Monday, 1 October 2012

Dangers of low interest rates: case study Japan

A lot of pro-fiscal stimulus arguments in the US and the UK come from the classical zero lower bound (ZLB) assumption, in which monetary policy is said to be ineffective when interest rates hit zero (the lower boundary). This means that the central bank is basically ineffective in its further monetary operations to kick-start the economy, since it cannot lower rates to negative levels (this is not to be confused with real negative interest rates paid on, for example, German bonds). 

So in this situation of the zero lower bound trap (or as Keynes called it the Liquidity trap), the only favourable option is to kick-start recovery via fiscal stimulus. In particular, the fiscal stimulus would include more spending on infrastructure projects and direct packages of support to certain business projects (like the green economy). 

(Disregard at the moment monetary stimulus arguments I’ve covered in three previous texts – here, here and here; ideas such as NGDP targeting for example certainly have merit, and they certainly overrule the ZLB assumption, but I don’t see them as the best response to the current crisis, simply due to a different opinion I hold in which type of shock caused such a persistent crisis.)

From another perspective, low interest rates signal that the government can borrow more under such good conditions. This is an example of a counter-cyclical economic policy, one that tries to stimulate the economy out of a recession (depression), and within its scope it is ok to increase the deficit and raise public debt in order to get the economy going. The reason this isn’t unsustainable are precisely the low interest rates at which governments can borrow. 

Without repeating my previous points on why I think infrastructure projects, more government spending and/or higher deficits won’t do us any good at the moment, I will just briefly touch upon the dangers of keeping interest rates too low for too long, and what their real costs for the economy might be. 

Here’s from a speech by James Bullard, President of the St. Louis Federal Reserve Bank, back in February 2012:
"...the lengthy near-zero rate policy punishes savers in the economy...
These low rates of return mean that some of the consumption that would otherwise be enjoyed by the older, asset-holding households has been pared back. In principle, the low real interest rates should encourage younger generations to borrow against their future income prospects and consume more today. However, this demographic group faces high unemployment rates and tighter borrowing constraints, which may limit its ability and willingness to leverage up to finance consumption. Consequently, the consumption of the older generations may be damaged by the low real interest rates without any countervailing increase in consumption by other households in the economy. In this sense, the policy could be counterproductive."
Ken Rogoff wrote a good article a while back titled “How Long for Low Rates?”, where he also emphasizes the dangers of low interest rates, saying that the low interest rate dynamic is not stable and that it could unwind quickly: 
"Investors are increasingly wary of a global financial meltdown, most likely emanating from Europe, but with the US fiscal cliff, political instability in the Middle East, and a slowdown in China all coming into play. Meltdown fears, even if remote, directly raise the premium that savers are willing to pay for bonds that they perceive as the most reliable, much as the premium for gold rises. These same fears are also restraining business investment, which has remained muted, despite extremely low interest rates for many companies."
What happened in Japan?

One good case study that can point us to the dangers of keeping low interest rates for too long is Japan:


Looking at the graphs we can see that slow responsiveness of monetary policy in the beginning of the 90-ies had negative repercussions for the economy. Also, the 1990 increase in rates was obviously a very bad idea. Having learned their lesson, the Japan central bank has kept rates at zero or near zero ever since, persistently for the last 16 years (FYI, it's currently zero, and has been since October 2010, down from 0.1).

For the record, Ben Bernanke criticized Japan's monetary policy on accounts that it was too slow, its communication policy was unclear, and that it was afraid to raise inflationary expectations (this caused Japanese inflation to levitate around zero for the past 20 years, with several deflation periods - see here). 

Was Japan hit by a one-off aggregate demand shock which would have been allegedly easily solved with monetary or fiscal stimuli? Not likely. It is true that Japan's economy was hit by an aggregate demand shock in the early 90s, but the shock triggered structural problems in the economy, all hidden due to the previous boom in the 80s. Japan didn't fail to react with fiscal or monetary stimulus, it failed to reform. 

The arguments that monetary or fiscal stimulus came too late are not very sound in this case. After all, they did occur. The fact that they were late meant that there was no immediate, short-run bounce-back of the economy. There was a reverse of the negative trend in 1996 and 1997, but this period, and all others, was characterized by sluggish growth, much like what the West is experiencing today. So their monetary and fiscal efforts could only produce short-run effects when the economy was expecting supply-side reforms. The case study of Japan isn't proof that they failed to apply a stimulus, it is proof that stimuli didn't work in Japan.

Observing it from today's perspective this is exactly what more fiscal stimuli would result in. Monetary policy would continue in keeping interest rates low and continue with unconventional measures, while ambiguous fiscal policy and higher taxes would keep the economy locked in the lower equilibrium. Today's economies in recession should take serious note of this.

Besides, have in mind that one other economy also entered a crisis in the early 90s which was rightfully portrayed as an aggregate supply shock and productivity slowdown. Regular readers of the blog recognize that this country is Sweden, and its structural reform response was more than successful. 

9 comments:

  1. Of course I think you are completely correct here. Which brings the question, what policy might actually work? Here Is what I would do if I were Economy Czar,(not that I like all these czars).

    1) Immediate real freeze in federal spending. Automatic increases due to unreformed entitlements must come from other spending.
    2) Immediate roll back of all government business regulation to 1998.
    3) End all extended unemployment benefits.
    4) Make the current tax system permanent -5% ( The current tax system about to expire is kept and All income, corporate, and capital gains taxes reduced by an additional 5%, then the whole thing made permanent so business can plan ahead).

    None of the above is monetary policy, but it would have the effect of changing the business climate, and reducing uncertainty.

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    1. none of these are likely to result in positive effects and here's why:

      1) unrealistic - what other spending? where would the money come from? as for the immediate freeze, what do you think this would accomplish in the short run?
      2) even more unrealistic - what do you mean by rolling back regulation to 15 years ago? A LOT has changed until then and a lot of new regulations were necessary to cope with new technological changes in the economy. I'm not saying that all of them were good, but a majority was certainly necessary. This is the main problem when people speak of deregulation, everyone claims that we need to cut it, but when asked what in particular should be cut off, no one has a clue.
      3) this would result in an enormous negative shock on consumption from which consumer confidence wouldn't recover for a very long time.
      4) I'm not sure what you mean by this, but it looks very close to Romney's economy plan, which makes me return to my point under no.1 = unrealistic.

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    2. I have to defend Kyle as he did raise a few good points. First of all his suggested policies are primarily aimed at helping the private sector grow, and helping businesses regain confidence, which essential for the economy to recover. After all, policy uncertainty is a huge constraining factor in the current recovery. Having a clear message on what needs to be done substantially reduces this uncertainty.

      Cutting income, corporate and capital gains taxes are a very good step in that direction. And so is deregulation. Ok, perhaps going back 15 years isn't the best solution, but I see what he meant.

      Ending extended unemployment benefits certainly won't result in an "enormous negative shock", and it won't depress consumption, since I doubt that the unemployed are making the majority of consumption today (these are just semantics, but your premises is false nonetheless).

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  2. As for the whole text, Japan isn't an example of a failed stimulus, cause they didn't apply one when it was needed - in the short run. Whatever they tried later was ineffective cause they had the same distorted austerity policies Europe is applying now, and USA is going for thanks to Congress.
    Interest rates are low cause they have to be. Whenever Bank fo Japan increased the rates, things started to go bad for the economy - as the graph shows.
    That's why I think low rates aren't a real problem at all. Everything that one learns at Econ 101 tells us that low rates should be used to acquire more debt. That's why I'm having problems in understanding why everyone is afraid of a fiscal stimulus, when it's only obvious that we desperately need one.

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    1. "Everything that one learns at Econ 101 tells us that low rates should be used to acquire more debt."

      That's exactly what Japan did, right? They DO have the biggest debt to GDP in the world today (even bigger than Italy and Greece). So how was this helpful for their economy?

      Japan engaged in a productivity slowdown which was a supply-side shock, and it should have been solved with supply-side measures.

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    2. Well Jack no wonder you don't agree with me, you think debt will save us. DEBT IS BAD!! period. We have ample evidence that high debt nations grow far slower than low debt nations. So acquiring debt to grow an economy is like a dog chasing it's own tail.

      Nearly all of our problems have been caused by excess debt, private, corporate, and public. And those problems caused by debt are going to cause a lot more pain in the near future if we ever do start to have an economic expansion.

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    3. Your comment has inspired me for a new short post on why debt is bad.

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    4. There is also the Reinhart-Rogoff effect of a slow recovery in an economy piled up with debt. But I left that out for now.
      I wrote about that some time ago. See here

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    5. Of course piling up debt can't be a good strategy in the longer run. All I'm saying is that today, in the short run, when interest rates are on their historical lows, the govt should take advantage of this and stimulate economic growth, since the private sector is unwilling to do anything and since the banks are hoarding cash.

      After all, the best way to decrease debt to GDP ratio is by increasing the denominator. In other words, kick-start demand and kick-start growth, and soon enough the debt won't be a problem anymore.

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