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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.
white.william@sunrise.ch. 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
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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.
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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.
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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)
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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)
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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.
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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.
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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.
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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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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.
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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)
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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).
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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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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)
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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.
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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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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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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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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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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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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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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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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.
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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)
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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)
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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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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
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