Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 1 July 2014

The financial instability argument for raising rates

There is a nice juxtaposition of recent articles in the Economist. This one, by P.W. (it is weird this convention they have for signing with just their initials), puts the “case against maxing out monetary policy” (a.k.a. raise rates now). The Fed, Bank of England and ECB “argue that the priority is to restore growth and to do battle against low inflation. But [they] grievously misread the risks before the financial crisis, which weakens their claim to be reading them correctly now.” Let’s call the proposition that we should raise rates now to avoid financial instability the BIS case, after the Bank of International Settlements who have been making this argument ever since the recession began. In contrast Ryan Avent writes that there are two big problems with this argument. I want to expand on his discussion, and be a little less polite.

I want to begin by conceding a point. Suppose, as a monetary policymaker, you believe a financial crisis is possible, and that by raising rates you may be able to prevent it. Assume, crucially, that there is nothing else you can do to help prevent the financial crisis. In that case, you will consider raising rates, even if inflation is below target. If you have just one instrument (interest rates) and two targets (inflation and preventing a crisis) you will be influenced by both targets. If you want this point expressed more formally, see this post and the paper by Mike Woodford it discusses. 
However that is not the end of the story. If you raise rates to prevent financial instability when inflation is below target, inflation will remain below target or may fall even further. You cannot ignore that. So if interest rates are raised today to head off a financial crisis, they will have to be lower in the future to deal with the lower inflation or even deflation you have caused.

This is not just what macroeconomic theory says. In mid-2010 the Swedish central bank started raising interest rates (from 0.25% to 2%), despite forecasts that inflation would stay below target and with unemployment well above its natural rate. They did this explicitly because they were worried about the build up of household debt and a possible housing bubble. Inflation began to fall, and since 2013 it has been at or below zero. As Lars Svensson has pointed out, even on its own terms this is not a very clever policy, because with lower inflation the real value of debt is higher than it would otherwise have been. But the key point for the current discussion is that now interest rates are coming down again (currently 0.75%), because you cannot ignore inflation being over 2% below target.

Some of those making the BIS case understand this. What they hope is that if interest rates are raised to, say, 2% and stay there, that will still give us enough monetary stimulus to eventually get inflation back up to target. It clearly was not correct in the Swedish case, and with Euro inflation still at 0.5% it looks pretty improbable there too. But maybe it could be correct for the US and UK. So by raising rates by a modest amount today we might prevent financial instability, but at the cost of delaying the recovery.

I want to make two observations that follow from the BIS argument. The first is that they are in effect saying that the Zero Lower Bound (ZLB) constraint on monetary policy is even more severe than we thought, because if we leave interest rates at the ZLB for too long this generates an unacceptable risk of financial instability. That in turn must strengthen arguments (pdf) for raising inflation targets above 2%. Strangely, I do not hear advocates of the BIS case also arguing for higher inflation targets. The second is that, the more severe the ZLB constraint is in practice, the more compelling the case for using fiscal stimulus when we hit the ZLB. (Fiscal policy has become more expansionary in Sweden.) Again, this is something you do not hear BIS advocates argue for – in fact they often push austerity.

As Ryan Avent says, we can avoid all these difficulties by adding an extra instrument, which is macroprudential regulation. If parts of the financial system appear prone to instability because people are taking insufficient account of risks, bring in controls (or maybe taxes) of various kinds to stop this happening. Now, as R.A. notes, those taking the BIS position counter that such measures are untested and may not be effective. Here is a typical example in the FT, where it is stated that “macroprudential policies will fail to stop investors taking irrational risks”.

So we must raise interest rates, and delay the recovery, because nothing else can stop some in the financial system taking excessive risks. To which I can only say, summoning all my academic gravitas, what audacity, what impudence! Not only have we had to suffer the consequences of the Great Recession because of excessive risk taking within a largely unregulated financial system, we now have to cut short our main means of getting out of that recession because they might do it again. I do not know what planet these people are on, but if its mine, can they please get off and play their games elsewhere.


  1. Thank you for sharing a joint US/European perspective on the ZLB.

  2. Excellent post.

  3. Do you have a tally for the accumulated difference between potential GDP and measured GDP for the UK?

  4. PierGiorgio Gawronski2 July 2014 at 01:53

    Also, you/they are assuming that the two 'conflicting' objectives - demand recovery, and financial stability - are uncorrelated. But what if higher interest rates reduce demand --> reduce debts sustainability --> increase banks non performing loans --> financial instability? Then the two objectives would collapse to one (recovery) with the other following.
    And indeed, in the back of the BIS mind there's the idea that the two objectives are not uncorrelated, but financial stability --> confidence --> causes demand rcovery. So it is financial stability that central bankks should aim at, then aggregate demand will follow. Remember? Markets Always clear!

    1. The point is, however, that several hundreds of millions of people - who had absolutely NO power to effect financial instability - suffer, while those who knowingly took irrational risks suck up 93% of US economic recovery gains.

      Up your market clearing!

    2. I was being sarcastic towards the BIS... I think hard money can destabilize banks through non-performing loans; financial stability in a depression is better ensured by expansionary policies; growth cures financial instability.The BIS guys, on the other hand, believe that hard money boosts 'confidence' hence aggregate demand. I think that unconsciously they feel they can catch two birds with one policy; and maybe me, PK, SWL, too. But which policy is the right one? By raising interest rates, the BIS guys think they can prevent financial bubbles while also boosting GDP growth; I don't. My conclusion: at the BIS they don’t know anything about expectation management at the zero bound. Expectations are indeed crucial: an aggregate demand shortfall is always a psychological problem. But they don’t know how to handle it!

  5. “macroprudential policies will fail to stop investors taking irrational risks”, says the FT. There’s a simple solution to that: implement full reserve banking. Under full reserve, even if investors do take irrational risks, it doesn’t matter too much. Certainly banks don’t go insolvent in consequence.

  6. On the BBC website 29 June 2014 Last updated at 21:19 "BIS: Central banks warned of 'false sense of security'"

    You'll see there's not even the name of a correspondent from the BBC on this article, as though this stuff self-manifests.

    Here's a question for the last six years: has the BBC become part of 'movement conservatism'?

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  8. 'I do not know what planet these people are on, but if its mine, can they please get off and play their games elsewhere.'

    Well said! Or at least get them out of our banking system!

  9. So, if you know a car doesn't have good brakes, but you get in and you still go at 100 MPH and get into an accident, then you're going to say, "Well the car should have had better brakes." Well duh yeah; but it doesn't. And it's an idiot who goes 100 MPH knowing the car - today, at this moment - doesn't have good brakes.

    Here's one way of adding brakes. Low rates increase asset prices. The danger is when rates eventually go higher, assets which have been used as collateral will lose value and the value left to pay on loans will not be covered by the collateral. So when rates are low, haircuts on assets should be greater, and deposits for borrowing should be increased. E.g., using a rough, back-of-the-envelope calculation, deposits for homes should now be no lower than 30%. (Or, if you want to pretend you are sparing the borrower, demand that banks have hard assets - such as cash or short-term treasuries - to cover a 30% drop in housing collateral.) Now, when you get something like *that* passed, come back to us and talk about how you can lower rates all you want. But until then, no amount of itty-bitty regulation from the central bank will stop the flood which comes when asset prices naturally go lower when rates are increased. That naturally exposes, inevitably, the financial system to enormous losses because loans have been made on collateral which are now worth a lot less.

  10. The obvious solution, then, is to get cash through taxation instead.

    As the US financial sector rose from 11% to 21% of GDP, at least half the gain should have been taxed away to redeem the Social Security Trust Fund bonds in cash, and keep government budget deficits lower, if indeed anybody truthfully thinks our current level of debt is harmful.

    They certainly didn't think 30x leverage on mortgage debt was going to be any problem, now did they? (wink, wink)

  11. Why the financial instability argument for raising rates is probably right.

    (i) Macroprudential policy would be great if it worked, but the track record shows that our regulators are not up to the job.

    (ii) What we really need is fiscal stimulus -- because monetary policy is too weak to do anything but drag out a balance sheet recession.

    (iii) As long as the central banks provide enough monetary stimulus to provide cover for the politicians to avoid fiscal stimulus, policy will aggravate the balance sheet recession instead of resolving it -- and in the end we will have a crisis that dwarfs previous crises.

    Obviously you don't agree with all three of those points, but I think you should acknowledge that it hangs together logically.

    The principal reason to promote current monetary policy is because you don't believe the politicians will ever get their act together and you'd prefer to risk a massive crisis tomorrow than to guarantee real economy stress today. Which I have to admit is a reasonable argument against the financial instability argument for raising rates, given the uncertainties involved.

    On the other hand, I think its worth acknowledging that for those who think fiscal policy is a better tool (not the BIS!), the financial instability argument is a coherent and not outrageous point of view. It's just a difference of opinion on the probability and costs of a future massive crisis relative to the costs of immediate suffering.

  12. Simon, O/T: Where's the best place to find a chart of the price level (P) vs year which compares a theoretical model of P to empirical data? Here's two examples of what I mean for Canada and for Japan. Those both use the same model, by the way, and the author of the model also created a related pair of curves for the interest rates in those two countries (and others). He's trying to compare his model results with professional examples but he can't find any professional examples (he says when he does a Google image search for "price level model" he only finds his own plots (again he's looking for model results vs empirical data)!). Do you have any idea where he should he be looking?


  13. The attempt by the ECB to raise rates (in 2011) backfired, and now rates are lower than before. Maybe there's a lesson there?

  14. I think this post is totally brilliant.

  15. Yep. Good post.

    "However that is not the end of the story. If you raise rates to prevent financial instability when inflation is below target, inflation will remain below target or may fall even further. You cannot ignore that. So if interest rates are raised today to head off a financial crisis, they will have to be lower in the future to deal with the lower inflation or even deflation you have caused."

    That's the key point. We could think of it as a variant of Friedman's argument in What Monetary policy can and cannot do. The best cure for low interest rates is lower interest rates.

    1. Yes, this is a great point that Simon makes, quite apart from the fact that negative shocks to AD seem to be financially destabilising; indeed, arguably moreso than positive shocks.

      I'd rephrase the final line though: the way to get higher interest rates is to print more money*.

      * And commit to a permanently higher base level, ceteris paribus.

  16. The BIS is worse than Simon indicates. It thinks deflation would be fine.

  17. Pretty much everybody with an insane amount of money thinks deflation would be fine. They'd LOVE journeymen at $35/wk, just like in the good old days. Ergo CEO efforts like "The Can Kicks Back" and other such nonsense.

  18. The argument of those advocating higher overnight rates to prevent financial instability rest critically on the assertion that there is insufficient evidence that macroprudential regulation can prevent excessive risk-taking. However, where is the evidence that the blunt instrument of higher overnights rates will be more successful? Did not the Fed in trying to pop what it believed was a stock market bubble in the late 1920s by raising overnight rates succeed in producing, or at least contributing, to the financial crisis of the early 1930s and the Great Depression? Furthermore, raising overnight rates may actually increase financial instability if it succeeds in harming economic growth, which could lead to weaker household and business balance sheets.

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