Central Bank of the world facing a global dilemma


Since the 1980s low interest rates – both nominal and real – have become a constant feature of developed countries. Many today are wondering: how long can this trend persist?

A Geneva report on this subject, prepared jointly by the International Center for Monetary and Banking Research and the Center for Economic Policy Research in 2015, stated that interest rates would remain low for a long time, but hardly infinitely. Meanwhile, today in the world economy bonds with negative returns totaling more than $ 13 trillion are in circulation, so many scientists and investors began to believe that rates could remain low forever.

If this is the case, then the central banks face a difficult dilemma: should they keep their limited supply of gunpowder dry or should they use it proactively in the event of a slowdown in economic growth, the member of China Finance 40 Forum, an analytical organization, wonders in an article on Project Syndicate, Associate Professor, National Development School, Peking University, Miao Yanliang.

The answer should be sought beyond monetary policy or national boundaries. Why? It will be useful here to recall the basic concept of interest, which has always been a source of disagreement in economic theory. As the Austrian economist Eugen von Böhm-Bawerk pointed out in his 1890 book Capital and Percent, “the theory [of percents] is a variegated picture of extremely conflicting opinions, of which not one is able to defeat the others and not one is willing to admit itself the vanquished.”

Today, the situation has not changed much. Explanations of the current period of low interest rates are given by two clearly incompatible schools of science: neoclassical theory and Keynesian theory.

Non-classical thinkers, following the traditions of Alfred Marshall, Knut Wicksell and Irving Fisher, believe that real interest rates are determined by real economic forces. Money (or monetary policy) plays a neutral role, and the interest rate is what balances savings and investments, which depend on time preferences and profitability, respectively (hence the title of Fisher’s book on this subject in 1930, “The Theory of Percentage, Defined by impatient desire to spend income and the opportunity to invest it “). Using neoclassical approaches, one can identify a number of structural factors (from demographic changes leading to increased savings, to a slowdown in technological progress leading to lower demand) that explain the “secular” decline in interest rates.

In contrast, according to John Maynard Keynes’s “liquidity preference theory”, interest is better perceived as a premium for refusing liquidity for a certain period of time. This is not about saving in general, but only about saving money. Accordingly, the interest rate is determined simultaneously by the offer of liquidity and the preference for liquidity on the part of participants in the economy.

In normal times, these two scientific schools do not overlap and can coexist. Keynes focused on nominal rates, and Fisher on real ones; Keynes focused on the short term and Fisher on the long term. Keynesian principle of short-term monetary non-neutrality does not directly contradict the Fisher principle of long-term neutrality. When central banks act in Keynesian fashion by lowering nominal rates, real rates usually fall due to the effect of inflexible prices.

But today, interest rates are stuck on or near the lower zero border (abbreviated ZLB), and therefore these two approaches most likely came into collision: a reduction in the nominal rate causes an equivalent and immediate decrease in inflation expectations, so the real rate remains unchanged.

Some economists call this change in expectations the “Neo Fisher effect,” given that the traditional Fisher effect (inflation follows the nominal rate with a one-to-one coefficient) should only be observed in the long run.

The Fisher effect does not occur if inflation expectations remain fairly stable. However, as soon as rates fall into the trap of ZLB, inflationary expectations begin to decline, and the familiar Keynesian effect gives way to the neo fisher effect.

This is precisely what makes the ZLB distinctive: Fisher displaces Keynes. Central banks can reduce nominal rates to zero as much as they like or even enter negative territory, but real rates will remain unchanged. The more Keynesian the actions of the central bank become (attempts to stimulate demand by lowering rates), the more Fisher’s economy becomes – at least in terms of inflation expectations. And when this happens, monetary policy becomes not only powerless, but also potentially harmful.

Yes, of course, the idea of ​​the Neo Fisher effect causes an ambiguous reaction in the scientific community. But even if no unusual Fisher effect exists, the policy of fixing interest rates or the situation when rates are forced into the ZLB trap will still multiply possible shocks. Attempts to avoid such situations can put central banks in a difficult dilemma. Should they lower bids when necessary, even though such actions could trap Fisher?

An overdose of monetary policy can create conditions for monetary “non-neutrality”, pushing down equilibrium real rates. This pressure can be carried out through at least two channels. The first is a cycle of financial booms and crashes.

Persistently low interest rates stimulate risk appetite, which can lead to financial imbalances and increase debt. When the music stops playing, central banks have to cut rates further to cope with the inevitable collapse. The second channel is the erroneous distribution of resources, which occurs if excess liquidity inhibits Schumpeter’s “creative destruction”, because non competitive firms receive saving support.

To solve this dilemma, a fundamental change in the planning and implementation of economic policy is required. We need to significantly improve coordination at the national and international levels.

At the national level, monetary policy should not be the only option available. A more active role should be played by fiscal policy and structural reforms, and in addition, macroprudential policies, which can cope with cycles of financial booms and failures, should be made a top priority.

At the international level, a well-integrated financial assistance network would help reduce the need for self-insurance through safe assets. One good way to pool resources is to increase the firepower of the International Monetary Fund through quota reform. A new, improved international monetary system cannot be built in a day, but we must start somewhere.


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