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Summary

  • Many assume central banks are the main culprit for creating asset bubbles by running too loose monetary policy.
  • However, central banks are not in control of longer-term interest rates and these have been on a downward trajectory for a couple of decades. We look at what's behind this.
  • The fact that central banks aren't the main culprit creating asset bubbles doesn't mean they are helpless in preventing (or at least moderating) them.
  • But that comes at a significant cost which so far few central banks are willing to assume.

It is sort of a common view that central banks are at least partly responsible for the emergence of asset bubbles, lowering rates to deal with the effects of the last one, creating a bit of a bubble cycle. In fact, one of our first Seeking Alpha articles described this process.

Inadequate (that is, too lax) monetary policy plays a central role in the Austrian perspective, producing overinvestment, misallocation of capital, and a 'cleansing' process to get rid of the excess capital (if only the central banks would let this process happen).

Others, like David Stockman argue against the Fed setting rates at all:

The heart of the evil is interest rate pegging itself. That is, the replacement of market prices with administered prices -direct and indirect- throughout the financial system.

And some would like to constrain the Fed by returning to a gold standard or abolish the Fed altogether (or even fractional reserve banking).

For starters, one has to realize that the domain of administered rates is rather small and at the short-end, at best central banks have some degree of influence over longer-term rates, which are more important for the economy, but these aren't administered rates.

More interestingly, what if central banks have little to do with falling interest rates? What if there are economic forces at work that have led to a substantial decline in interest rates without much, if any, central bank interference?

This is indeed the central idea behind secular stagnation, a set of ideas that argue that many developed economies have experienced a secular decline in the so-called Wicksellian interest rate, or the FERIR, the Full Employment Real Interest Rate, and have some difficulty of attaining full employment and financial stability at the same time as a result.

What is the FERIR? It is the real interest rate that equate planned investment with planned savings, that is, it's the real interest rate that produces a financial balance in the private sector. There are quite a few reasons that lend support to falling FERIRs, let's discuss some of these, relying on work by Summers and others from a recent CEPR book.

These are factors that either increase the level of desired savings, or reduce the level of desired investment, leading to a secular increase in S-I and falling real rates:

  • Demographics: Slower population growth (or even declines, as in Japan and some European countries) requires less investment in new capital goods.
  • Lower priced capital goods: With Moore's Law operative and ICT taking an ever bigger slice of capital investments, the financial layouts are declining. A company like WhatsApp can command a greater market value than Sony but required next to no capital investment.
  • Rising inequality and rising profit shares shift income from those with low propensity to save to those with high (or at least higher) propensity to save. We have argued this some years back already.
  • Increase in demand for save assets due to greater financial instability, and reduced supply, lowering returns on save assets, which function as a benchmark.
  • Ongoing decrease in inflation, which means that at any given real interest rate, real after-tax interest rates are higher, reducing investment demand.

Of these factors, we can only recognize the hand of central banks in the successful battle against inflation since the early 1980s has been largely responsible for this (although globalization and technology probably also have contributed to a decline in inflation).

It looks like central banks are more followers than trendsetters with respect to declining interest rates. Apart from these theoretical factors, there is also some degree of empirical evidence.

Behavior of the economy
While economic growth 2003-7 was reasonably good, it wasn't stellar and it was boosted by factors like:

  • A distinct loosening of credit standards (banks being able to get rid of much of the credit risks from sub-prime mortgages through securitization).
  • Leading to a construction boom and a housing boom and a rise in household debt of 4% per year (from 67% of GDP in 2001 to 94% in 2007).
  • The emergence of substantial fiscal deficits

Despite so much tailwinds, the economy never really overheated, inflation never became a serious problem, imagine what economic performance would have been in the absence of these tailwinds.

One could object that apart from the 2008 crisis, there hasn't really been any long-term trend in the financial position of the private sector (S-I), if anything, that trend has been mildly downwards:

However, one has to realize that with globalized capital markets, looking at the US in isolation could easily give the wrong picture. Barry Eichengreen stressed the point that what matters for US interest rates is not US savings but global savings and on a world scale, there has been a savings glut, although relatively stable at 25% of global GDP:

It has become a ritual for the IMF to keep having to cut its forecasts, a sign of the malaise in the global economy as excess manufacturing capacity lingers and a record 25pc world saving rate drains aggregate demand. [The Telegraph]

If China rebalances towards more consumption, this savings glut could well decline and secular stagnation might melt away, but we aren't there yet.

One does see how the private sector surplus increases during crisis, and how unemployment (in red) correlates closely with that, not just for the last crisis, which displayed by far the largest swing in S-I, but also for the previous crisis.

Other indications come from the large and rather persistent output gap (the difference between potential output and actual production). This is no mystery. If the financial sector swings into a large surplus and this is insufficiently compensated by an equal swing into deficit by the public sector, demand is lower than potential output (the output an economy could produce employing all its available production factors).

Economic studies
There are economic studies, such as the one from Laubach and Williams, which argue that the FERIR (or natural rate of interest, as they call it) has steadily declined:

Real rates have fallen
There is no question that for some time already, real rates have fallen steadily in Europe and the US (not to mention Japan).


(click to enlarge)
There are a couple of things to argue here. Central banks control the short rates (in the US, the Federal Funds Rate), but their grip on longer-term rates is tenuous at best. One might argue that surely the massive QE has had an impact and indeed it has, but a modest one, whilst QE is hardly garden variety monetary policy.

In fact, central banks had to resort to QE because one of the consequences of steadily falling inflation and real rates is that 'normal' monetary policy has lost much of its traction and is bumping up against the zero lower bound, and QE has had limited impact on rates, despite often dire public finances.

Liquidity trap
When the private sector moves sharply into a financial surplus, it essentially means that the FERIR, the rate necessary to create full-employment, is negative:

This is one interpretation of the secular stagnation theorem, which sees it as a more or less permanent liquidity trap. Krugman notes in the CEPR book that "the liquidity trap is becoming the new normal," as he notes that since the advent of the low inflation area in the 1980s we've spend like a quarter of the time in a liquidity trap.

A quarter of the time isn't exactly the new normal, but on the other hand, much of the non-liquidity trap years were asset bubble years, which is going to the heart of the policy dilemmas that Summers highlights.

Credit standards
Another important element left out of 'blame the Fed' accounts is that credit standards can easily deteriorate independently of monetary policy. For instance, securitization of mortgages enabled many financial institutions to get risk off of their balance sheet, hide it in complex tradable instruments.

One of the more notable consequences has been to turn much of the mortgage business into a volume business where 'throughput' emerged as the most important metric (robosigning and all), irrespective of creditworthiness of clients. A massive deterioration of credit standards ensued with which the business of monetary policy had little, if anything, to do but inflating a housing bubble nevertheless.

Policy implications
There are many policy implications, but for the limited purpose of this article we highlight a few.

  • If the Fed is not the main force responsible for creating asset bubbles, this doesn't mean they can't prevent them by raising rates. However, one should realize that the cost of that is high. In Sweden, rates were raised to dampen the rise in house prices, but the economy faltered and prices threatened to fall into deflationary territory, producing a rather embarrassing turn-around in Swedish monetary policy
  • This suggests a rather awkward dilemma: keep economy at full employment, but risk that the resulting low rates cause financial instability, or manufacture higher rates which harms the economy further.

Here is Larry Summers (from the same CEPR book):

It may be impossible for an economy to achieve full employment, satisfactory growth, and financial stability simultaneously simply through the operation of conventional monetary policy.

Conclusions
While not conclusive, there is a fair bit of evidence to bear against the supposition that the Fed is the sole, or even the main instigator of asset bubbles. While at times central banks have a certain influence on longer-term interest rates, they are not anywhere near in full control of these. Low rates are largely the product of economic forces which have little to do with Fed policy.

That doesn't mean that the Fed cannot be instrumental in reverting (or at least mitigating) the rise of asset bubbles, but this isn't as straightforward as some seem to think:

  • Asset bubbles are difficult to recognize ex-ante
  • Raising rates in order to prevent or deflate emerging asset bubbles brings significant cost in terms of lost output and employment
  • Macro-prudential policies targeting specific asset markets with specific measures (tying mortgages to income, forcing larger down-payments, hiking margin rates, etc.) can significantly blunt, but probably not entirely eliminate this policy dilemma.
Source: What If Central Banks Aren't Responsible For Asset Bubbles?