LONDON (Reuters Breakingviews) - Central banks are gradually waking up to what should be their most important challenge. That’s the good news. The bad news is that the best way they have to address this challenge may not help much, and is economically dangerous and politically unpopular. Doing nothing, though, is even more hazardous.
The key problem for the monetary authorities is neither unwanted inflation nor debilitating deflation. No one really knows why, but after almost four decades of global disinflation, prices and wages seem to be broadly stable. Things might change, but in recent years both the mandates and the mindsets of today’s monetary authorities have not been fit for purpose.
In particular, the focus on the non-problem of price instability encouraged monetary authorities to sleepwalk into the 2008 global financial crisis. Their belief that only inflation mattered allowed them to doze through the blowing of a gigantic global credit bubble, the boom phase of what the Bank for International Settlements aptly calls the financial cycle.
Central bankers have stirred from their dogmatic slumber. The fear of future credit excess has led them to endorse much tighter control of lending quantity and practices: so-called macro-prudential regulation. And although they are often coy about admitting it, the fear of a damaging credit bust helps explain why they have spent the last nine years looking for reasons not to tighten monetary policy. Among the big economies, only the United States has increased the policy rate, and even then to a still-puny range of 1 percent to 1.25 percent.
Credit has indeed been restrained in some countries. The BIS calculates that since 2007 the ratio of private debt to GDP has declined in the United States and United Kingdom by 16 percentage points and 13 percentage points respectively. In Spain, which had the biggest property crash, the fall has been 39 percentage points.
However, the rest of the world continues to borrow away, so much so that the global ratio has increased by 23 percentage points, to 138 percent. China, where the ratio has almost doubled, is the biggest culprit, but the ratio has risen by 30 percentage points or more in Canada, France, Korea, Poland, Switzerland and Turkey.
The BIS notes other signs of global financial excess. The reliance on short-term dollar financing for global trade and portfolio flows is still high. And disinflation adds to the potential danger, since, as Italy’s dire experience has shown, bad loans tend to get worse when nominal GDP growth slows to a crawl.
In retrospect, the decade of ultra-low policy rates looks like a mistake. While the slow recovery in the real economy suggests that loose monetary policy was at best a blunt instrument for stimulus, it almost certainly encouraged the resumption or continuation of risky credit expansion in many countries. It also entrenched expectations of ever-bullish markets for financial assets. The more secure those hopes become, the more certain they are to be proved false.
But this is a hard mistake to correct. A sharp increase in policy interest rates could bring an immediate financial crisis – a spiral of defaulting borrowers, crumbling bank balance sheets and sudden shortages of credit and confidence. Not only could the price of a new monetary regime be high, but the effects might be less than desired. While central banks control the short-term cost of money, their actions may not push up longer-term yields or immediately curb financial excess.
Still, central banks are in the wrong place on interest rates, and need to move to a better position. Low rates have already done what they can for the real economy, but they continue to breed the credit excesses which make an eventually more serious breakdown more likely. Macro-prudential curbs can help, but cannot withstand the rising tide forever.
There could even be gains in the short term. Anything which makes leveraged financial speculation less alluring is good for the world, and the lack of cheap money and the availability of higher interest income should have that effect. A more normal interest rate environment could possibly lead to a healthier financial attitude, with less interest in playing the markets and more investment in real assets.
As for the downside, another great recession can be avoided. The biggest problem in 2008 was not actually the sharp turn in the credit cycle, but the severe drop in business and consumer confidence after Lehman Brothers was allowed to fail. That error does not have to be repeated.
A steady and coordinated global increase in policy interest rates might well push some institutions over the edge. But the authorities need not repeat their mistake. They can help wind down excesses and recognise losses while using fiscal policy to ensure there is enough money around to protect trade, jobs, investments and depositors.
Interest rate stimulus has lost whatever kick it once had. It is time to make money substantially more expensive.
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