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The false logic of rate cuts

The false logic of rate cuts
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First Published: Tue, Feb 17 2009. 12 33 AM IST

Image: StockXpert
Image: StockXpert
Updated: Tue, Feb 17 2009. 12 33 AM IST
Central bankers around the globe are trying to outdo each other in pushing their policy interest rates inexorably towards zero. Alas, this march may be as deadly for the respective economies as the leap of small mammals into the sea.
Image: StockXpert
All major central banks have cut official interest rates sharply in order to cheapen funding costs for commercial banks and borrowers, or are intending to do so. Many are suggesting further cuts. Their declared aims include unfreezing credit markets and halting the decline in asset prices to stabilize economic conditions. For its part, the Open Market Committee members of the US Federal Reserve voted unanimously to push its benchmark rate to between zero and 0.25%, down from 1%. Not to be outdone, the Bank of Japan (BoJ) cut its benchmark rate to 0.1%, a move from the sublime to the ridiculous and extending almost two decades of near-zero interest rates.
Then the Bank of England cut official interest rates to a 315-year low of 1%. And China’s central bank has been cutting its one-year lending rate while the Reserve Bank of Australia lowered its policy rate, the cash rate, to a 45-year low of 3.25%.
Rate cuts have also occurred in India, South Korea and Taiwan.
From September, the Fed accumulated at least $2 trillion in assets in buying agency debt, commercial paper issued by firms, and mortgage-related and consumer loan-related securities. Now, the US central bank is acting like a commercial bank in supplying credit directly to financial consumers.
Amid all this, the monetary base in the US rose by 107% from just under $1 trillion to nearly $3 trillion from 8 August to 9 January. And a 40% increase in the money supply over the last six months of 2008 ensures that a future recovery will be accompanied by surging price levels.
Taking steps to raise the reserves within the banking system reflects a hope that lower interest rates will stimulate business borrowing to finance more investment spending. Despite lower short-term interest rates, credit costs have not fallen in the US. The “yield spread”—which measures the difference between short-term central bank interest rates and corporate bond yields and reflects default risk—is at its highest level since the Great Depression.
On the face of it, this policy has failed. Matters are worse when considering the original premise of all these actions, which was that a presumed “credit crunch” driven by a liquidity crisis would be relieved by pumping vast amounts of money with artificially low interest rates.
As is often the case with government institutions, hyperbole trumps reality. It turns out Federal Reserve data show commercial bank lending increased 2.36% during the last quarter of 2008 and was up by $386 billion, or 5.63%, for 2008. During 2008, business lending was up by $152 billion, or 10.6%, real estate loans rose by $213 billion, or 5.9%, and consumer lending rose by $73.5 billion, or 9%. While some categories of bank lending such as loans to farmers, broker-dealers and governments were down by $53.2 billion, or 5.4%, total bank lending was clearly up.
Fed data on credit market conditions measured by commercial bank credit outstanding did hit a six-month plateau from April to September. But during the first half of 2008, commercial bank credit outstanding stood at about $9.4 trillion and never went below the amount at the beginning of 2008.
After that brief pause, commercial bank credit rose again in September and the year ended with more lending than during 2007. All these radical steps were undertaken to deal with a “credit crunch” that was a phantom. The question now should be why is lending so high given current circumstances, rather than how to boost it further.
In all events, using banks to pump money into the economy is probably the wrong approach, at least in the US. As it is, the amount of credit supplied to the American economy by banks and other depository institutions in the financial sector declined from 40% in 1982 to about 22%.
Much of the perceived credit tightness reflects large declines in loan securitization. Demand for loans usually declines during a recession. In the current situation, sharp falls in stock market and house prices are likely to induce most households to try to make up for lost wealth by saving more and shunning new debt.
In all events, massive central bank tampering with the economy and deficit spending is behind many recent economic disasters. In the 1970s, loose monetary policy with a weak dollar, higher tax rates and massive public sector borrowing to boost spending led to stagflation. More recently, when markets tried to correct themselves after the dot-com bubble burst, the Fed drove down interest rates and helped fuel the housing and commodity bubbles.
Pushing interest rates to extremely low levels and keeping them there for a long time reinforces the tendencies the cuts aimed to reverse. Interest rates that are at or near zero level destroy the livelihoods of savers and makes them more fearful for the future so they save more from current incomes. Signals that there is little likelihood of short-to-medium-term recovery deepen economic problems, so businesses cut capital spending instead of raising it and increase their savings.
It sounds good that having interest rates on newly issued government debt close to zero means the cost of servicing debt is low. But it becomes hard to raise interest rates since doing so will balloon the fiscal deficit by forcing up debt servicing costs.
Zero interest rates encourage massive government spending that leads to massive public sector indebtedness. While this government spending diverts resources away from private sector activities, it reinforces a dependency on yet more government spending. This will further dampen private sector investment due to the anticipation of higher future tax burdens. How does any of this sound like the right thing to do?
In all events, lost in the rush to encourage more investment spending is the fact that the quality of lending and borrowing is more important than the quantity of such transactions. If market rates are zero but the average return to capital is negative, more borrowing will lead to more losses so that newly created funds will destroy wealth, not boost it.
Christopher Lingle is a research scholar at the Centre for Civil Society in New Delhi and a visiting professor of economics at Universidad Francisco Marroquin in Guatemala. Comments are welcome at theirview@livemint.com
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First Published: Tue, Feb 17 2009. 12 33 AM IST