Seven years have passed since the start of the financial crisis, and the vast majority of central banks around the world have already lowered their interest rate to the zero lower bound* or are still continuously lowering their benchmark interest rates.
It appears that the majority of central banks think they have to choose between the lesser of two evils, either: 1) allowing banks to create more money to finance more debt-based spending, asset bubbles, and growth, or 2) less debt-based spending, limiting the build-up in debt, at the cost of low or zero growth. In this post we ask whether there really is no alternative.
Why Central Banks Lower Interest Rates?
In the last couple of weeks, interest rates have been lowered by Romania, Australia, Serbia, Russia, Thailand, Hungary, and China. A few others have signalled that they are considering similar moves (i.e. New Zealand and Norway). In fact, since January this year over 20 central banks have lowered their interest rates, compared to nearly 5 for the same period last year.
The reason central banks have been lowering interest rate across the world is largely as response to falling prices and the threat of global deflation – prompted by falling oil prices and the hangover effects of the financial crisis.
The theory is that by lowering the interest rates on the reserves banks hold at their central bank, banks should be incentivised to increase lending, creating more money and lowering the interest rates they offer to borrowers. In turn, the lower interest rates should incentivise consumers/investors to borrow more, and thus spend more, boosting economic growth.
Lower Interest Rates => More Borrowing => Money Creation => More Spending => More Growth.
Some Reasons for Caution
Lowering interest rates should be approached with caution for a number of reasons – especially when the majority of central banks are doing it at the same time. Firstly, governments and their central banks are actively relying on banks to create more money and for the private sector to take on more debt at a quicker rate. This is dangerous because rapid rates of borrowing, excessive leverage and irresponsible lending are all factors that help promote financial crises.
Secondly, low interest rates incentivise investors to take on more risky investments in the search for greater returns. Janet Yellen, chairwoman of the US Federal Reserve Bank, warned that this “reach-for-yield type of behaviour” induced by low interest rates poses a variety of “potential dangers”.
The Joint Committee of the European Supervisory Authorities warns that “Persistently low interest rates have sustained the demand for riskier investments and provided investors with incentives for enhancing their portfolio returns.”
Thirdly, low interest rates and the ‘reach-for-yield type of behaviour” often leads to asset price increases, and even asset bubbles. For example, last week Federal Reserve Bank of St. Louis President James Bullard said:
“A risk of remaining at the zero lower bound too long is that a significant asset-market bubble will develop…If a bubble in a key asset market develops, history has shown that we have little ability to contain it,” he said, citing the housing bubble that preceded the last recession.”
China and Global Debt
China provides a great example of why lowering interest rates can backfire. In the last six months China has lowered interest rates three times and has been progressively doing so since 2011. Chinese private sector debt has quadrupled in the last 7 years, and with a debt-to-GDP ratio of 282% China’s debt as a share of GDP is higher than in the US and Germany. According to McKinsey Global Institute, China’s soaring debt levels are one of three of the biggest threats to global financial stability.
Every time the interest has been lowered, the Shangai Composite Index of shares has responded with a significant price increase. Decreasing interest rates has prompted investors toward Chinese stocks despite a plethora of evidence of an impending economic slowdown. The Wall Street Journal recently suggested that China had a lesson to learn from the recent crisis. Mainly, that while stock markets can give some insight into economic activity, it is worth remembering that the Dow Jones Industrial average hit record highs in October 2007, right after the FED had begun reacting to the worsening debt crisis.
At the global level, since 2007, rather than deleverage, global debt has increased by about 35% ($57 trillion). By continuously lowering their interest rates, all of the world’s biggest economies currently have more borrowing in respect to their GDP than in 2007. Indeed, the global debt to GDP ratio has increased by 17% since the crisis, posing even more risk to a fragile financial system.
IMF and the Lesser of Two Evils
While the IMF has previously warned that the lowering of interest rates incurs significant financial risk, it holds that “the threat of global economic anaemia outweighs potential asset bubbles”. Which effectively suggests that we have to rely on increased levels of lending (or money creation), higher levels of risk, and more asset bubbles to spur economic growth.
Clearly, the IMF thinks it is stuck between a rock and a hard place, and that it must choose between the lesser of two evils. Either they encourage more debt-based spending (money creation for spending), which will fuel growth but may also result in asset prices bubbles, or they encourage deleveraging (paying down of debts), avoid another credit bubble, but sacrifice their targets for economic growth. Is there really no alternative? Paul Hannon, of the Wall Street Journal, recently pondered a similar question:
“What central banks have been doing for the past seven years doesn’t seem to have removed the need for more of what central banks have been doing. It seems increasingly possible that central banks should have been doing something different, and that what they’ve been doing is part of the problem.”
Sovereign Money as an Alternative
At Positive Money, we think that there is an alternative that would address many of these problems. Instead of trying to prompt growth by lowering interest rates in order to encourage more debt and money creation, central banks should be creating ‘Sovereign Money’ and spending this money directly into the real economy.
Sovereign money could be created in the public interest, without anyone else having to go further into debt. The Treasury could issue a certain amount of ‘perpetual zero-coupon bonds’. These would be interest free and would never need to be repaid. The central bank could then purchase these bonds by crediting the Treasury account with newly created money. So that the central bank’s balance sheet would balance out, the newly created money would appear as a liability of the central bank and an asset of the Treasury. The perpetual zero coupon bonds would be an asset to the central bank and a liability of the Treasury.
To prevent the abuse of such money creating powers, the central bank would be responsible for deciding how much money to create, in line with its inflation targets. The money would then be transferred to the government. Politicians would have no influence over how much money to create, while the central bank would have no influence on where to spend the money.
This money would be spent into the economy through government budgets instead of being lent into the economy by banks. Rather than prompting asset bubbles and more debt, this form of stimulus would fuel the real economy, create jobs, and make it possible for ordinary people to start reducing their own debts.
*A zero-bound interest rate normally refers to a central bank short-term interest rate, which is at or near zero.