Financial Stability and Instability, Ultra-Low Interest Rates, Quantitative Easing, and the Mammon of Unrighteousness: (Late) Tuesday Focus for October 7, 2014

Larry Elliott: IMF warns period of ultra-low interest rates poses fresh financial crisis threat: “The Washington-based IMF said…

…that… the risks to stability… c[o]me from the… shadow banking system… hedge funds, money market funds and investment banks that do not take deposits from the public. José Viñals, the IMF’s financial counsellor, said:

Policymakers are facing a new global imbalance: not enough economic risk-taking in support of growth, but increasing excesses in financial risk-taking posing stability challenges…. Risks are shifting to the shadow banking system in the form of rising market and liquidity risks. If left unaddressed, these risks could compromise global financial stability.

The stability report said low interest rates were “critical” in supporting the economy because they encouraged consumers to spend, and businesses to hire and invest. But it noted that loose monetary policies also prompted investment in high-yield but risky assets and for investors to take bigger bets. One concern is that much of the high-risk investment has taken place in emerging markets, leaving them vulnerable to rising US interest rates…. The IMF said there was a trade-off between the upside economic benefits of low interest rates and the money creation process known as quantitative easing and the downside financial stability risks… developments in high-yielding corporate bonds were “worrisome”, that share prices in some western countries were high by historical norms, and that there were pockets of real estate over-valuation…

I have come to the conclusion that those who say that quantitative easing has increased systemic financial-market risks have simply not thought hard enough about what quantitative easing is. In quantitative easing the central bank takes duration risk off of the private sector’s balance sheet and onto the governments, that is, the taxpayers’. The ratio of risk to be borne to private-sector risk-bearing capacity falls. The presumption is that this makes financial markets less, not more, vulnerable to systemic risk. You could tell some kind of complex contrarian story with demand and supply curves that slope in non-obvious ways. But none of those who say that quantitative easing increases systemic risk make such arguments–and if they understood quantitative easing properly, they would understand that they need to and feel impelled to do so.

The argument that ultra-low interest rates and the anticipated continuation of ultra-low interest rates for a considerable time period raises systemic financial risks is less mired in the, well, mire. But it, too, is not obvious. An economy sinks into depression when households, savers, and businesses in aggregate believe that they are short of the assets they need to hold to ensure liquidity–that after subtracting off assets they are holding as savings vehicles they do not have enough cash and enough safe nominal assets that could be pledged to immediately raise cash. As a result, the aggregate of households, savers, and businesses try to cut their spending below their income in order to build up their liquid cash and safe collateral balances; but since my income is nothing more than your spending, they fail and so production, income, and spending fall until the private sector finds itself so poor that it no longer seeks to build up its liquid cash and safe collateral balances.

In such a situation the government, by trading its cash and its safe collateral liabilities for risky financial assets and four currently-produced goods and services both:

1. creates more of what the private sector wants to hold, and so reduces or eliminates the gap between current and desired holdings of liquid cash and safe collateral.

2. lowers interest rates and so increases the value of the future relative to the present, providing a direct financial incentive both to spend now on the creation of long-duration real assets and to spend now out of what are now more valuable anticipations of future income.

On the one hand, higher asset valuations and higher levels of production and income greatly reduce the risks associated with financial assets backed by real wealth of one form or another. On the other hand, the tilting of the intertemporal relative price structure greatly increases the incentive to create long-duration financial assets–which will inherently be speculative, and some of which will partake to some degree of the unhedged out-of-the-money put or even the Ponzi nature. Which of these effects will be larger? For small reductions in interest rates, the first-order effect on the value of existing collateral assets in making finance safer will outweigh the second-order creation of new long-duration assets in making finance riskier. To the extent that prudential regulation is effective–or even exists–the range over which reductions in interest rates will improve stability is larger. To the extent that the economy is already flush with long-duration financial assets–which it is–the range over which reductions in interest rates will improve stability is larger.

The first-class study of this I know finds no evidence of the IMF’s contention that policies of ultra-low interest rates have laid the foundations for increased risks of systemic financial instability in the United States. Outside the United States? Yes, times of low interest rates in the core are times of opportunity–cheap financing is available to finance economic development–but also times of danger–are their financial markets robust enough to control and manage the hot-money fluctuations?–in the periphery. But how much weight does the argument that prudential policy in the periphery may go wrong have in militating against policies that–correctly–aim at appropriate internal balance in the core?

I am now more inclined to view worries that ultra-low interest rate and quantitative easing policies raise risks of future financial instability as the last-gasp argument of the austerians–as one more attempt to find an argument, any argument, to justify universal bankruptcy and the war on the Keynesian Mammon of Unrighteousness.