Adverse effects of unconventional monetary policy.

• Author: Hoffmann, Andreas
• Position: Report

Following the recent waves of financial crises in the advanced economies and a prolonged period of low interest rates, major parts of the world economy are experiencing low growth, a rise in financial volatility, and low rates of inflation. Specifically, in Japan and in large parts of die eurozone the crises persist. In large parts of the world, unconventional monetary policies--that is, ultra-low interest rates and large-scale asset purchases, also known as "quantitative easing" (QE)--are seen as important determinants of employment and growth. The announced exit from unconvendonal monetary policy in the United States, where growth appears more robust, has clouded the growth perspectives of many emerging market countries. The Chinese growth engine, which was a main driver of world growth during the 2000s, has begun to stutter--and emerging market corporate bond markets have come under pressure.

Macroeconomists have identified several reasons for the recent wave of financial crises in the advanced economies. One strand of literature explains financial crises as result of a random or exogenous shock, amplified by the irrationality of human action (Keynes 1936, De Grauwe 2011), asymmetric information and financial constraints (Bernanke, Gertler, and Gilchrest 1996). Another strand of literature suggests that a savings glut--caused by a higher saving propensity of the aging populations in Germany, China, and Japan--has contributed to a fall in (natural) interest rates in advanced economies (Bernanke 2005, Summers 2014, von Weizsacker 2014).

On the contrary, assessments (implicitly) based on the Taylor rule suggest that overly expansionary monetary policies during the 2000s sowed the seeds for financial exuberance and therefore the current crisis (Taylor 2007; Jorda, Schularick, and Taylor 2015). Adrian and Shin (2008), Brunnermeier and Schnabel (2014), as well as Hoffmann and Schnabl (2008, 2011, 2014), have shown that overly expansionary monetary policy can contribute to financial market bubbles that lead to crisis. Selgin (2014), Selgin, Lastrapes, and White (2012), as well as Howden and Salerno (2014), see public central banks at the root of macroeconomic instability.

Depending on the view of the very roots of the crisis, policy recommendations point in different directions. One side emphasizes the need for unconventional monetary policy to stabilize the financial system--for example, by easing collateral constraints to maintain growth and employment (Draghi 2014, Bernanke 2014). In contrast, the other side sees ultra-low interest rate policy and QE as major sources of distortions and bubbles. These critics demand a timely exit from unconventional monetary policy to prevent further distortions caused by boom and bust in the financial markets.

This article contributes to the second strand of literature. We discuss the developments during the last three decades against the backdrop of the monetary overinvestment theories of Wicksell (1898), Mises (1912), and Hayek (1929, 1937). In particular, we elaborate on channels through which ultra-low interest rate policies can contribute to a decline in investments and growth in the world economy.

Monetary Overinvestment Theories and Boom-and-Bust in Financial Markets

In order to model boom-and-bust cycles based on the overinvestment theories of Wicksell, Mises, and Hayek we distinguish between four types of interest rates. First, the internal interest rate it reflects the (expected) returns of (planned) investment projects. Second, Wicksell's natural interest rate in is the interest rate that balances the supply (saving) and demand (investment) of capital.1 Third, the central bank's policy interest rate [i.sub.cb] shall represent the interest rate that commercial banks are charged by the central bank for refinancing operations. Fourth, we define the capital market interest rate [i.sub.c] as the interest rate set by die private banking (financial) sector for credit provided to private enterprises. For simplicity, we shall assume that central banks simply set a policy interest rate and that the capital market interest rate equals this policy interest rate (see Hoffmann and Schnabl 2011).

According to die monetary overinvestment theories, an economy is in equilibrium when the natural rate of interest equals die policy interest rate--that is, planned saving (S) equals planned investment (I). An economic upswing starts when positive expectations due to an important innovation raise the internal interest rate of investment, bringing about a rise in investment demand at given interest rates. In Figure 1, this corresponds to a rightward shift of the investment curve from [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]. The natural rate of interest rises along from [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]. Credit demand in the economy rises.

[FIGURE 1 OMITTED]

If the central bank increases the policy interest rate from [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII], assuming a perfect interest rate transmission to credit markets, planned saving and investment in the economy will stay in equilibrium ([S.sub.2] = [I.sub.2]). If, however, the central bank does not raise the policy interest rate, [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] as shown in Figure 2, relatively low interest rates will give rise to an unsustainable monetary overinvestment boom. Holding policy rates too low (for too long) will be referred to as a Type 1 error in monetary policy.

To market participants, a rise in credit to the private sector at constant interest rates signals that saving activity of households increased. Additional investment projects aim to satisfy the expected rise in future consumption. As planned household saving did not actually increase, an unsustainable disequilibrium between ex ante saving and investment [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] arises. In the following, additional investments of some enterprises trigger additional investments of other enterprises (cumulative upward process). As soon as capacity limits are reached and employment is high, wages and prices rise.

At first, rising prices signal additional profits and therefore trigger a further increase in investment. There may be spillovers to financial markets. Increases in expected profits of companies are typically associated with rising stock prices. Given relatively low interest rates on deposits, shares are attractive. When stock prices move upward, trend-followers will provide extra momentum such that "the symptoms of prosperity themselves finally become ... a factor of prosperity" (Schumpeter 1911: 226). Consumption is fuelled by rising stock prices via the wealth channel, which leads, with a lag, to an increasing price level.

[FIGURE 2 OMITTED]

The boom turns bust when the central bank increases the central bank interest rate to stem inflation (Mises 1912; Hayek 1929, 1937). Then investment projects with an internal interest rate below the risen natural interest rate turn out unprofitable. The fall in investment of some firms will depress investment of other firms as expected returns fall. When stock (and other asset prices) burst, balance sheets of firms and banks worsen, bringing about further disinvestment (cumulative downward process). Wages fall and unemployment rises. The investment curve shifts back from [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII].

In this situation, the central bank should cut the central bank interest rate to contain the downward spiral. Based on the monetary overinvestment theories, we consider holding policy interest rates at a high plateau during the downturn a Type 2 monetary policy error. Figure 2 shows that when the policy interest rate is above the natural interest rate [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII], credit supply is restricted further such that ex ante saving is higher than investment ([S.sub.3] > [I.sub.3]).

According to Mises (1949: 572), "The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion." Hoffmann and Schnabl (2008, 2011, 2014) outline that the spate of boom and bust cycles in different parts of the world since the 1980s can be understood based on monetary overinvestment theories.

[FIGURE 3 OMITTED]

They make, however, one clear distinction: central banks have tended to hold policy interest rates too low during periods of economic upswing, fueling booms in financial markets (i.e., Type 1 errors in monetary policy). During financial crises, however, central banks have slashed interest rates decisively to stabilize the economy and prevent Type 2 errors in monetary policy. Specifically, in the so-called Jackson Hole consensus, U.S. central bankers agreed that central banks do not have sufficient information to spot bubbles, but should react swiftly in times of financial turmoil (Blinder and Reis 2005). Consequently, we observe (in cycles) a downward trend in nominal and real interest rates in the large economies (Figure 3).

[FIGURE 4 OMITTED]

Once interest rates have reached the zero-bound (in Japan since 1999 and the United States and Europe since 2008), central bank balance sheets have been inflated more aggressively to prevent a meltdown of the financial sector by pushing down the interest rate on the long end of the yield curve (Figure 4). The discussions on tapering and the long-delayed increase in interest rates (for the first time after nine years) by the Federal Reserve, signal that an exit from such low interest rate policies is a difficult endeavor because large distortions have emerged and politically it is difficult to end ultra-low rates on government debt (see Buiter 2010).

Negative Growth Effects of Low Interest Rate Policies

Although the drop in interest rates...