Commentary / Japan

Central banks' failed policies

by Christopher Lingle

Special To The Japan Times

The Bank of Japan was an innovator in terms of “unconventional” monetary policy. At the end of the 1990s, the BOJ introduced zero interest rate policy and quantitative easing (QE) policy long before other central banks.

But in response to the 2007-08 financial crisis, central bankers around the world have been playing “follow the leader” when it comes to monetary policy. For its part, the U.S. Federal Reserve has been suppressing interest rates ever closer to, and below, zero.

Monetary policy is partly guided by a belief that lowering the cost of borrowing and the returns on bonds will lead to higher bond and share prices. The resulting capital gains is supposed to spark a “wealth effect” that along with lower interest rates on commercial and consumer loans stimulate investment and consumption. In turn, rising aggregate demand will supposedly bring job creation and higher profits.

Despite interest rates being at historical lows throughout much of the world, there continues to be sluggish economic growth, especially in developed economies. When central bankers found that zero interest rate policy did not achieve their goals, they doubled down and moved toward negative-nominal interest rate policy.

Now, Sweden’s Riksbank and the BOJ followed Switzerland and Denmark to set their main policy interest rates below zero, followed by the European Central Bank. Besides seeking to halt a tendency for assets prices to decline after various bubble burst and stimulate price inflation, they all sought to halt the appreciation of their currencies.

In turn, a great deal of sovereign debt now carries a negative nominal interest rate such that lenders receive less than the amount invested. The total value of government bonds with negative yields is $11.7 trillion, up by 12.5 percent increase since the end of May.

Among these negative-yielding bonds is about half of all debt issued by eurozone governments and most of Japan’s government bonds. Now, private sector firms are engaging in the same innovative technique. Sanofi, a French pharmaceutical company, and Henkel, a German consumer company, recently sold new bonds worth more than €1.5 billion at an interest rate of minus 0.05 percent.

It has to be said that QE, zero interest rate policy, negative interest rate policy and other unconventional monetary policies have failed in their objectives. In fact, these policies have triggered economic responses that are diametrically opposed to their intended goals. It turns out that zero lower-bound yields and interest rates have caused investment, an important source of productivity growth, to remain below pre-crisis levels. As it is, America’s year-on-year productivity is trending downward.

The BOJ has held interest rates at or near zero for over a decade without generating any significant real or nominal GDP growth. Japan’s economic growth for the April-June quarter was 0.2 percent, and on an annualized basis the economy grew by 0.7 percent. This makes it unlikely that future tax revenues will be sufficient to repay Japan’s mammoth debt when yields on its sovereign debt move back up.

It turns out that monetary policies to suppress yields allowed governments to borrow at historically-low interest rates and avoid economic restructuring or reforming their fiscal stance. As such, governments ignored the root causes of earlier financial malaise while artificially boosting asset prices into “bubble” proportions.

The one “success” of artificially low interest rates is in allowing governments to embark on an unprecedented wave of borrowing to support their profligate ways. Since 2007, governments around the world added about $57 trillion to their outstanding debts.

In the United States, federal government debt rose to $17.5 trillion. The debts of all levels of government are now just over 104 percent of GDP in 2015, up from an average of 62 percent from 1940 until 2015.

But an increased debt burden on households and firms tends to induce them to reduce current spending in anticipation of higher future tax bills. Economists point to the “Ricardian Equivalence” theory whereby growing fiscal deficits and increased public-sector debt fail to boost aggregate demand.

Another problem is that central bankers’ focus on lower credit costs distorted the operation of capital markets and destroyed the concept of risk. While it is strange to buy a bond with a negative yield with repayments less than face value, it is rational to do so given the irrational context of unconventional monetary policies.

One reason that artificially cheap credit did not spark economic growth was that capital was diverted from the real sector of the economy to the financial sector. Instead of new credit going into new businesses or for existing businesses to spend on plant or equipment or research and development, it was diverted into financial assets with lower risks and costs. For example, many corporations borrowed at low interest rates to buy back shares.

This financialization of economic activity also worsened income and wealth inequalities.

Artificially low interest rates pushed up prices of long-dated bonds and housing while also pumping air into stock prices. As such, whoever held long-term assets experienced large increases in wealth. Meanwhile, tepid borrowing by businesses to expand production meant that absolute gains by wage earners were swamped by losses in their relative position.

Keeping lending rates low also pushed down interest rates that commercial banks paid on saving deposits while also depressing money market rates of interest.

For their part, savers are spending less to replenish lost earnings from punishingly low interest rates by saving more to achieve their long-term purchasing power goals. Keeping interest rates at or near zero for so many years has brought real human harm to people who worked hard and tried to save for their own retirement.

While taking away good options for savers, near-zero yields also harm companies like insurance companies and pension funds that have long-term liabilities based on expected higher future returns. If yields and rates do not return to normal levels, lower profits will induce these companies to demand higher premiums or reduce pension benefits or engage in defaults.

While cheap credit sounds nice, it has failed to achieve the intended economic gains and caused asset prices to soar, creating a global bond market “bubble” over the past decade. Since most other assets tend to be priced relative to bonds, a correction in asset pricing that must inevitably occur will cause creditors suffer massive losses.

Once “debt saturation” sets in, as happened in Greece, creditors will refuse to buy more bonds. A rush will occur to sell to avoid large capital losses on bonds that are now priced at historic highs.

With the bond market having more sellers than buyers, it will become clear that central bankers really cannot control interest rates as they move sharply upward. What starts as a liquidity crunch will morph into a banking crisis that will become a financial crisis that gives way to an economic crisis. For all this we can thank central bankers and their hubris in acting as “central planners” with the single most important price in any market economy, the interest rate.

Instead of being our saviors, central bankers have destroyed wealth, created instability and set conditions for the next big economic crisis. This conclusion is important to understand since the usual assertion is that inherent instability of financial markets or manic behavior of individuals causes economic trauma.

Christopher Lingle is a research scholar at the Center for Civil Society in New Delhi and a visiting professor of economics at Universidad Francisco Marroquin in Guatemala.