Saturday, 16 October 2010

Monkeying with interest rates: US, Japan and EU monetary policy

Monkeying with interest rates

THINK ASIAN BY ANDREW SHENG

EVERY Chinese child knows the old story about monkeys who were offered a choice of two bananas in the morning and three in the afternoon, versus three in the morning and two in the afternoon.

Most monkeys chose the latter, but the traditional answer was that there should be no difference because both choices end up with five bananas. Who is right?

Actually, the monkeys are right. Three bananas in the morning are better than two in the morning, because there is a time preference of consumption now versus consumption later.

The two choices are not the same because there is a value attached to time, which is the interest rate.

The interest rate is the price to compensate for delayed consumption, because in the afternoon the monkey risks not getting the third banana, so it prefers to consume one more in the morning.

The two choices are identical when the interest rate is zero, because there is no reward for consuming now or later.

This is exactly the dilemma the world faces under quantitative easing, which is another word for printing money.

There are two reasons why advanced countries may want interest rates to be near zero.

The first is that after a crisis, zero interest rates mean that the central banks do not fear higher inflation.

The second is that zero interest rates subsidise the borrower, especially since the advanced economies are all highly in debt.

But zero interest rates have huge distortive effects on resource allocation.

If the advanced countries are growing at 2%-3% per annum, the real interest rate should be around 2%-3% per annum, because the savers should be compensated for the growth in the economy, otherwise their capital is being eroded in value.

With interest rates at zero, markets also have difficulty pricing risks.

The gross interest rate or dividend should always price in an element of risk that the borrower may default or inflation may rise.

By printing too much money and keeping interest rates very low, central bankers in advanced economies are hoping to reflate their economies.

Japan has tried this for decades without any success.

Actually, my diagnosis of the Japanese debt deflation is that there are two mutually reinforcing reasons of demographics of an aging population and lower income from low interest rates.

As the population ages, the economy must slow. Lowering interest rates causes the aging population to save more, rather than consume, because their income from their savings is declining.

This creates a vicious circle. In the short run, the low interest rates create a bond bubble (since the price of the bond is the inverse of the bond yield).

When the government runs higher and higher fiscal deficits, it can only do so by lower and lower interest rates.

This is exactly what has happened in Japan, when the domestic fiscal debt has reached 200% of gross domestic product (GDP) and if interest rates rise to global levels, the government would have an impossible fiscal crisis and the bond market would implode.

Europe and the US are running large fiscal deficits with fiscal debt averaging 100% of GDP and rising.
Central bankers are a conservative breed – they seldom talk bluntly.

However, the president of the Federal Reserve Bank of Kansas, who hosts an annual exclusive Jackson Hole Economic Symposium in August for central bankers, recently gave a brave speech called “Hard Choices”.

You know you are considered a respected central banker when you are invited to the Annual Jackson Hole conference. Needless to say, I have never been invited there.

The first hard choice is regulatory. President Hoenig considered that the “too big to fail” problem will not go away easily.

He said, “The Basel Committee just announced an agreement to establish for our largest global banks a Tier 1 capital-to-asset ratio of 3%. This is a 33-to-1 leverage ratio.

Bear Stearns entered this crisis and failed with a 34-to-1 leverage ratio. It leaves a small cushion for error and is a level of risk that I judge unacceptable.” Thank you for telling the truth, President Hoenig.

The second hard choice is monetary. Paul Krugman warned that “deflation is a serious risk and that the US could become another Japan, which must be avoided at all costs”.

President Hoenig dissects that hard choice: “But as much as I want short-term improvement, I am mindful of possible longer-term consequences of zero interest rates and further easing actions. Rather than improve economic outcomes, I worry that the FOMC is inadvertently adding to “uncertainty” by taking such actions.”

He correctly diagnosed that “the financial collapse followed years of too-low interest rates, too-high leverage, and too-lax financial supervision as prescribed by deregulation from both Democratic and Republican administrations.

In judging how we approach this recovery, it seems to me that we need to be careful not to repeat those policy patterns that followed the recessions of 1990-91 and 2001.

If we again leave rates too low, too long out of our uneasiness over the strength of the recovery and our intense desire to avoid recession at all costs, we are risking a repeat of past errors and the consequences they bring.”

He advocates “dropping the ‘extended period’ language from the FOMC’s statement and removing its guarantee of low rates. This tells the market that it must again accept risks and lend if it wishes to earn a return.”

In other words, he favours easing off “quantitative easing” by getting the market back to normal.
“A zero policy rate during a crisis is understandable, but a zero rate after a year of recovery gives legitimacy to questions about the sustainability of the recovery and adds to uncertainty.”

I congratulate President Hoenig for his frank and realistic assessment of the current dilemma of excessive low interest rates.

Unfortunately, I am not sure that his central banking guests may want to follow his advice. A great pity if they don’t.


>Tan Sri Andrew Sheng is adjunct professor at Universiti Malaya, Kuala Lumpur, and Tsinghua University, Beijing. He has served in key positions at Bank Negara, the Hong Kong Monetary Authority and the Hong Kong Securities and Futures Commission, and is currently a member of Malaysia’s National Economic Advisory Council. He is the author of the book “From Asian to Global Financial Crisis”.

US, Japan and EU monetary policy: Monkeying with interest rates

September 22nd, 2010
Author: Andrew Sheng, University of Malaya and Tsinghua University

Every Chinese child knows the old story about monkeys who were offered a choice of two bananas in the morning and three in the afternoon, versus three in the morning and two in the afternoon. Most monkeys chose the latter, but the traditional answer was that there should be no difference because both choices end up with five bananas. Who is right?

Actually, the monkeys are right. Three bananas in the morning are better than two in the morning because there is a preference for consumption now versus consumption later. There is a value attached to time, which is represented by the interest rate. The two choices are identical when the interest rate is zero, because there is no reward for consuming now or later.

This is exactly the dilemma the world faces under quantitative easing, which is another word for printing money.

There are two reasons why advanced countries may want interest rates to be near zero. The first is that after a crisis, zero interest rates imply that central banks do not fear higher inflation. The second is that zero interest rates subsidise the borrower, which is especially pertinent nowadays when advanced economies are all highly in debt.

But zero interest rates have huge distortive effects on resource allocation. If advanced countries are growing at 2-3 per cent per annum, the real interest rate should be around 2-3 per cent because savers should be compensated for the growth in the economy, otherwise their capital is being eroded in value.

With interest rates at zero, markets also have difficulty pricing risks. The gross interest rate or dividend should always price in an element of risk that the borrower may default or inflation may rise.

So why support a zero interest rate policy?

By printing too much money and keeping interest rates very low, central bankers in advanced economies are hoping to reflate their economies. Japan has tried this for decades without any success.

Keeping with the Japanese example, the demographics of an aging population and lower income from low interest rates are two mutually reinforcing reasons for Japanese debt deflation. As the population ages, the economy must slow. Lowering interest rates causes the aging population to save more, rather than consume, because their income from their savings is declining. This creates a vicious circle. In the short run, low interest rates create a bond bubble (since the price of a bond is the inverse of the bond yield). When the government runs higher and higher fiscal deficits, it can only do so by lower and lower interest rates.

This is exactly what is happening in Japan. If interest rates rise to global levels, the government would have an impossible fiscal crisis and the bond market would implode. Europe and the US are also in danger of the same outcome – the US and some European countries are running large fiscal deficits averaging 100 per cent of GDP and rising.

Central bankers and policy makers need to talk bluntly about this worrying problem. Luckily, Thomas Hoenig, president of the Federal Reserve Bank of Kansas, who hosts an annual exclusive Jackson Hole Economic Symposium in August for central bankers, recently gave a brave speech called ‘Hard Choices.’

The first hard choice he discussed is regulatory. President Hoenig considered that the ‘too big to fail’ problem will not go away easily. ‘The Basel Committee just announced an agreement to establish for our largest global banks a Tier 1 capital-to-asset ratio of three per cent. This is a 33-to-1 leverage ratio. Bear Stearns entered this crisis and failed with a 34-to-1 leverage ratio. It leaves a small cushion for error and is a level of risk that I judge unacceptable.’

In addition to improved regulatory practices, the second hard choice is monetary. President Hoenig succinctly dissected this policy dilema. ‘[A]s much as I want short-term improvement, I am mindful of possible
longer-term consequences of zero interest rates and further easing actions. Rather than improve economic outcomes, I worry that the FOMC is inadvertently adding to “uncertainty” by taking such actions.’

He correctly diagnosed that ‘the financial collapse followed years of too-low interest rates, too-high leverage, and too-lax financial supervision as prescribed by deregulation from both Democratic and Republican administrations. In judging how we approach this recovery, it seems to me that we need to be careful not to repeat those policy patterns that followed the recessions of 1990-91 and 2001. If we again leave rates too low, too long out of our uneasiness over the strength of the recovery and our intense desire to avoid recession at all costs, we are risking a repeat of past errors and the consequences they bring.’

He advocates ‘dropping the “extended period” language from the FOMC’s statement and removing its guarantee of low rates. This tells the market that it must again accept risks and lend if it wishes to earn a return.’ In other words, he favours easing off quantitative easing by getting the market back to normal. ‘A zero policy rate during a crisis is understandable, but a zero rate after a year of recovery gives legitimacy to questions about the sustainability of the recovery and adds to uncertainty.’

I congratulate President Hoenig for his frank and realistic assessment of the current dilemma of excessive low interest rates. Unfortunately, I am not sure that his central banking guests may want to follow his advice. It would be a great pity if they didn’t.

Andrew Sheng is Adjunct Professor at the University of Malaya and Tsinghua University, Beijing.