also have record high levels of

householddebt service to copewith.Such countries include someof the largestand fastest

growingoftheEMEs;China, India,BrazilandTurkey inparticular.While it istrue thatthese

increasesinEMEshavecomeoffverylowlevels,thespeedoftheincreasehasbeennotable,

andmightwellhaveoutpacedthecapacityofthelocalfinancialsystemstoaccuratelyestimate

thecapacityofborrowerstorepay.Indeedbymid2012,thepercentageofnonperformingcar

loans in Brazil had already jumped sharply. Whether in AMEs or EMEs, the need for

households to deliver adds a further reason to doubt that ultra easymonetary policy can

sustainablystimulatetherealeconomy.

Noris

it

difficult

to

find

evidence

for

the

buildup

of

horizontal

(sectorial

malinvestments)

during

the last upswing of the credit cycle. Themost obvious example is seen in the construction

industryinmanycountries,mostlybutnotexclusivelyintheAMEs.Evidently,thiswasclosely

related to the increased spendingonhousing and infrastructure referred to above72.Closely

related,thefinancialsectoralsoexpandedveryrapidlypriortothestartofthecrisis in2007,

beforeimplodingimmediatelyafterwards.Theglobalautomotiveindustrywitnessedamassive

increase in production capacity, not only prior to 2007, but also afterwards as automakers

extrapolated past increases in sales in EMEs far into the future. China in particular was

estimatedtohavesixmillionunitsofunutilizedcapacityin2011(twicethesizeoftheGerman

carmarket)

73

,with

dealers

also

struggling

with

ahuge

increase

in

inventory.

Finally,

there

was

alsoasubstantialincreaseincapacityintherenewableenergyindustry.Asaresult,thepriceof

solarpanelsandwindpoweredturbinescollapsedafterthecrisisbeganandmanyproducers

facedbankruptcy.

70ThisproblemisanalogoustothatfacedbyJapanesecorporationsinthe1990s,aftermanyyearsofdebt

financedinvestmentwhichprovedunprofitable. Koo(2003)stronglycontendsthattheweaknessofinvestment

spendinginJapaninthe1990swasduetothisbalancesheeteffect,andwasnotduetoashortageofloans

causedbyaweakenedbankingsystem.71

SeeBIS(2012)p29forafullerdocumentation.AlsoseeMcKinsey(2010)whoidentifythehouseholdsectorin

fiveof

the

fourteen

countries

they

consider

as

having

ahigh

probability

of

future

deleveraging.

They

identify

Spain,

theUS,theUK,CanadaandKorea.WhilethehouseholdsectorsinBrazil,Russia,ChinaandIndiawerenotjudged

tobeoverleveraged,notethatthedataconsideredextendedonlyto2009.Thusthereportmissedtherecent

sharpincreasesinhouseholddebtlevelsinthosecountries.72

Increasedspendinggenerallyresultsinmoreproduction,butnotnecessarily. Supplyresponsivenessinthe

constructionindustryinfactvarieswidelyacrosscountries.Forexample,theresponseintermsofnewhousing

startswasmuchgreaterintheUSthantheUK,duetotheverystrictplanningandzoningrestrictionsinthelatter.73

SeeKPMGGlobal(2012)


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22

Beyondtheseincreases intheglobalcapacitytoproducefinalgoodsandservices,therewere

markedexpansionsinthecapacitytoproduceintermediateandprimarygoodsaswell.Muchof

thiswasdrivenbydevelopmentsinChinawhereproductivecapacitywasstillexpandingrapidly

as of mid 2012 The steel and aluminium industries head a long list of sectors where

overcapacityhasbeenevident fora long time74.As forprimaryproducts,heavy investments

havebeenmadeinLatinAmerica,inAustralia,andanumberofothercountriestoproduceand

exportbasic

commodities

to

support

the

development

efforts

in

South

East

Asia.

Should

any

linkinthisdemandchainprovefaulty,theseinvestmentsinprimaryproductscouldalsoprove

much less profitable than is currently anticipated. Finally, there has been a commensurate

increase inthecapacityoftheglobaldistribution industry,not leastcontainershipsandbulk

shipping,whosefuturecouldbesimilarlyexposed.

2) MisallocationsinthecreditdownswingEconomicdownturns,whatevertheircause,arealwayspainful.Outputthatmighthavebeen

produced is lost, and unemployment rises.Moreover, those lesswell off, oftenmarginally

attachedto

the

work

force,

seem

to

suffer

the

most.

This

is

the

familiar

Keynesian

argument

for

usingmacroeconomicstimulusinsuchcircumstancestoraiseaggregatedemand75.However,as

alluded to above, preWar economic theorists thought downturns also had some positive

qualities. For those concerned about rapid credit expansion and malinvestments, the

downturnsimplyrevealstheunsustainabilityofthepreviousexpansionanditsinevitableend.

The downturn was then a time of necessary rebalancingwith resources shifting from less

productivetomoreproductiveuses.Schumpeterinparticularstressedtheopportunitieswhich

excessresourcesprovidedtoentrepreneurshavingnewideasandnewproductstheconcept

ofcreativedestruction. Fromthisperspective,monetarypolicychoicesinadownturnshould

againbalance

off

short

term

benefits

against

longer

term

costs.

ConsistentwiththedominanceoftheKeynesianparadigm,monetarypolicyhasbeenusedwith

increasingvigoroverthelastquartercenturytoaddressprospectiveoractualdownturnsinthe

economy. For example,USmonetary policywas eased significantly in 1987 after the stock

marketcrashofOctober. Itwas furthereasedsharply in theearly1990s,after theproperty

boomandthecollapseoftheSavingsandLoanAssociations. Inspiteofunemploymentfalling

wellbelowprevailingestimatesoftheUSNAIRU,theUSfailedtoraiseratesin1997reflecting

concernsaboutthepossibleglobaleffectsofthecrisisinSouthEastAsia.In1998,thefailureof

74SeeEuropeanChamberofCommerceinChina(2009).Inpresentingthereport,thePresidentoftheChamber

saidOurstudyshowstheimpactofovercapacity issubtlebutfarreaching,affectingdozensofindustriesand

damagingeconomicgrowth,notonlyinChinabutworldwide.Notethatthiswaswrittenbeforethefurtherspurt

ininvestmentspendingin2010.75

Recall,however,thatKeynesGeneralTheory(1936)wasdirectedtotheissueofDeepSlumps.Itisnotthen

clearthatKeyneswouldhaverecommendedsimilarpoliciesinthefaceofactualsmalldownturns,muchless

preventiveeasingtoprecludeevenprospectivedownturns.


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23

LTCM led to explicit easing. This was followed in 2001 by an unprecedentedly vigorous

monetarypolicy response toan impending slowdown,aggravatedby the stockmarketcrash

and theeventsofSeptember11.Finally,beginning in2007,monetarypolicywas furtherand

dramaticallyeasedinthevariouswaysdescribedatthebeginningofthispaper.

The followingparagraphswill focuson the longer term, cumulative,effectsof suchpolicies.

First,there isevidencethatallowing malinvestments topersist canreducepotentialgrowth

rates.Second,itcanbecontendedthattheaggressiveeasingofpolicyinsuccessivecyclesled

to serial bubbles of various sorts. In effect, these serial bubbles constrained the normal

process throughwhichmalinvestmentswould have been purged in the course of a typical

cyclicaldownturn.

The contention that easymonetary conditions lower the rateof growthofpotential isnotwithout counterarguments. On the one hand, some would contend that easy monetary

conditions inadownturnhelpthereallocationofrealresourcesfrom lesstomoreproductive

industries76.Aswell,iftheeconomyrecovers,thentheacceleratormechanismcanalsoleadto

morecapital

investment77.

These

arguments,

however,

must

also

consider

the

various

forces

(consideredabove)thatarecurrentlyactingtorestraininvestment.Ontheotherhand,tothe

extent that low interest ratesdodiscourage saving,capitalaccumulationwillbediscouraged

over time. Very low risk free rates, dominated by the actions of central banks, can also

mislead and contribute to costlymisallocations.Moreover, it ispossible thateasymonetary

conditionsactuallyimpede,ratherthanencourage,thereallocationofcapitalfromlesstomore

productiveuses.

This last argument rests on the contention that banks will offer advantageous borrowing

conditionstotraditionalcustomersinadownturn,evenwhentheysuspecttheyareinsolvent.

Peek and Rosengreen (2003) have investigated this phenomenon in Japan, and evidence of

similarbehaviorhas emerged inboth theUK and continental Europemore recently.78

Such

behavioronthepartofbanksisencouragedwhentheycanborrowverycheaply,andalsowhen

theyexpectthateasymoneywill leadtorecoveryand improvedprospectsfortheirclients.In

effect,lowinterestratesencourageallthepartiesinvolvedtogambleforresurrection.

Evergreeningof this sorthelpsmaintain theweak, thesocalledzombiecompanies,who

then continue to compete anddrag down the strong. The Peek andRosengreen study also

documented how productivity growth suffered particularly in those industrial sectorsmost

characterizedby

this

kind

of

bank

behavior.

Moreover,

the

perceived

need

to

support

the

weak

couldalsoleadtohigherinterestchargesforthosestrongenoughtoaffordit.Finally,itmight

alsoimplytightercreditconditionsforpotentialnewclientswithnewideasastohowtoadapt

76Seeforexample,Posen(2011)

77SummersandDelong(2012)

78SeeBIS(2012)p42and74,foralistofsupportingreferences.


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24

domesticsupplytochangingpatternsofdemandandforeigncompetition79.Sinceinnovationis

nowseenasaprimarydriverofproductivitygrowth(andthuspotential)80,financialconstraints

ofthissortwouldbeparticularlyworrisome.Andthiswouldbeevenmorethecaseincountries

(InEuropeandJapan)wherebanksremainthedominantsourceoffinance.

The Governor of the Bank of Japan has repeatedly suggested that Japans poor economic

performance in recent decades has been largely due to a failure to adapt its production

structure to the requirements of an aging population and the growing competitiveness of

emergingAsiancountries81. Incontrast tohisadvice, andparticularlysince theonslaughtof

this current crisis, governments inmany AMEs have taken explicitmeasure like cars for

clunkers and short time working to support existing production structures. Since the

countriesthatusedtheseprogramsthemostactivelywerealsorunninglargecurrentaccount

surpluses at the time (eg: Germany, Japan, the Netherlands and Korea) it might also be

suggestedthatmanyofthejobssaved in theshortrunwilleventuallydisappear asglobal

tradeimbalancesdecline82

.Thesepolicieswerenotonlymistaken,inthattheyimpededlonger

run adjustment, but theywere also fiscally costly. This raises the question ofwhether they

mightnothave been under takenhad the governments financing costsbeenhigher at the

time.

Finally,thereistheissueofserialbubbles.Mentionwasmadeaboveofthesuccessivelymoreaggressive efforts made by central banks, since the middle 1980s, either to preempt

downturns (eg:after the stockmarketcrashof1987)or to respond todownturns (eg;1991,

2001and2008).Whatcannotbeignoredisthepossibilitythateachofthoseactionssimplyset

the stage for thenextboomandbustcycle, fuelledbyeverdecliningcredit standardsand

everexpandingdebtaccumulation.83

From theperspectiveof thishypothesis,monetaryeasingafter the1987 stockmarket crash

contributedtotheworldwidepropertyboomofthe late1980s.After itcrashed inturn,the

subsequenteasingofpolicyintheAMEsledtomassivecapitalinflowsintoSEAcontributingto

the subsequentAsian crisis in1997.This crisiswasusedasjustification fora failure to raise

policy rates, in the United States at least, which set the scene for the excessive leverage

79WiththeriseoftheEMEsandtheirdominanceoftraditionalmanufacturing,somecommentatorsevencontend

thatAMEsneedtodevelopawholenew,postindustrialinformationeconomy.Evidently,iftrue,thiswould

requirealotoffinancing.80Assuming

aCobb

Douglas

production

framework,

unexplained

movements

in

total

factor

productivity

have

for

decadesbeenthebiggestdriverofgrowthinmostAMEs.Inrecentyears,theOECDhasincreasinglyemphasized

theimportanceofinnovationinexplainingmovementsintotalfactorproductivity.81

Shirakawa(2012a,2012b)82

InEuropethecarindustrywasaparticularbeneficiaryofsuchprograms.ItisalreadybeingrecognizedinFrance,

ItalyandBelgiumthatsomeautoplantclosuresareinevitable.Thesubsidiariesofforeigncarfirmsoperatingin

Germanymightalsobeaffected.83

GeorgeSoros(2010)hasreferredtothisserialprocessasthedebtsupercycle.


25/45

25

employedbyLTCManditssubsequentdemisein1998.Theloweringofpolicyratesinresponse,

even though the unemployment rate in the AMEs seemed unusually low, led to the stock

market bubble that burst in 2000. Again, vigorous monetary easing resulted, as described

above,which ledtoaworldwidehousingboom.This boompeaked in2007 inanumberof

AMEs,seriouslydamagingtheirbankingsystemsaswell.However, inotherAMEs,thehouse

priceboomcontinuesalongwithstillrisingandoftenrecordhouseholddebtratios.Thislatter

phenomena,as

well

as

other

signs

of

rising

inflation

and

other

credit

driven

imbalances

in

EMEs84,reflectstheeasymonetarypoliciesfollowedworldwideintheaftermathofthecrisis.

Bymitigatingthepurgingofmalinvestmentsinsuccessivecycles,monetaryeasing thusraised

the likelihoodofaneventualdownturnthatwouldbemuchmoreseverethananormalone.

Moreover, theburstingof eachof these successivebubbles led to an evermore aggressive

monetarypolicy response. From a Keynesianperspective, this response seemed required to

offset the effects of the ever growing headwinds associatedwith all themalinvestments

notedabove. Inshort,monetarypolicyhasitself,overtime,generatedthesetofcircumstances

inwhichaggressivemonetaryeasingwouldbebothmoreneededandalsolesseffective. This

conclusionseemsevenmorejustifiedwhenweturntotheimplicationsofeasymoneyforthe

financialsector.

c) EffectsonthefinancialsectorSimilar to theway thateasymoney insuccessivecyclesencouraged imprudentborrowing, it

alsoencouragedimprudentlending85.Thereareanumberofdangersassociatedwiththis.The

first of thesewould be that lenders suffer losses severe enough to cause an eventual and

markedtighteningofcreditconditions.Thiscouldoccurspontaneously,helpingprecipitatean

economicslowdown,orcouldfollowuponaneconomicslowdown(ledfromthedemandside)

that significantly raised loan losses. Tighter credit conditions would feed back on the real

economy,aggravating thedownturn.There seemsclearevidenceof suchphenomena today,

andalsointhehistoricalrecord86.

Asecondconcernwouldbethateasymonetaryconditions, inassociationwithregulatoryand

technicaldevelopments,wouldencourageover time thedevelopmentofashadowbanking

sector based less on traditional banking relationships andmore on collateralized lending.

Again,there isclearevidenceofsuchanexpansion inrecentyears.Sincethiskindof lending

seemstobeevenmoreprocyclicalthantraditionalbanklending,andsubjecttootherrisksas

well87,this

would

have

to

be

thought

of

as

another

unintended

consequence

of

easy

monetary

84ForsomeinterestingobservationsonrecentdevelopmentsinEMEs,seeHoffman(2012)

85Forafulleranalysisofhowexpandingsafetynets,notleastmonetaryeasingindownturns,havecontributed

tomoralhazardonthepartofbothlendersandborrowers,seeWhite(2004).86

ReinhartandRogoff(2009)p14587

Forafullerassessment,seeFinancialStabilityBoard(2012)


26/45

26

conditions. A third concern is that insurance companies, and other lenders,might find it

increasinglydifficult toearn adequate returnson their assets.This could again imply longer

termproblemsforanimportantpartofthefinancialsector.

1) BanksandshadowbankinginthecreditupswingThemainstayof traditionalbanking is toborrow short and lend long.Withpolicy rates low

relativeto

longer

term

rates,

and

relative

to

rates

incorporating

acounterparty

risk

premium,

bankshaveanincentivetocreatecreditasthedemandforcreditincreases.Therateofgrowth

ofcredit intheAMEsandtheEMEsbetween2003and2007waswellabove therespective

growthratesofnominalincome.

Moreover, there is growing evidence that banks and financialmarketsmore generally can

becomeoverlyoptimisticabout the risks that they run in their lendingpractices.RecentBIS

WorkingPapersbyBorioandZhu(2008),Gambacorta(2009),Disyatat(2010)andAltunbasetal

(2010)allprovideevidenceoftheimportanceofwhattheycalltherisktakingchannelofthe

transmissionmechanismofmonetarypolicy88.TobiasandShin(2008aand2008b)alsoprovide

compellingevidence thatShort term interest ratesaredeterminantsof thecostof leverage

andarefoundtobeimportantininfluencingthesizeoffinancialintermediarybalancesheets.

Inaddition,AdrianandShinnestablishanempirical linkbetweenhigher leverage, inducedby

lower interest rates,and subsequentgrowth ratesofhousing investmentanddurablegoods

consumption.

More anecdotal evidence also supports the hypothesis that low rates encouragemore risk

takingandsofterlendingstandards. Intheyearsleadinguptothecrisiswhichbrokein2007,

lending standardsdropped almosteverywhere,with subprimemortgages tohouseholds and

covenantlight

loans

to

corporations

being

the

most

egregious

examples.

Similarly,

there

were

sharpdeclines in the sovereign spreadsofEMEsandof lower rated corporateand financial

paper.Beginning in themiddleof2003,whenpolicy rates in theAMEswereattheir lowest

level, the prices of houses inmany countries, aswell as the prices of other illiquid assets

(including commodities), began to rise sharply. Similarly, the cost of insurance against

unexpectedevents(proxiedbytheVixindex)felltorecordlowlevels.Insum,illiquiditywasin

highdemandandliquiditywasforsalecheaply.Allofthesetrendswereconsistentwithacredit

drivenexpansionfosteredbylowpolicyrates.89

88AlsoseeMaddaloniandPeydro(2010)

89Apuzzleiswhyincreasesinpolicyrates,intheUSinparticularbetweenmid2004and2007,failedtostopthe

excesses.Tworeasonssuggestthemselves.First,thedynamicoftheboomwassogreatthatthemeasured

increaseinpolicyrates(essentially25basispointspermeeting)wasinadequatetooffsettheexpectedgains.

Second,becausetheincreasesinpolicyratesweresowelltelegraphed,therisksinvolvedinleveragedpositions

weredecliningevenmorethanthespreadwasnarrowing.WiththeSharperatiodeclining,therewasapositive

invitationtotakeonevenmoreleverage.AdrianandShin(2008)seemtotakethispointseriously.Theystate(p28)


27/45

27

Creditexpansionsofthissort, ifnotrestrainedbysufficientlyhighpolicyrates,eventuallyrun

intotwootherconstraints.Thefirstoftheseisashortageofcapital,whichresultsin leverage

ratios rising to uncomfortable levels. The second is a shortage of longer term and reliable

funding to support the credit expansion. Indeed, Kaminska (2012) contends that this latter

problemisaterminaldiseaseaffectingbanking,andwasgreatlyaggravatedbythesecularfall

in interest rates90. However, banks took aggressive steps to confront both problems, thus

allowingthem

to

continue

to

meet

the

demand

for

credit

expansion

promoted

by

low

borrowing costs. As noted above, this implied a deeper eventual downturn than otherwise

givenbothlargermalinvestmentsandalsoastructurallyweakenedfinancialsector.

Banksfirstconfrontedthecapitalshortageproblembyexploitingopportunitiesforregulatory

arbitrageopenedupbythe introductionofriskweightedassets inthefirstBaselAccordof

1992. Slovik(2011)investigatesthebehaviorof15ofthelargestsystemicallyimportantbanks

in theAMEs.Hedocumentshow the ratioof riskweightedassets to totalassets fellalmost

monotonicallyfrom70percentofGDPin1992tojust35percentjustpriortotheonsetofthe

crisis. The implicationhedraws is that largebanks, stretchingbackover twodecades,have

beendrawingback from their traditional lineofbusiness;namelytoactivelysearch forand

evaluate lending opportunities and advance loans to credit worthy enterprises and

households91. Instead, large banks have increasingly pursued a different businessmodel,

basedonshadowbanking,whichpromisedtoalleviateboththecapitalproblemandthelong

termfundingproblemsimultaneously.

Theessenceofshadowbankingistomakeloans,securitizethem,sellthesecuritiesandinsure

them, and actively trade all the financial assets involved92. In effect, traditional relationship

bankingisreplacedbyacollateralizedmarketsystemwiththerepomarketatitsheart.Banks

thusget

risky

assets

off

the

balance

sheet,

reducing

the

constraints

just

noted,

while

providing

arichsourceoffeesandfurtherprofitsfrommarketmakingandproprietarytrading.However,

while seemingly convenient to the financial institutions involved, shadow banking activities

havesignificantexternalities(orsystemicrisks)forthefinancialsystemasawhole.

Ifcentralbankcommunicationcompressestheuncertaintyaroundfutureshortrates,theriskoftakingonlong

livedassetsfinancedbyshorttermdebtiscompressed. .. Inthissense,thereisthepossibilitythatforward

lookingcommunicationcanbecounterproductive. ThispointwasalsomaderepeatedlyinBISAnnualReports

priorto

the

beginning

of

the

crisis.

90Kaminska(2012),p.3Theconsequencesoffallingyieldswere,afterall,potentiallydeadlyforbanksif

mismanaged.Notonlydidtheythreatenthemarginsbankscollectedviacheapliabilities,theyincreasingly

compromisedfundingsupplyaltogether.91

Slovik(2011)p.6.Toputthisotherwise,theratiooftotalloanstototalassetsforDeutscheBankfellfrom85

percentin1990to27percentin2010.ForUBSthedeclinewasfrom78percentto22percent,andforBankof

Americafrom58to42percent.SeeSlovikTable1.92

ThemostcomprehensivedescriptioncanbefoundinPozsaretal(2010).AlsoFinancialStabilityBoard(2012)


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28

A recent reportby the Financial StabilityBoard (2012)enumeratesmanyof these risks.Not

least, is thecomplexityand inherentnontransparencyofshadowbankingthus itsname.

With long chains of interactions involving collateral, rehypothetication93and large offsetting

positionsinCDSandotherderivatives,exposuretocounterpartyriskbecamealmostimpossible

toestimate. Inassociationwiththebel

federal reserve bank of dallas

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