Zero interest rate policy: Treatment may be expensive as the crisis

Posted by on 16 October 2009

By Andrew Sheng and Michael Pomerleano

The national authorities and the international community should be commended for the speed of action taken to stop the spread of the financial crisis. To protect the financial system from the deflation in asset bubbles, the public sector has essentially guaranteed all deposits, rescued systemically important institutions, made large liquidity injections and brought interest rates to zero or near zero under a zero interest rate policy. Almost all systemically important central banks entered into ZIRP under emergency conditions at the same time.

But the polices adopted to combat the crisis are creating their own problems. In the medium term, the treatment may be as expensive as the crisis.

The “shadow” set of liabilities - the guarantees put up around financial systems a year ago, the quantitative easing without adequate collateral, and zero interest rates - are popular because they are the path of least resistance for policymakers forced into emergency action. The measures receive less legislative scrutiny than fiscal action and do not appear to entail immediate cost. What they have done is postpone costs.

ZIRP poses global risks in an interconnected economic world by essentially replicating Japan’s liquidity trap globally. In the aftermath of the 1990s asset bubble, Japanese fiscal deficits eventually led to a large public debt bubble more than twice the size of GDP.

First, the rescue plans guarantee and replace private losses and debt with public losses and debt. There has been a large transfer of risks from private balance sheets to the sovereign balance sheet, including central bank balance sheets. As a result, the line between monetary policy and fiscal policy has been blurred, since central bank “investor of last resort” action is quasi-fiscal action. Such transfers are fiscally sustainable only with ZIRP, because increases in interest rates would incur a huge servicing burden.

With the deadweight rescue costs of the financial crisis increasing, the room for much-needed fiscal action on social spending and infrastructure reform has shrunk dramatically. Yet politicians will not permit higher rates to crowd out fiscal expenditures on education, health, and infrastructure, making the exit from ZIRP problematic. Witness Japan’s zero deposit rates 20 years after the crisis. With a debt-to-GDP ratio of more than 200 per cent, raising interest rates would prompt a fiscal crisis, massive capital inflows, and further deflation.

Second, the Japanese yen carry trades will now be amplified globally. Low interest rates will lead to a search for yield, and risks will again be mispriced as investors arbitrage any rate and price differential with larger and larger leverage. ZIRP is essentially a fixed interest rate policy, because the nominal interest rate cannot be lowered below zero. Hence, volatility will surface in other asset prices and in large leveraged capital flows. ZIRP will encourage a regime of short-term reckless trading, higher volatility in financial markets, and less appetite for long-term investments because private investors will fear the funding maturity mismatch if interest rates rise. The public sector then has to bear the long-term investment risks, leading to crowding out and more resource allocation distortions.

Third, the ZIRP strategy of the leading central banks holds the entire world hostage to low interest rates. Chinese central bank governor Zhou Xiaochuan has articulated clearly what is called the “Triffin dilemma”. When a national currency is used an international reserve currency, the monetary authority issuing such a currency has the additional burden of having to address the consequences of monetary policy for other countries.

Just as the US hike in interest rates to combat inflation during the Volcker era of the early 1980s led to large outward capital flows from Latin America, creating the “lost decade” there, the entire world will have to follow the lead of the US in interest rates. How can any nation raise interest rates when vast sums of fiat paper dollars are ready to pounce on any carry trade opportunities that arise?

The exit strategy for numerous countries has to be through collective action, even if domestic conditions in emerging markets with faster growth mandate higher rates.

Finally, ZIRP arises from an overuse of monetary policy, when the cure lies in real sector action, namely fiscal policy. If the underlying problem is excess consumption funded by excess leverage, then deleveraging of the real economy is inevitable and throwing debt, guarantees, and quantitative easing at the global problem of insolvency will not succeed. It might slow the speed of adjustment, but it will be detrimental to reaching a new sustainable equilibrium. Despite the interventions, the profitability of the financial system will continue to be challenged by lower real sector profits, problems of de-leveraging, massive excess capacity, and risks.

In sum, reliance on ZIRP, quantitative easing, and guarantees provided policy makers around the world with “soft options”. They are not yet willing to meet the hard budget constraint of paying for losses now and avoiding further distortions. If we don’t change the incentives through fiscal measures and enforcement, the problems will not just be repeated, they will be worsened. We have to bite the bullet of real sector adjustment.

What are the prospects of exiting ZIRP? The Fed has recognised the need to exit ZIRP. In a recent speech, Kevin Warsh, governor of the Federal Reserve System said: “In my view, if policymakers insist on waiting until the level of real activity has plainly and substantially returned to normal - and the economy has returned to self-sustaining trend growth - they will almost certainly have waited too long. A complication is the large volume of banking system reserves created by the non-traditional policy responses. There is a risk, of much debated magnitude, that the unusually high level of reserves, along with substantial liquid assets of the banking system, could fuel an unanticipated, excessive surge in lending.”

We got into the current crisis because national policies have externalities that do not add up to a collective global good. The world needs to exit ZIRP together, because first movers are likely to pay higher costs in terms of large capital flows. This reinforces the ZIRP liquidity trap. The G20 setting offers an excellent opportunity to collaborate on exiting ZIRP together.

Andrew Sheng is a former chairman of the Securities and Futures Commission, Hong Kong and author of book From Asian to Global Financial Crisis. Michael Pomerleano has worked at the Bank of International Settlements and at the Bank of Israel.