Twenty years ago, a youngish economist destined to become a household name in Australia issued a warning to central banks everywhere.
“[L]owering rates or providing ample liquidity when problems materialise but not raising rates as imbalances build up, can be rather insidious in the longer run,” he said.
“They promote a form of moral hazard that can sow the seeds of instability and of costly fluctuations in the real economy.”
So said Philip Lowe, the future Reserve Bank governor, in a paper he co-authored while on secondment at the Bank for International Settlements in Switzerland with senior BIS economist Claudio Borio.
The two presented their report to a March 2002 conference hosted by BIS – dubbed “the bank for central banks” – on how risks could grow even over times of apparent calm.
Of specific concern were financial imbalances, such as asset bubbles, that might emerge during stints of low inflation. In some circumstances, it would be appropriate for banks to take pre-emptive action “to preserve both financial and monetary stability”.
How central banks should act – and what they actually do – is at the heart of a fascinating if somewhat alarming new book by UK-based economic commentator Edward Chancellor.
The Price of Time explores the history and role of interest rates. Central banks, much like the nursery rhyme about “an old lady who swallowed a fly”, seem inured to solve each bout of market turmoil in a way that begets bigger instability in the future.
The warning by Borio and Lowe that authorities should be alert to the dangers of speculation – and the moral hazards that result when bad decision-makers get used to being rescued – is a constant theme running through the book.
The work is also timely, as an independent panel is halfway through a review of the RBA and its operations, due for completion in March.
That interest rates might be climbing in Australia, the US, New Zealand and elsewhere doesn’t diminish Chancellor’s case. As he notes, nominal rates may be off the record lows set during the Covid pandemic but they remain well below inflation, leaving them negative in real terms.
A favourite quote for the author is by Jeremy Stein, a Harvard University economist who served one term on the board of governors of the US central bank, the Federal Reserve.
Firm regulation of markets was all very well but monetary policy “gets into all the cracks”, Stein said. Excessively low interest rates pump up all manner of asset bubbles as investors desperate for some return on their money snap up property, shares, and until lately, cryptocurrency.
“All these extraordinary low interest rates [have] got into everything,” Chancellor told Guardian Australia. “And if we say we have the everything bubble, it sort of follows then that you’re going to have the everything bust.”
It’s perhaps surprising the purpose and perils of interest rates continue to confound experts and public alike. Most of us can grasp intuitively that somebody lending money or another asset to somebody else deserves a reward for the temporary transfer.
Ancient Mesopotamians “charged interest on loans before they discovered how to put wheels on carts”, Chancellor writes. Clay tablets dating back more than 4,000 years reveal borrowers offered up collateral – from homes, land and slaves to even the wife of an ancient borrower – as surety for repayment.
While the history of interest down the millennia is fascinating, the book’s main point is to highlight the snowballing challenges of the past quarter century.
In September 1998, Long-Term Capital Management, a giant US hedge fund with exposures some estimate at $US1tn ($A1.5tn), blew up. To prevent market contagion, the Fed cut its interest rate in what became a template for later responses by central banks to such stresses as the global financial crisis and the supply shocks of the Covid pandemic.
“The total calculated cost of each crisis is greater than the previous ones,” Chancellor says. And “the geographical reach of them is more extensive”.
It is China, however, that prompted the author to examine the genesis of market distortions and the role of interest rates.
By keeping interest rates artificially low for decades but particularly after the GFC in 2008, China has engineered the biggest expansion of lending in history. It has alone accounted for as much as half of global investment since then, Chancellor says.
As the Guardian has noted recently, the value of property in China is now double that of the US and triple Europe’s. That’s despite China having annual economic output of only about three-quarters as large as those two regions.
Forests of new apartment blocks destined to remain empty have sprung up, while increasingly costly tunnels and high-speed railways to remote regions hint at the economic waste.
“Because interest rates neither reflect the return on capital nor credit risk, China’s economy has suffered from the twin evils of capital misallocation and excessive debt,” Chancellor wrote.
People may have overlooked the risks in China because of the increasing role of the state in the economy and its tight grip over banks. Or, “simply because China was able to sail through the last crisis without too much apparent damage”.
Chancellor is not in the practice of making predictions but China, he says, has set itself on “a highly unsustainable path”. The challenges facing Xi Jinping as the Chinese president tries to revive confidence in a slumping real estate market while navigating the economy though rolling Covid-related lockdowns are formidable.
And as for that Borio-Lowe paper, Chancellor says they were on the money: “If you looked at real estate booms and credit booms, and put them together, you get what [they call] high-cost recessions.”
“It’d be interesting to confront [Lowe] with this research that he wrote,” he says, noting that the RBA under Lowe had likely acted in a way “contradictory” to his research with Borio on the dangers of allowing asset bubbles to inflate.
As to where Lowe now stands on the issue of overly low interest rates – the cash rate sat at a record low of 0.1% for 18 months until May 2022 – a spokesperson provided a short answer: “We are unable to help on this one.”
• The Price of Time, The Real Story of Interest by Edward Chancellor is published by Penguin ($55)