Cheap credit is creating the conditions for the next financial crisis.
In October 2019, Mario Draghi’s eight-year term as president of the European Central Bank (ECB) is due to end. He is in a race against time to avoid an unusual accolade for a central banker: never once to have raised interest rates during his tenure.
In decades gone by, central bankers earned their spurs by their expert navigation of the ebb and flow of the business cycle. For Draghi, however, no such dexterity has been required. All he has done is cut rates – eight times, from 1.5 per cent to zero.
He is far from alone. Mark Carney has been even less busy. In the 66 months that Carney has been governor of the Bank of England (BoE), the chore of adjusting interest rates has troubled him for only three – and the policy rate remains a mere quarter of a per cent above its lowest level in 300 years.
But the ECB and the BoE have nothing on the splendid lassitude of the Bank of Japan. Not only has its governor since 2013, Haruhiko Kuroda, never once raised rates; his predecessor Masaaki Shirakawa, whose term began in 2008, didn’t either.
This is the striking truth of the world’s most advanced economies. While GDP growth, inflation and unemployment in have long since recovered to historically normal levels following the crisis of 2008, their financial systems remain mired in an unprecedented experiment – one that has paralysed monetary policy for a decade.
Recent turbulence on the world’s stock markets suggests that many investors fear the prospect of central bankers bringing this Great Monetary Experiment to a close. Yet perhaps no less problematic are the consequences of allowing it to continue.
Modern monetary policymaking is based on the simple idea that by varying the policy rate (or “bank rate”), a central bank can influence demand, and in doing so, control the rate of inflation. Raise interest rates, and borrowing becomes more expensive throughout the economy, cooling growth and inflation. Cut interest rates, and borrowing gets cheaper – with the opposite effect. Toggle nimbly between the two, and a target rate of inflation – say, 2 per cent, as in the UK – can be hit.
One important detail is that this effect is achieved not only directly, by adjusting the cost of borrowing, but also indirectly by making assets cheaper or more expensive. When the interest rate available from the central bank falls, other, higher-yielding assets become more attractive – so their prices get pushed up. When the policy rate rises, by contrast, alternative assets look relatively less alluring – so they are sold down, until their price falls enough to entice savers back.
Because borrowing at any scale depends not just on cost but on collateral, this valuation effect of monetary policy constitutes a second important channel of its effectiveness. When interest rates fall, the value of capital assets used as collateral for loans – be they shares, intellectual property, or real estate – inflates. As a result, credit becomes not only cheaper to service, but easier to access.
Few would dispute that the process of asset price inflation has taken place across most advanced economies as a result of the Great Monetary Experiment of the past decade.
