Federal Reserve Bank of Dallas Globalization and Monetary Policy Institute Working Paper No. 126 http://www.dallasfed.org/assets/documents/institute/wpapers/2012/0126.

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Ultra Easy Monetary Policy and the Law of Unintended Consequences*

William R. White August 2012 Revised: September 2012 Abstract In this paper, an attempt is made to evaluate the desirability of ultra easy monetary policy by weighing up the balance of the desirable short run effects and the undesirable longer run effects the unintended consequences. The conclusion is that there are limits to what central banks can do. One reason for believing this is that monetary stimulus, operating through traditional (flow) channels, might now be less effective in stimulating aggregate demand than previously. Further, cumulative (stock) effects provide negative feedback mechanisms that over time also weaken both supply and demand. It is also the case that ultra easy monetary policies can eventually threaten the health of financial institutions and the functioning of financial markets, threaten the independence of central banks, and can encourage imprudent behavior on the part of governments. None of these unintended consequences is desirable. Since monetary policy is not a free lunch, governments must therefore use much more vigorously the policy levers they still control to support strong, sustainable and balanced growth at the global level. JEL codes: E52, E58

William R. White is currently the chairman of the Economic Development and Review Committee at the OECD in Paris. He was previously Economic Advisor and Head of the Monetary and Economic Department at the Bank for International Settlements in Basel, Switzerland. +41 (0) 79 834 90 66. white.william@sunrise.ch. This is a slightly revised version of the paper circulated in August 2012. The views in this paper are those of the author and do not necessarily reflect the views of organizations with which the author has been or still is associated, the Federal Reserve Bank of Dallas or the Federal Reserve System.

UltraEasyMonetaryPolicyandthe LawofUnintendedConsequences2
ByWilliamWhite
This long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy,toouselessataskifintempestuous seasons they can only tell us that when the storm is long past the sea is flat again.

Noverydeepknowledgeofeconomicsis
usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a presentillbysowingtheseedsofamuch greaterillforthefuture. Ludwigvon Mises

JohnMaynardKeynes

A. Introduction
Thecentralbanksoftheadvancedmarketeconomies(AMEs)3haveembarkedupononeofthe greatesteconomicexperimentsofalltimeultraeasymonetarypolicy.Intheaftermathofthe economic and financial crisis which began in the summer of 2007, they lowered policy rates effectivelytothezerolowerbound(ZLB).Inaddition,theytookvariousactionswhichnotonly causedtheirbalancesheetstoswellenormously,butalsoincreasedtheriskinessoftheassets theychosetopurchase.Theiractionsalsohadtheeffectofputtingdownwardpressureontheir exchangeratesagainstthecurrenciesofEmergingMarketEconomies(EMEs).Sincevirtuallyall EMEs tended to resist this pressure4, their foreign exchange reserves rose to record levels, helpingtolowerlongtermratesinAMEsaswell.Moreover,domesticmonetaryconditionsin theEMEswereeasedaswell.Thesizeandglobalscopeofthesediscretionarypoliciesmakes themhistoricallyunprecedented.EvenduringtheGreatDepressionofthe1930s,policyrates andlongertermratesinthemostaffectedcountries(liketheUS)wereneverreducedtosuch lowlevels5. In the immediate aftermath of the bankruptcy of Lehman Brothers in September 2008, the exceptional measures introduced by the central banks of major AMEs were rightly and

Theviewsexpressedherearepersonal.Theydonotnecessarilyrepresenttheviewsoforganizationswithwhich theauthorhasbeenorstillisassociated. 3 Itisimportanttonotethat,inspiteofmanysimilaritiesinthepoliciesofvariousAMEcentralbanks,therehave alsobeenimportantdifferences.SeeWhite(2011), 4 ThisphenomenonwasnotinfactconfinedtoEMEs.AnumberofsmallerAMEs,likeSwitzerland,havealso resistedupwardpressureontheirexchangerates. 5 SeeBankforInternationalSettlements(2012)Graph1V.8

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successfully directed to restoring financial stability. Interbank markets in particular had dried up,andtherewereseriousconcernsaboutafinancialimplosionthatcouldhavehadimportant implicationsfortherealeconomy.Subsequently,however,asthefinancialsystemseemedto stabilize,thejustificationforcentralbankeasingbecamemorefirmlyrootedinthebeliefthat suchpolicieswererequiredtorestoreaggregatedemand6afterthesharpeconomicdownturn of2009.Inpart,thiswasaresponsetotheprevailingorthodoxythatmonetarypolicyinthe 1930shadnotbeeneasyenoughandthatthiserrorhadcontributedmateriallytotheseverity of the Great Depression in the United States.7 However, it was also due to the growing reluctance to use more fiscal stimulus to support demand, given growing market concerns abouttheextenttowhichsovereigndebthadbuiltupduringtheeconomicdownturn.Thefact that monetary policy was increasingly seen as the only game in town implied that central banks in some AMEs intensified their easing even as the economic recovery seemed to strengthen through 2010 and early 2011. Subsequent fears about a further economic downturn,reopeningtheissueofpotentialfinancialinstability8,gavefurtherimpetustoultra easymonetarypolicy. FromaKeynesianperspective,basedessentiallyonaoneperiodmodelofthedeterminantsof aggregatedemand,itseemedclearlyappropriatetotrytosupportthelevelofspending.After the recession of 2009, the economies of the AMEs seemed to be operating well below potential,andinflationarypressuresremainedsubdued.Indeed,variousauthorsusedplausible versions of the Taylor rule to assert that the real policy rate required to reestablish a full employmentequilibrium(andpreventdeflation)wassignificantlynegative.Suchfindingswere usedtojustifytheuseofnonstandardmonetarymeasureswhennominalpolicyrateshitthe ZLB. Thereis,however,analternativeperspectivethatfocusesonhowsuchpoliciescanalsoleadto unintended consequences over longer time periods. This strand of thought also goes back to thepreWarperiod,whenmanybusinesscycletheorists9focusedonthecumulativeeffectsof bankcreatedcreditonthesupplysideoftheeconomy.Inparticular,theAustrianschoolof thought, spearheaded by von Mises and Hayek, warned that credit driven expansions would

SeeinparticularBernanke(2010).ThereasonsforconductingQE2seemtodiffersubstantiallyfromthereasons forconductingQE1. 7 Bernanke(2002) 8 ThecatalystforthesefearswasasharpslowdowninEurope.Thiswasdrivenbyconcernsaboutsovereigndebtin anumberofcountriesintheeurozone,andassociatedconcernsaboutthesolvencyofbanksthathadbecome overexposedtobothprivateandsovereignborrowers.AlsoofimportancewerefearsofthefiscalcliffintheUS. Thisinvolvedexistinglegislationwhich,unlessrevised,wouldcuttheUSdeficitbyabout4percentofGDP beginninginJanuary2013.Asdiscussedbelow,thisprospecthadachillingeffectoncorporateinvestmentand hiringwellbeforethatdate. 9 Foranoverview,seeHaberler(1939).Laidler(1999)hasaparticularlyenlighteningchapteronAustriantheory, andthemaindifferencesbetweentheAustriansandKeynesians.Hethennotes(p.49)Itwouldbedifficult,inthe wholehistoryofeconomicthought,tofindcoexistingtwobodiesofdoctrinewhichsogrosslycontradictone another.
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eventuallyleadtoacostlymisallocationofrealresources(malinvestments)thatwouldendin crisis.BasedonhisexperienceduringtheJapanesecrisisofthe1990s,Koo(2003)pointedout that an overhang of corporate investment and corporate debt could also lead to the same result(abalancesheetrecession). Researchers at the Bank for International Settlements have suggested that a much broader spectrum of credit driven imbalances10, financial as well as real, could potentially lead to boombustprocessesthatmightthreatenbothpricestabilityandfinancialstability11.ThisBIS wayofthinkingabouteconomicandfinancialcrises,treatingthemassystemicbreakdownsthat could be triggered anywhere in an overstretched system, also has much in common with insights provided by interdisciplinary work on complex adaptive systems. This work indicates thatsuchsystems,builtupasaresultofcumulativeprocesses,canhavehighlyunpredictable dynamics and can demonstrate significant non linearities12. The insights of George Soros, reflectingdecadesofactivemarketparticipation,areofasimilarnature.13 Asatestimonytothiscomplexity,ithasbeensuggestedthatthethreattopricestabilitycould alsomanifestitselfinvariousways.Leijonhufvud(2012)contendsthattheendresultsofsuch credit driven processes could be either hyperinflation or deflation14, with the outcome being essentially indeterminate prior to its realization. Indeed, Reinhart and Rogoff (2009) and Bernholz (2006) indicate that there are ample historical precedents for both possible outcomes.15 As to the likelihood that credit driven processes will eventually lead to financial instability,ReinhartandRogoff(2009)notethatthisisacommonoutcome,thoughtheyalso

Animbalanceisdefinedroughlyasasustainedandsubstantialdeviationfromhistoricalnorms,forwhich thereisnocompellinganalyticalexplanation. 11 SeeinparticularthemanyworksauthoredorcoauthoredbyClaudioBorio,includingBorioandWhite(2003). SeealsoWhite(2006).TheoriginsofthiswayofthinkinggobacktotheworkofAlexanderLamfalussyandpossibly evenbefore.SeeClement(2010)ontheoriginsofthewordmacroprudential,whosefirstrecordeduseatthe BISwasin1979. 12 Thereisalonghistory(althoughnevermainstream)oftreatingtheeconomyasacomplex,adaptivesystem.It goesbacktoVeblenandevenbefore.However,thisapproachreceivedsignificantimpetuswiththefoundingof theSantaFeInstituteintheearly1990s.SeeWaldrop(1992).Forsomerecentapplicationsofthistypeofthinking seeBeinhocker(2006)andHaldane(2012).Fromthisperspective,aneconomysharescertaindynamic characteristicswithothercomplexsystems.Buchanan(2002)suggeststhefollowing.First,crisesoccuronaregular basisincomplexsystems.TheyalsoconformtoaPowerLawlinkingthefrequencyofcrisestotheinverseoftheir magnitude.Second,predictingthetimingofindividualcrisesisimpossible.Third,thereisnorelationship betweenthesizeofthetriggeringeventandthemagnitudeofthesubsequentcrisis.Thiswayofthinkinghelps explainwhytheGreatModerationcouldhavebeenfollowedbysuchgreatturbulence,andwhymajoreconomic criseshavegenerallyemergedsuddenlyandwithnoclearwarning. 13 Soroshaswrittenprolificallyonthesethemesovermanyyears.Forarecentsummaryofhisviews,seeSoros (2010) 14 Inearlierpublications,Leijonhufvudreferredtothecorridorofstabilityinmacroeconomies.Outsidethis corridor,hesuggeststhatforcesprevailwhichencourageaneverwideningdivergencefromequilibrium.Seealso White(2008) 15 Thishelpsexplainthecoexistencetodayoftwoschoolsofthoughtamonginvestorsaboutfutureprice developments.
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note that the process more commonly begins with a recession feeding back on the financial systemthantheotherwayaround16.ReinhartandReinhart(2010)documenttheseverityand durabilityofdownturnscharacterizedbyfinancialcrisis,implyingthatthiscomplicationwould seem more likely to shift the balance of macroeconomic outcomes towards deflation rather thaninflation. Inthispaper,anattemptismadetoevaluatethedesirabilityofultraeasymonetarypolicyby weighing up the balance of the desirable short run effects and the undesirable longer run effectstheunintendedconsequences.InSectionB,itissuggestedthattherearegroundsto believethatmonetarystimulusoperatingthroughtraditional(flow)channelsmightnowbe less effective in stimulating aggregate demand than is commonly asserted. In Section C, it is further contended that cumulative (stock) effects provide negative feedback mechanisms that also weaken growth over time. Assets purchased with created credit, both real and financial assets, eventually yield returns that are inadequate to service the debts associated withtheirpurchase.Inthefaceofsuchstockeffects,stimulativepoliciesthathaveworkedin thepasteventuallylosetheireffectiveness. It is also argued in Section C that, over time, easy monetary policies threaten the health of financial institutions and the functioning of financial markets, which are increasingly intertwined. This provides another negative feedback loop to threaten growth. Further, such policiesthreatentheindependenceofcentralbanks,andcanencourageimprudentbehavior on the part of governments. In effect, easy monetary policies can lead to moral hazard on a grand scale17. Further, once on such a path, exit becomes extremely difficult. Finally, easy monetarypolicyalsohasdistributionaleffects,favoringdebtorsovercreditorsandthesenior management of banks in particular. None of these unintended consequences could be remotelydescribedasdesirable. Theforceoftheseargumentsmightseemtoleadtotheconclusionthatcontinuingwithultra easymonetarypolicyisathoroughlybadidea.However,aneffectivecounterargumentisthat such policies avert near term economic disaster and, in effect, buy time to pursue other policiesthatcouldhavemoredesirableoutcomes.Amongthesepoliciesmightbesuggested18 moreinternationalpolicycoordinationandhigherfixedinvestment(bothpublicandprivate)in AMEs.Thesepolicieswouldcontributetostrongeraggregatedemandatthegloballevel.This would please Keynes. As well, explicit debt reduction, accompanied by structural reforms to redressotherimbalancesandincreasepotentialgrowth,wouldmakeremainingdebtsmore easilyserviceable.ThiswouldpleaseHayek.Indeed,itcouldbesuggestedthatacombinationof

SeeReinhartandRogoff(2009)p.145.Severefinancialcrisesrarelyoccurinisolation.Ratherthanbeingthe triggerofrecession,theyaremoreoftenanamplificationmechanism. 17 ThisisdiscussedfurtherinWhite(2004) 18 White(2012b)

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all these policies must be vigorously pursued if we are to have any hope of achieving the strong,sustainedandbalancedgrowthdesiredbytheG20.Wedonotliveinaneitheror world. Thedangerremains,ofcourse,thatultraeasymonetarypolicywillbewronglyjudgedasbeing sufficient to achieve these ends. In that case, the bought time would in fact have been wasted19.Inthiscase,theargumentspresentedinthispaperthenlogicallyimplythatmonetary policyshouldbetightened,regardlessofthecurrentstateoftheeconomy,becausethenear term expected benefits of ultra easy monetary policies are outweighed by the longer term expectedcosts.Undoubtedlythiswouldbeverypainful,but(bydefinition)lesspainfulthanthe alternativeofnotdoingso.JohnKennethGalbraithtoucheduponasimilarpracticalconundrum someyearsagowhenhesaid20 Politicsisnottheartofthepossible. Itischoosingbetweentheunpalatableandthedisastrous. ThismightwellbewherethecentralbanksoftheAMEsarenowheaded,absentthevigorous pursuitbygovernmentsofthealternativepoliciessuggestedabove.

B. WillUltraEasyMonetaryPolicyStimulatetheRealEconomy?
Stimulative monetary policies are commonly referred to as Keynesian. However, it is importanttonotethatKeyneshimselfwasnotconvincedoftheeffectivenessofeasymoneyin restoring real growth in the face of a Deep Slump. This is one of the principal insights of the GeneralTheory.21Incurrentcircumstances,twoquestionsmustbeaddressed.First,willultra easy monetary conditions be effectively transmitted to the real economy? Second, assuming theanswertothefirstquestionisyes,willprivatesectorspendingrespondinsuchawayasto stimulatetherealeconomyandreduceunemployment?Itissuggestedinthispaperthatthe answertobothquestionsisno. a) UltraEasyMonetaryPolicyandtheTransmissionMechanism When the crisis first started in the summer of 2007 the response of AME central banks was quite diverse. Some, like the ECB, remained focused on resisting inflation which was rising under the influence of higher prices for food and energy. Others, like the Federal Reserve, lowered policy rates swiftly and by unprecedented amounts. However, by the end of 2008,

GovernorShirakawaoftheBankofJapanhasmadethisargumentparticularlyforcefully.SeeShirakawa(2012a and2012b).ItalsoresonatesstronglyinbothEuropeandtheUnitedStates.Theirrespectivecentralbankheads haverepeatedlycalledongovernmentstotakethenecessarymeasurestodealwithfiscalandotherproblemsthat areultimatelygovernmentresponsibilities.SeealsoIssing(2012)p3andFisher(2012).Bothhavestressed repeatedlythatthatthereareclearlimitstowhatcentralbankscando. 20 Galbraith(1993). 21 SeeKeynes(1936).Asnotedbelow,however,thisskepticismseemedtomarkachangefromhisearlierthinking.

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againstthebackdropofthefailureofLehmanBrothersanddeclininginflation,virtuallyallAME central banks were in easing mode and policy rates were reduced virtually to zero. This responseshowedclearlythecapacityofcentralbankstoact.Atthesametime,havinglowered policyratestoorneartheZLB,theseactionsalsoimpliedaseriouslimitationonthefurtheruse oftraditionalmonetarypolicyinstruments.Further,astimeworeon,doubtsbegantoemerge abouttheeffectivenessofsomeofthetraditionalchannelsoftransmissionofmonetarypolicy. An important source of concern was whether lower policy rates would be effectively transmittedalongtheyieldcurvetolongermaturities.Duetothepotentiallyinteractingeffects ofrisingtermandcreditspreads,longratesmightfalllessthannormally(orindeedmighteven rise) in response to lower policy rates. This phenomenon has already been witnessed in a numberofperipheralcountriesintheeurozonearea.Afteryearsofdeclininglongratesdriven by convergence trades, prospects of continuing slow growth (or even recession) in these countriesraisedconcernsaboutthecontinuedcapacityoftheirgovernmentstoservicerising debtlevels.TheEuropeanCentralBanktookvariousstepstosupportthepricesofsovereign bonds in the various countries affected, but these measures have not thus far proved successful.22 Incontrast,forsovereignsdeemednottohavecounterpartyrisk,therehasbeennoevidence of such problems. Indeed, long term sovereign rates in the US, Germany, Japan and the UK followedpolicyratesdownandarenowatunprecedentedlowlevels.However,therecanbe noguaranteethatthisstateofaffairswillcontinue.Onedisquietingfactisthattheselongrates havebeentrendingdown,inbothnominalandrealterms,foralmostadecadeandthereisno agreementastowhythishasoccurred.23Manycommentatorshavethusraisedthepossibility of a bond market bubble that will inevitably burst24. Further, long term sovereign rates in favored countries could yet rise due to growing counterparty fears. In all the large countries noted above, the required swing in the primary balance needed just to stabilize debt to GNE ratios(athighlevels),isverylarge25.Suchmassivereductionsingovernmentdeficitscouldbe

TheECBdirectlypurchasedsuchbondsin2010and2011underitsSMPprogram.Morerecentlyithasextended LTROfacilities,withsomeofthefundsprovidedbeingusedbybankstopurchasebondsissuedbytheirnational sovereigns.CriticsofthesepoliciescontendthattheECBcouldlowerthesebondspreadsifitweretoannouncea targetforsuchspreadsandmakecredibleitswilltoimposeit.Forvariousreasons,botheconomicandpolitical, theECBhasthusfarchosennottodothis.However,itremainsanopenissue. 23 Forafulleranalysisofthepotentialcontributingfactors,seeTurner(2011) 24 PerhapsthebestknownmarketparticipanttoexpressthisviewwasBillGrossofPimco,thoughhehas subsequentlychangedhismind. 25 Forcalculationsindicatinghowlargetheneededswingmightbe,seeCecchettietal(2010).Theircalculations indicatetheprimarysurplusmustswingby15percentagepointsofGDPintheUnitedKingdomandJapan,and11 percentagepointsintheUnitedStates.Generallyspeaking,theadjustmentsrequiredinlargecontinental Europeaneconomiesaresmaller.
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hard to achieve in practice. In the US and Japan, in particular, the absence of political will to confrontevidentproblemshasalreadyledtodowngradesbyratingagencies26. Asforprivatesectorcounterpartyspreads,mortgageratesinanumberofcountrieshavenot followedpolicyratesdowntothenormalextent.IntheUnitedStatesinparticular,astheFed Funds rate fell sharply from 2008 onwards, the 30 year FNMA rate declined much less markedly27. In part, widening mortgage spreads reflect increased concentration in the mortgagegrantingbusinesssincethecrisisbegan,andalsoincreasedcostsduetoregulation. However,italsoreflectsthegloballossoftrustinfinancialinstitutions,whichhasledtohigher wholesale funding costs. In addition, costs of funds have risen in many countries due to the failureofdepositratestofullyreflectdeclinesinpolicyrates28.Afullerdiscussionoftheeffects oflowinterestratesonthefinancialindustryisreservedforlater Spreads for corporate issues have also fallen less than might normally have been expected, eveniftheabsolutedeclinehasbeenverysubstantial.Nevertheless,thesespreadscouldrise again if the economy were to weaken or even if economic uncertainties were to continue. Paradoxically,ariseincorporatespreadsmightevenbemorelikelyshouldgovernmentspursue credibleplansforfiscaltightening29.Theseplansmightwellinvolvetaxincreasesandspending cutsthatcouldhavematerialimplicationsforbothforwardearningsandcompaniesnetworth. Thiscouldconceivablyincreaseriskpremiaoncorporatebonds. A further concern is that the reductions in real rates seen to date, associated with lower nominal borrowing rates and seemingly stable inflationary expectations, might at some point beoffsetbyfallinginflationaryexpectations.Inthelimit,expectationsofdeflationcouldnotbe ruledout.Thisinfactwasanimportantpartofthedebt/deflationprocessfirstdescribedby IrvingFisherin1936.Theconventionalcounterargumentisthatsuchtendenciescanbeoffset by articulation of explicit inflation targets to stabilize inflationary expectations. Even more powerful,acentralbankcouldcommittoapriceleveltarget,implyingthatanypricedeclines wouldhavesubsequentlytobeoffsetbypriceincreases30. However,thereareatleasttwodifficultieswithsuchtargetingproposals.Thefirstismakingthe target credible when the monetary authorities room for maneuver has already been

TherecentratingsdowngradeoftheUSwasnotduetoanychangeintheobjectiveeconomiccircumstances. Rather,itreflectedanassessmentthatadysfunctionalCongresswasincreasinglyunlikelytomakethe compromisesnecessarytoachieveameaningfulreductionoftheUSdeficit. 27 Moreover,averageeffectiverateonoutstandingUSmortgagesfellevenless;homeownerswithnegative effectiveequitywereunabletorefinancetheirmortgagesatlowerrates,asinearliercycles. 28 OnthisgeneralquestionoftheincreasedcostoffinancialintermediationseeLowe(2012). 29 SeeDugger(2011).DuggerintroducestheconceptofFiscalAdjustmentCost(FAC)discounting.Hecontendsthat companiesarealreadyassessingtheeffectsoffiscalconstraintontheirownbalancesheetsandearnings.Ineffect theybegintotreatlongtermfiscalshortfallsaspresentvalueoffbalancesheet(corporate)liabilities. 30 Thisisverysimilartotheprocessthatworkedunderthegoldstandard.Fallingpriceswereexpectedtoreverse, thusloweringtheexanterealinterestrateandencouragingpricestorise.
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constrained31 by the zero lower bound problem (ZLB). The second objection is even more fundamental;namely,thepossibilitythatinflationaryexpectationsarenotbasedprimarilyon central bankers statements of good intent. Historical performance concerning inflation, changing perceptions about the central banks capacity and willingness to act, and other considerations could all play a role. The empirical evidence on this issue is not compelling in eitherdirection32. Lower interest rates are not the only channel through which monetary conditions in AMEs mightbeeasedfurther.Whethervialowerinterestratesorsomeothercentralbankactions, reflationary forces could be imparted to the real economy through nominal exchange rate depreciation33andtheresultingincreaseincompetitiveness34.However,animportantproblem withthisproposedsolutionisthatitworksbestforasinglecountry.Incontrast,virtuallyallthe AMEsareneartheZLBanddesirousoffindingotherchannelstostimulatetherealeconomy. Evidently,thisstillleavesthepossibilityofabroadernominaldepreciationofthecurrenciesof AMEsvisavisthecurrenciesofEMEs.Indeed,giventhetradesurplusesofmanyEMEs(not leastoilproducers),andalsotheinfluenceoftheBalassaSamuelsoneffect,arealappreciation oftheircurrenciesmightbethoughtinevitable. The problem rests with the unwillingness of many EMEs to accept nominal exchange rate appreciation;thesocalledfearoffloating.Tothisend,theyhaveengagedovermanyyearsin large scale foreign exchange intervention and easier domestic monetary policies than would otherwise have been the case. More recently, the rhetoric concerning currency wars has sharpenedconsiderably,andanumberofcountriesturnedforatimetocapitalcontrols35.The principal concern about these trends in EMEs is that they might lead to a more inflationary domesticoutcome36. Another channel through which monetary policy is said to work is through higher prices for assets,inparticularhousesandequities.Ineffect,higherpricesaresaidtoaddtowealthand this in turn spurs consumption. Before turning (below) to the latter link in this chain of causation,considertheformerone.Inthosecountriesinwhichthecrisisraisedconcernabout the health of the banking system (eg; US, UK, Ireland, Greece, Spain) house prices began to

ForanelegantdescriptionofthisproblemseeYamaguchi(1999).Eventoday,theBankofJapanrefusestoseta targetforinflation,butratherespousesalessambitiousgoal 32 SeeGalatiandMelick(2004).AlsoGalati,HeemiejerandMoessner(2011)whichprovidesasurveyofrecent theoryandtheavailableempiricalevidence. 33 Svenson(2003) 34 Howlongnominaldepreciationresultsinarealdepreciationisanotherhighlydebatedissue.Inflationwould presumablybelessofaproblemincountrieswithhighlevelsofexcesscapacity.ExperienceofdepreciationinLatin Americancountriesoverdecadesindicatesthisneednotalwaysbethecase. 35 Interestingly,theIMFnowseemsmorewillingthanhithertotoacceptbothlargescaleinterventioninforeign exchangemarketsandcapitalcontrols.SeeOstryetal(2010) 36 RecenteffortsinChinatoraisedomesticwagesinordertospurdomesticconsumptionworkinthesame direction.
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declinesharplyearlyinthecrisis.Lowerpolicyrateswerenotsufficienttoreversethistrend.In contrast, in countries where the health of the banking system was never a serious concern, housepricesdidcontinuetoriseaspolicyrateswerelowered.Thishasraisedconcernsofan eventualandaggravatedcollapse. As for equity prices, stock indices in the AMEs did recovery substantially after policy easing began. However, it is also notable that these increases began to moderate in the summer of 2010andagaininthemiddleof2011.Ineachcase,theannouncementofsomenonstandard policymeasurethencausedstock pricestoriseonceagain.Morebroadly,however,thevery fact that a number of central banks felt the need to have recourse to such non standard measures indicates that standard measures had failed to produce the stimulative effect desired. The durability of real gains supported by the expansion of nominal instruments alsoseemshighlyquestionable. Finally, an evaluation is needed of the effectiveness of the many non standard monetary policymeasuresthathavebeentakenbycentralbanksinlargeAMEs,pursuanttoreachingthe ZLB37.Thehighlyexperimentalnatureofthesemeasuresisattestedtobyvariousdifferences observedinwhatdifferentcentralbankshaveactuallydone.AsdescribedbyFahretal(2011) thereareimportantdifferencesbetweenthepracticesoftheFedandtheECB. Perhaps most important, the Fed seems to have treated its non standard measures as a substitute for standard monetary policy at the ZLB. In contrast, the ECB treats them as measures to restore market functioning so that the normal channels of the transmission mechanism policy can work properly. Second, while the Fed made increasingly firm pre commitments(thoughstillconditional)tokeepthepolicyratelowforanextendedperiod,the ECB consciously made no such pre commitment Third, whereas the Fed has purchased the liabilities of non financial corporations as well as those of Treasury and Federal agencies, the ECBhaslentexclusivelytobanksandsovereigns. Fourth,whiletheECBconductedonlyrepos,in ordertofacilitateexitfromnonstandardmeasures,theFedmadeoutrightpurchases. Many of the non standard measures taken to date are broadly similar to those undertaken earlier by the Bank of Japan. It is instructive therefore that the Japanese authorities remain highly skeptical of their effectiveness38 in stimulating demand. Perhaps the most important reason for this is that the demand for bank reserves tends to rise to match the increase in supply;inshort,loangrowthdoesnotseemtobemuchaffected.If,inexpandingthereserve base,thecentralbankalsoabsorbscollateralneededtoliquefyprivatemarkets,thattoocould beanegativeinfluence.Thistopicisreturnedtobelow.

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ForanearlyanalysisseeBorioandDisyatat(2009) Shirakawa(2012a,2012b)

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Itisofcoursetruethatstillmoreaggressiveunconventionalmeasurescouldbeintroducedthat mighthavetheeffectdesired.Indeed,inchastisingtheBankofJapanforitstimidity,Bernanke (2000)and(2003)explicitlysuggestedtargetsforlongterminterestrates,depreciationofthe currency,ahigherinflationtarget(say3to4percent)andfiscalexpansionentirelyfinancedby the central bank. Unfortunately, for each of these policy suggestions there is a convincing counterargument. Explicittargetsforlongrateshardlyseemrequiredwithlongratesalreadyatrecordlows.Asfor thedifficultiesofachievingacurrencydepreciation,thesehavebeendiscussedabove.Recent suggestions for a higher inflation target39 have also generated wide spread criticism, particularly since inflation in AMEs has stayed stubbornly and unexpectedly high to date. Finally,fiscalexpansionentirelyfundedbymonetarycreationcould,givenAMEsovereigndebt levelsgenerallythoughtofasunsustainable,easilyraisefearsoffiscaldominanceandmuch higherinflation.Perhapstheclearestindicationoftheforceofthesecounterargumentsisthat Chairman Bernanke, having proposed these policies almost a decade ago, has not found it appropriate to reassert them more recently, in spite of the ongoing and (again) unexpected weaknessoftheUSrecovery40. b) Wouldprivatesectordemandrespondtoeasiermonetaryconditions? Conventionalthinkingisthatlowerinterestrateswillencouragehouseholdstosaveless(and consume more) and will encourage companies to invest more. In both cases, spending is broughtforwardfromthefuture,becausethediscountratehasbeenreduced.Evenabstracting fromtheinfluenceofcumulativestockconsiderations(bothrealandfinancial)onspending41, thisconventionalthinkingcanbechallengedinanumberofways. Aconsiderationthatappliestobothhouseholdandcompanyspendingisthemessagegivenby ultra easy monetary policy. To the extent that such measures are unprecedented, indeed smackingofdesperation,theycouldactuallydepressconfidenceandthewilltospend.Keynes referencestoanimalspiritsintheGeneralTheorywouldseemappropriatehere.Indeed,the greater the respect held by the public for the central bank in question, the more likely this outcomemightbe.Higherrespectwouldincreasethelikelihoodthatthepublicwouldbelieve thatthecentralbankhadidentifiedproblemsthattheythemselveshadnotforeseen.

SeeBlanchardetal(2011) Ball(2012)ratherattributestoadifferentcausetheunwillingnessofBernanketopursuehisearlierpolicy prescriptions.BallsuggeststhatgroupthinkandashypersonalitypreventedBernankefromspeakingout forcefullyatanFOMCbriefingin2003.Atthismeeting,hisearliersuggestionswereessentiallyruledoutbythe Fedstaff.IthinkithighlyimplausiblethatthesecharactertraitswouldhaveseriouslyconditionedBernankes behavioroverthenextnineyears,particularlyafterhebecametheChairmanoftheFOMC. 41 Tobedealtwithinthenextsectionofthepaper.

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A number of other considerationsmight affect household spending inparticular. Perhaps the mostimportanthastodowiththeassumedpositiverelationshipbetweentheinterestrateand the desired rate of saving. While it is conventional wisdom that lower interest rates will stimulate consumption, Bailey (1992) and others have long argued that even the sign of this relationship is ambiguous. Suppose that savers have a predetermined goal for the minimum amount of savings they wish to accumulate over time. This would correspond to someone wishingtopurchaseanannuityofacertainsizeuponretirement,atadesiredage.Evidently,a lowerinterestratealwaysimpliesaslowerrateofaccumulation.But,ifinfacttheaccumulation ratebecomessolowthatitthreatenstheminimumaccumulationgoal,theonlyrecourse(other thanpostponingretirement)willbetosavemoreinthefirstplace42.Aswillbediscussedbelow, asimilarlogicaffectsthebehaviorofthosefinancialinstitutions(likeinsurancecompanies)who havecommittedtoprovidingannuitiesorwhoofferdefinedbenefitpensions. The distributional (income) implications of interest rate changes for aggregate household spending also receive too little attention. Very low rates imply less household disposable incomeforcreditorsandmoredisposableincomefordebtors.Shouldthemarginalpropensity to consume of creditors (say older, credit constrained people living off accumulated assets) exceedthatofdebtors,theneteffectofredistributioncouldbetolowerhouseholdspending rather than raise it43. This argument has in the past been invoked occasionally by central bankers in EMEs. More recently, Lardy (2012) and Rogoff (2011 ) have both recommended endingfinancialrepressioninChinaasawaytoraisehouseholdconsumption.Thecoreoftheir argumentisthathigherinterestrateswouldraisedisposableincomeandconsumptioninturn. Finally,theargumentthathigherwealth(generatedbylowerratescausingrisingassetprices) willleadtomoreconsumerspendingalsoneedsseriousreevaluation.Whilenotdenyingthe empirical robustness of this relationship in the past, the argument suffers from a serious analytical flaw. Lower interest rates cannot generate wealth, if an increase in wealth is appropriately defined as the capacity to have a higher future standard of living44. From this perspective, higher equity prices constitute wealth only if based on higher expected productivity and higher future earnings. This could be a byproduct of lower interest rates stimulatingspending,butthisissimplytoassumethehypothesismeanttobeundertest. As for higher house prices raising future living standards, the argument ignores the higher futurecostoflivinginahouse.Rather,whathigherhousepricesdoproduceismorecollateral againstwhichloanscanbetakenouttosustainspending.Inthiscase,however,theloanmust

Strictlyspeakingthisconclusionfollowsonlyiftherateofgrowthofproductivity(andeconomicpotential)has alsofallen.Thustheremustbeanincreaseinsavingtoreconstitutelostwealth. 43 AsWalterBagehotputitoveracenturyagoJohnBullcanstandmanythings,buthecannotstandtwoper cent. 44 SeeBailey(1992)andMerton(2006)

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be repaid at the cost of future consumption45. No wealth has in fact been created. In any event, as noted above, house prices in many countries have continued to fall despite lower policyrates46.Thisimpliesthattheneedforpaybackcannolongerbeavoidedbystillfurther borrowing. Anumberofcounterargumentscanalsobemadetothehypothesisthatultraeasymonetary policywillraisecorporateinvestment.Firstnotethefactthatinvestment,asaproportionof GDP, has been trending down in most AMEs in recent years. This has occurred in spite of generally solid corporate profits, healthy balance sheets, large cash reserves and very low interestratesoveranumberofyears.Anumberofreasonshavebeensuggestedtoexplainthe lackofinvestmentresponsetothesepropitiousfinancialconditions. Thefirsthasbeenanenvironmentofevergrowinguncertaintyaboutanumberofimportant issues; future domestic demand in light of uncertainty about job prospects, future foreign demandgivenuncertaintyaboutexchangeratesandprotectionism,anduncertaintyastohow theburdenoffiscalrestraintandpossiblesovereigndebtreductionmightaffectthecorporate sector. A second set of concerns is closely related. In many AMEs anti business rhetoric is becomingmorecommonandthepoliticalmomentumseemstobeshiftingtowardsextremism. Moreover,growingconcernsaboutrisingincomeinequality(returnedtobelow)andconcerns abouttheethicalstandardsofthebankingcommunitycouldalltooeasilybeconvertedintoa broaderantibusinessagenda47. Athirdreasonforcontinuinglowinvestmentseemstohavebeenaseculartrendonthepartof corporatemanagementsinAMEstomaximizecashflow.Theincentiveforthisshorttermism could be that it allows for larger payouts for both salaries and dividends, also raising equity pricesandthevalueofmanagementoptionsinthebargain.Evidently,however,suchbehavior comesattheexpenseofbothfixedcapitalinvestmentandthefuturehealthofthefirmitself.If low interest rates encourage firms to borrow more money, which they can use for the same shorttermpurposes,thenpresumablythelongertermdamagewillbeevenworse. Ithasevenbeensuggestedthatlowinterestrateshavethemselvescontributedtolowerfixed investment in AMEs. One channel would be via higher commodity prices (as a result of the public sector investment boom in China), which raises costs in AMEs and reduces profits. Perhaps more importantly, many corporations still have significant obligations in the form of defined benefit pension plans. Ramaswamy (2012) presents a chilling quantitative analysis of the effects of interest rate changes on public pension funds and defined benefit funds. The

SeeMuellbauer(2007)andWhite(2006b) SomeestimatesindicatethatUShouseholdersequityintheirhousesfellfromapeakofabout$10trillionto$6 trillionattheendof2011. 47 Forananalysisofantibusinessattitudesinthe1930s,undertheRooseveltadministration,seePowell(2003) andSmiley(2000).

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essenceoftheargumentisthatlowerinterestratesreducetheassetrevenuesofpensionfunds andraisethepresentvalueoffutureliabilities.Fundingshortfallseventuallyhavetobemade upbythesponsoringcompany,reducingprofitsandfundsavailableforinvestment. ArecentreportbytheconsultingfirmMercerindicatesthatthe1500leadingcompaniesinthe UShadapensiondeficitof$689billionasofJuly2012;i.e.,theyareonly70percentfunded.In the UK, the Pension Protection Fund recently estimated that almost 85 percent of defined benefitplanswereunderfunded,withacumulativeshortfallofover$400billion48.Moreover, proposedchangestopensionrules,incountriesusingIFRSaccountingstandards,seemlikelyto maketheimpactoflowratesoncompanieswithsuchpensionfundssignificantlyworse49. To summarize, there are significant grounds for believing that the various channels through whichmonetarypolicymightnormallyoperateareatleastpartiallyblocked.Moreover,there are also grounds for belief that neither household nor corporate spending would react as vigorously as in the past, even if the traditional transmission channels were functioning properly.Notetoothattheissueofdebtstocks,otherimbalances,andthepossibilityofa credit crunch affecting the real economy have not yet even been mentioned. These influenceswillalsoweighonboththecapacitytospendandthewilltospend,furtheroffsetting theinfluenceofultraeasymonetarypolicies.Aswell,suchpolicescanhaveotherunintended consequenceswhichmightalsotendtogrowovertime.

C. CouldUltraEasyMoneyHaveUnintendedConsequences?
Theunexpectedbeginningofthefinancialandeconomiccrisis50,anditsunexpectedresistance topolicymeasurestakentodate,leadstoasimpleconclusion.Thevarietyofeconomicmodels usedbymodernacademicsandbypolicymakersgivefewinsightsastohowtheeconomyreally works51.Ifweacceptthisignoranceasanundesirablereality,thenitwouldalsoseemhardto deny the possibility that the policy actions taken in recent years might also have unintended consequences. Indeed, it must be noted that many pre War business cycle theorists focused theirattentiononpreciselythispossibility. Perhaps a good jumping off point for such analyses might be the work of Knut Wicksell. He made the distinction between the natural rate of interest, which equalized saving and

Evenasofmid2010,whenbondyieldsweresignificantlyhigherthaninearly2012,therewereestimatesthat sustainedlowratesimpliedthathalfofUKcompaniesarebust.SeeJohnson(2010). 49 UnderproposalsoutstandingasofJune2012,companieswillnolongerbeabletodeferrecognitionofactuarial gainsandlosses.Currently,theycandosousingthesocalledcorridormethod.Inaddition,companieswillno longerbeabletoassumealowerratefordiscountingliabilitiesthantheassumedrate(oftenunreasonablyhigh) atwhichassetsaccumulate. 50 TheWEO,publishedbytheIMFinthespringof2008,predictedrealgrowthintheadvancedeconomiesin2009 of3.8percentofGDP.Theactualoutcomewas3.7percent,aforecasterrorof7.5percentagepointsofGDP. Theywerebynomeansaloneinmissingthisdramaticturnaround. 51 FormoreonthisseeWhite(2010)
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investment plans, and the financial rate of interest, set by the banking sector. Were the natural rate to diverge from the financial (or market) rate set by the banking sector, prices would respond and a new equilibrium would eventually be reestablished at a different price level.LaterthinkersintheWickselliantradition(theAustriansinparticular)ratherlaidemphasis on the possibility that a divergence of the market rate from the natural rate might have consequences beyond changing the price level.52 Referred to as imbalances in this paper, theseconsequenceswouldeventuallyleadtoacrisisofsomesortifinflationaryforcesdidnot emergefirst.Moreover,ithasalsobeensuggestedthemagnitudeofanycrisiswoulddepend on the size of the accumulated imbalances, which would themselves depend on the size and durationofthedifferencesbetweenthetworates Werewetoadoptthisanalyticalframework,policymakerstodaywouldseemtohaveserious causeforconcern.Forsimplicity,supposethatthenaturalrateofinterest(real)fortheglobal economyasawholecanbeproxiedbyanexpostmeasure;thepotentialrateofgrowthofthe globaleconomy,asestimatedbytheIMF.Reflectingglobalizationandtechnologytransfer,this measure has been rising steadily for the last twenty years. In contrast, if one proxies the financial rate of interest (real) by an average of available breakeven rates (say for ten year TIPS),thismeasurehasbeenfallingforthelasttwentyyears.Moreover,atthegloballevel,the naturalrateofinterestroseabovethefinancialratein1997,andthegapkeptwideningatleast untiltheonsetofthecrisisin200753.Fromthisperspective,underlyinginflationarypressures and/orimbalanceshadbeencumulatingformanyyearsbeforethecrisisbegan. Indeed, the magnitude of the crisis which began in 2007, and the lack of response in many AMEstomacroeconomicmeasurestodate,canalsobeviewedasevidenceinsupportofusing this kind of framework. In contrast to the ex post measure of the natural rate, assumed for simplicityabove,mostofthoseintheWickselliantraditionassumedthenaturalratewasanex anteconcept,relatedtoexpectationsaboutthefuturerateofreturnoncapital.Evidently,as noted also by Keynes and his discussion of animal spirits, these expectations could change quite dramatically over time. It could then be suggested that the (ex ante) natural rate collapsedin2007,toalevelwellbelowthefinancialrate,asadirectresultoftheimbalances that had built up earlier. Moreover, given this particular way of thinking and noting that the financial rate is now constrained by the ZLB, this gap can only be redressed by raising the naturalratetoencourageinvestment54.AsdiscussedinSectionBb)above,thiswillnotbean easytask.

SeeLaidler(1999),p35 SeeBIS(2007)andHanoun(2012)Graph4.Hanounalsoprovidesevidence(Graph5)that,forthelastdecadeat least,theglobalpolicyratehasgenerallybeenwellbelowtheratesuggestedbyaglobalTaylorrule.Fora descriptionofthechangesincentralbankbalancesheets,seeBankforInternationalSettlements(2012),p40. 54 Acorollaryofthiswouldbethatinvestedcapitalthatwasnolongerprofitableshouldberemovedfrom production.

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The approach taken below is to identify possible unintended consequences of rapid credit andmonetarygrowth,andthentoevaluatewhethersuchconcernswouldseemtobejustified bythefactsofrecentdevelopmentsand/orlikelyprospectsforthefuture.Consistentwiththe discussionabove,theseconcernswouldincluderisinginflationandimbalancesofvarioussorts. Tobemorespecific,thelatterwouldincludemisallocationsofrealresources(notonlyincredit upswingsbutalsoindownswings),undesiredeffectsonthefinancialsector(notonlybadloans but also unwelcome changes in financial structure) and rising income inequality. Evidently, interactionsbetweenthesevariousimbalancescouldleadinprincipletoprotractedrecessions and even debtdeflation. Worse, rising income inequality could threaten social and even politicalstability. a) Thelikelihoodofrisinginflation PerhapsthefirstquestiontobeaddressedishowinflationwasavoidedintheAMEsduringthe manyyearsthatfinancialrateswerewellbelownaturalratesandcreditgrowthwasvery rapid55? One possible answer is that a growing commitment by central banks to the maintenance of low inflation succeeded in anchoring inflationary expectations. This explanation,however,ishardtoreconcilewiththeobjectivefactofrapidmonetaryandcredit expansionengineeredbycentralbanksoverthatperiod. Amoreplausible(oratleastcomplementary)explanationwouldbethemajorincreaseinthe rate of growth of potential in the EMEs, accompanied by a series of investment busts in a number of countries; Germany after reunification, Japan after the bubble, South East Asia after the Asian crisis, and the US after the TMT crash of the early 2000s. In effect, a secular increaseinglobalsupplywasmetbyadecreaseinglobaldemandwiththepredictableresultof reducinginflation56.Thisprovidedthecontextinwhicheasymonetarypoliciescouldbemore easilypursued. Looking forward, the likelihood of rising inflation in the AMEs would seem to be limited. In mostcountriesthereappearstobeasignificantdegreeofexcesscapacity,andSectionBabove impliesthatultraeasymonetarypolicyisunlikelytoremedythisproblemquickly.Nevertheless, some sources of concern remain. In some countries, like the UK, exchange rate depreciation couldhaveanimpactoninflation.Crisisrelatedreductionsinthelevelofpotentialcouldalso prove greater than is currently expected,57leaving room for policy mistakes. Finally, a sudden shift in inflationary expectations, perhaps linked to further measures to extend ultra easy monetary policies, cannot not be completely ruled out. While inflation expectations show no trends(awayfromdesiredlevels)inrecentyears,theydoseemtohavebecomemorevolatile.

AlternativeexplanationsfortheGreatModerationarediscussedatlengthinBorioandWhite(2003) AmoredetailedanalysisisavailableinWhite(2008).SeealsoIssing(2012)p10. 57 TheOECDestimatesthatthelevelofpotentialintheOECDcountriesfellaftertheonslaughtofthecrisisby about3percentonaverage.Theystress,however,thattheseestimatesarehighlyimprecise.

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AperhapsmorepressingproblemisthepossibilityofsharplyhigherinflationinEMEs.Inpart due to their fear of floating, many EMEs seem to be operating near full capacity, and monetary conditions are generally very loose. As well, the rate of growth of potential now seemstobeslowingafterprevioussharpincreases58.Thiscouldinturn,viathehigherpriceof imports,leadtoinflationacceleratingunexpectedlyintheAMEsaswell.Ineffect,thiswould be a reversal of the secular disinflationary impulses sent by EMEs to the AMEs in previous years.SinceAMEcentralbanksunderestimatedtheimportanceofthepositivesupplyshocksin earlier years, it is not unlikely that they would also fail to recognize the implications of its reversal. While such an inflationary outcome might be judged useful in resisting debt/deflation of the Fisher type, rising inflation along with stagnant demand in AMEs would clearly imply other serious problems for the central banks of AMEs. On the one hand, raising policy rates to confront rising inflation could exacerbate continuing problems of slack demand and financial instability.Ontheotherhand,failingtoraisepolicyratescouldcauseinflationaryexpectations torise.Further,weredifferentcentralbankstoresponddifferently,astheydidin2008,there mightalsobeunwelcomeeffectsonexchangerates. b) Misallocationsofrealresources New books, articles in the popular press and even rap videos indicate that the KeynesHayek debateoftheearly1930sisonagain59.Itremainshighlyrelevanttotheissueofwhetherultra easy monetary policies might have unintended consequences. Keynes was fundamentally interestedindemandsidepoliciesthatwouldreviveeconomiesinaDeepSlump.Incontrast, HayekandothermembersoftheAustrianschoolwerefundamentallyinterestedinsupplyside issues. They rather focused on how the economy got into a Deep Slump in the first place, consciousofthepossibilitythatremedies(moreofthesame)mightactuallymakethingsworse overtime. The Austrian conclusion was that credit created by the banking system, rather than the on lendingofgenuinesavings,wouldindeedspurspendingbutwouldalsocreatemisallocationsof realresources(malinvestments).Thesesupplysidemisallocationswouldeventuallyculminate in an economic crisis. Moreover, they concluded that the magnitude of the crisis would be

AsEMEsbegintoindustrialize,theyinitiallyhavethebenefitofrapidurbanization(asagriculturalproductivity rises)andtheinternationaltransferoftechnology.Overtimebothofthesecatchupfactorssupportinggrowth becomelessimportant. 59 ItisimportanttonotethatthedebatewaswiththeKeynesoftheTreatiseandnotyettheKeynesofthe GeneralTheory.IntheTreatiseonMoney,Keynescalledformonetaryauthoritiestotakeextraordinary, unorthodoxmonetarypoliciestodealwiththeslump.Kregel(2011)p1,contendsthatTheunorthodoxpolicies thatKeynesrecommendsareanearlyperfectdescriptionoftheultraeasymonetarypoliciesfollowedinJapan, andmorerecentlyinothercountries.Recall,asnotedabove,thatKeynesenthusiasmforsuchmonetarymeasures hadfadedbythetimeoftheGeneralTheory.

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closely related to the amount of excess credit created in the previous upswing. Jorda, Schularick and Taylor (2012), using data from 14 AMEs dating back to the 1870s, provide convincingempiricalevidencethatthisintuitionwasessentiallycorrect60.Asimilarconclusion arisesfromthehistoricaldatausedbyReinhartandReinhart(2010),andfromrecentUSdata basedondifferencesinlocalmarketeconomicconditions61. Thisconclusiondoesnot,however,logicallyruleoutthepossibilitythatHayekandKeyneswere bothright.Itissimplyafactthattheeconomydoeshavebothademandsideandasupply side.Itisalsoafactthatpolicyactionsdohavebothneartermandlongertermimplications. Thus, demand side stimulus might well work to stimulate the economy in the near term, but suchstimulusmightcomewithalongertermprice.Evaluationoftheneartermbenefitsand longertermcostsofmonetarystimulusis,infact,thecentralthemeofthispaper. Inpractice,Keynesianthinkinghasalmostcompletelydominatedthepolicyagendaformostof thepostWarperiod.Thus,thepredominantconsiderationforpolicymakers62hasbeenthenear termeffectsofmonetaryeasingonaggregatedemand,andtheassociatedimpactoninflation. Over the last two decades or so, with inflation near target levels or even threatening to fall belowtarget,policymakerssawlittleneedtoraiseinterestratesincyclicalupturns.Similarly, thereseemednoimpedimenttovigorousmonetaryeasingindownturns. Even within the Keynesian framework, however, these policies might now be thought questionable. As noted just above, the disinflationary trends observed in the global economy were in large part the result of positive supply shocks, rather than solely due to deficient demand.Theyshouldinprinciplehaveelicitedadifferentandtighterresponse63.Viewedfrom an Austrian perspective, the policy error was even graver. Below the surface of the Great Moderation, such policies encouraged financial exuberance64 which allowed significant

SeealsoReinhartandReinhart(2011) MianandSufi(2011)relatethemagnitudeoflocaldownturnsintheUS(primarilyinthenontradedsector)to thedegreeofhouseholdborrowingthatbuiltupinthesamelocalityduringtheboom. 62 VirtuallyallAMEcentralbanksgiveprideofplacetoafirstpillar;namelytheirestimateoftheoutputgapand itseffectoninflationviaanaugmentedPhillipscurve.FirsttheBundesbank,butnowalsotheECB,haveasecond, monetarypillarwhichrelateslowfrequencymovementsinmonetaryaggregatestolongerterminflationary trends.Thisisstillverydifferentfromlookingatcreditdevelopmentsfortheirpossibleunintended consequences,particularlyonthesupplysideoftheeconomy. 63 Thereisacuriousasymmetryhere.Ithasbeenwellacceptedfordecadesthatnegativesupplyshocks,for exampleincreasesinenergypricespushingupinflation,neednotcausepolicyratestorise.Thelogicwasthatfirst roundshiftsinthepricelevelcouldbetoleratediftheyhadnosecondroundeffectsonwagesandinflation. Incontrast,positivesupplyshocksdidinpracticeseemtoleadtolowerratesthanotherwise.Onthisissue,see Beckworth(2008).Perhapsthecluetotheasymmetryisthat,inbothcases,policyrateswinduplowerthan otherwisewhichtendstobebotheasyandpopular. 64 Issing(2012)notes(p3)thatacombinationofinflationtargetingandsupplysideshockscanturnpolicyintoan independentsourceofinstability(It)fuelsfinancialexuberanceandfinancialexuberanceinturncreatesfinancial imbalances.
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malinvestmentstobuildupinbothphasesofsuccessivecreditcycles.65Thesedevelopments aredocumentedbelow. 1) Misallocationsinthecreditupswing In a comprehensive review of pre War theories of business cycles, Haberler (1939) distinguished between two forms of malinvestment thatarise in theupswing of the credit cycle:verticalandhorizontal.Verticalmalinvestmentsimplyanintertemporalmisallocation.It occurs when easy and cheap access to credit causes an inordinate shift towards capital investments,andparticularlytolongerlivedcapitalinvestments.Forthesamereason,saving rates would be reduced and debts allowed to accumulate. These would eventually constrain futurespending66justatthetimetheincreasedsupplypotentialwascomingonline.Horizontal malinvestmentsareinvestmentsinparticularsectorsthateventuallyleadtoexcesscapacity. Inbothkindsofmalinvestment,theeventualoutturnisacollapseinprofits.Thisresultsinthe forced termination of further investment in projects already well advanced, less new investment in general, and an investment collapse in those particular sectors that had expandedthemostduringthecreditupswing.Lookingatdevelopmentsoverthelastdecadeor so,itisveryeasytofindevidenceofsuchprocessesatwork. First, consider vertical malinvestments. In the years of easy credit conditions preceding the onsetofthecrisis,investmentinthehousingstockinvirtuallyeveryAMErosesharply67.House prices rose markedly, as did housing starts in most cases. The fact that these developments wereunsustainableisnowalltooevident.IncountriesliketheUS,theUK,SpainandIreland, thehousingdownturnisalreadywelladvanced,housepricescontinuetofall,andconstruction activityhasslowedmarkedly.Insomeothercountries(Canada,Sweden,Denmark,Norwayetc.) housepriceshavecontinuedtoriseandconstructionactivityremainselevated.Nevertheless, concernsaboutoverbuildinginthesecountriesarebeingexpressedevermoreforcefully68. Similarly, in many EMEs relatively easy credit conditions have also led to sharp increases in constructionactivityandinhouseprices.Inmanycases,notleastChinaandBrazil,activityhas focusedontheproductionofhighendpropertieswhichremainvacantaftertheirpurchase.

OnreturningfromavisittotheUSinthelate1920s,Hayekforetoldadeepslump.Onbeingtoldthiswas impossible,becauseUSpriceswereessentialstable,Hayekapparentlyrespondedthatthiswaspreciselythe evidenceofanunderlyingproblem.Increasesinproductivityshouldhavebeenpushingpricesdown,butcredit expansionwasholdingthembackup. 66 Ineffect,savingswouldproveinadequatetopurchaseallofthegoodsandservicesprovidedbytheincreased investmentgeneratedartificiallybycreditreceivedfromthebankingsystem. 67 AmongtheAMEs,onlyGermany,SwitzerlandandJapanfailedtoreflectthesedevelopments.Inpart,thiswas becauseallthreecountrieswerestillrecoveringfromtheirown,earlier,housepricebubbles. 68 SuchconcernshavebeenexpressedinthevariouscountryreviewsorganizedbytheEconomicandDevelopment ReviewCommitteeoftheOECD.Australia,NewZealand,Canada,theScandinaviancountriesandanumberof othersallseemtobeexposedinthisregard.
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Giventhisoverhangofinventory,itisnothardtobelievethatadownturnwillproveinevitable. Since housing is long lived, cannot be readily used for other purposes, and is generally not internationallytradable,theeffectsofthisparticularkindofmalinvestmentcouldbefeltfora longtime. Anotherexampleofverticalmalinvestmentswouldbethemassiveincreasesininfrastructure investment,largelyprivatelyfinanced,whichoccurredgloballypriortotheonsetofthecrisis. Indeed,inmid2008,theEconomistmagazinecalledthisinfrastructureinvestmentthebiggest boominhistory69.Whilethisprivatesectorboomcametoahaltwiththeonsetofthecrisis,it wasreplacedinpartbypublicsectorspendingoninfrastructure.Thishasbeenmostmarkedin China,whereoverallspendingoninvestmentsince2008hashoverednear50percentofGDP. Neithertheprivatesectornorpublicsectorphasesofthisinvestmentboomwouldhavebeen possiblewithoutreadyaccesstorelativelycheapcredit.Indeed,intheChinesecase,thecentral authoritieslargelyavoidedfiscalexpansionbyexplicitlyorderingChinesebankstoprovidethe loansrequiredbylowerlevelsofgovernmenttomeettheirspendinggoals. Large scale spending on infrastructure is not in itself a bad thing. In many circumstances, particularly in EMEs, the social rate of return might be expected to well exceed the cost of financing. However, there is accumulating empirical evidence that many large infrastructure projects cost far more to build than originally estimated and produce far fewer benefits. Flyvbjerg(2009)gives manyexamplesoflargeprojectsinAMEsthatwouldneverhavebeen builtifexpostestimatesofbenefitsandcostshadbeenavailable.HecitestheChannelTunnel, theDanishGreatBeltTunnel,theBigDiginBostonandtheMillenniumDomeamongahost ofothers. Flyvbjerg notes as well three global trends that increase the likelihood of infrastructure investmentsbecomingmalinvestments.Thefirstisthetrendtowardsmorerapidspending, driven by the exigencies of spending quickly during a downturn. This raises the risk of both wasteandcorruption.Thesecondistherisingproportionofglobalinfrastructurespendingin EMEs, given the presumption that governance of such projects might be even worse than in AMEs70. In China, for example, the dominant influence of the Communist Party on both borrowers and lenders is hard to reconcile with objective assessment of the net benefits of suggestedprojects.71Third,infrastructureprojectseverywhereareincreasinglydependent on

TheEconomist(2008) Flyvbjergultimatelyblamesbadgovernanceforthesebadoutcomes.Ineffect,thoseputtingtogetherprojects consciouslyunderestimatecostsandoverestimatebenefits.Theydothistomaketheirprojectsmore competitivewithothersinthesearchforfunding,especiallyfromgovernments. 71 SeeMcGregor(2010)forabroaderdiscussion.Foramorespecificexample,Chinaisintentonbuildingover 20000kilometersofhighspeedrailtacktolinkupitsmajorcities.Atthesametime,thereistobeamassive expansionofairportservicetothesamedestinations.Noteaswell,thatmanyprestigeprojectsfavoredbylocal governmentsaredesignedtooutdotheprojectsofotherlocalgovernments.Thisarecipeforovercapacity.

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IT and communications systems, where large projects have an even more dismal record of accomplishmentthanprojectsinothersectors. Athirdexampleofverticalmaladjustment,promptedbyeasycreditconditions, hasbeenthe massivebuildupofexportcapacityinmanycountriesinSouthEastAsia.Lowinterestratesin theimportingAMEsensuredhighlevelsofconsumptionandreadymarkets.Conversely,inthe exporting countries, low interest rates encouraged investment to satisfy those demands. Government commitment to export led growth strategies also implied resisting upward exchangeratepressures,andencouragedeasiermonetarypolicyinturn.Today,manyofthese exportingcountriesremainheavilyreliantonsalestoAMEs72whosedebtsaresuchthatthey cannolongeraffordtoborrowtofinancesuchsales. A fourth and final example of vertical maladjustment is provided by the sharp drop in household saving rates over many years in a number of AMEs, most notably in the English speaking countries. In many of these countries, house prices were rising rapidly during the periodofrapidlyexpandingcredit.Somehouseholdslikelybelieved(wrongly)thattheywerein factwealthierasaresult,andspentmoreaccordingly.Insomecountries,mostnotablythe UnitedStates,higherhousepricesalsoprovidedmorecollateraltosupportfurtherborrowing. Sinceintheearlyyearsofthiscenturythereweresignificantfearsofinadequatedemandand potentially even deflation, this borrowing was welcomed by policymakers as intertemporal optimization. However, at the time, little or no attention was paid to the fact that such optimization would by definition require payback and could act as a serious constraint on growthinthefuture73. The need for payback is most clearly evident in sharp increases in household debt service ratiosinmanycountries74.TheseincludetheEnglishspeakingcountriesnotedabove,butalsoa number of peripheral countries in Europe as well. Further, perhaps linked to the fear of floating phenomena discussed above, many EMEs now also have record high levels of household debt service to cope with. Such countries include some of the largest and fastest growing of the EMEs; China, India, Brazil and Turkey in particular. While it is true that these increasesinEMEshavecomeoffverylowlevels,thespeedoftheincreasehasbeennotable,

Thisisnottodenysuccessfuleffortsbyanumberofcountries,includingChina,toexpandmarketsinother EMEs.Ofcoursethisstillleavesthebroaderquestionoftherobustnessofthetotalityofthosemarketsinthe eventofaseriousdownturnintheAMEs. 73 ThisproblemisanalogoustothatfacedbyJapanesecorporationsinthe1990s,aftermanyyearsofdebt financedinvestmentwhichprovedunprofitable.Koo(2003)stronglycontendsthattheweaknessofinvestment spendinginJapaninthe1990swasduetothisbalancesheeteffect,andwasnotduetoashortageofloans causedbyaweakenedbankingsystem. 74 SeeBIS(2012)p29forafullerdocumentation.AlsoseeMcKinsey(2010)whoidentifythehouseholdsectorin fiveofthefourteencountriestheyconsiderashavingahighprobabilityoffuturedeleveraging.TheyidentifySpain, theUS,theUK,CanadaandKorea.WhilethehouseholdsectorsinBrazil,Russia,ChinaandIndiawerenotjudged tobeoverleveraged,notethatthedataconsideredextendedonlyto2009.Thusthereportmissedtherecent sharpincreasesinhouseholddebtlevelsinthosecountries.
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andmightwellhaveoutpacedthecapacityofthelocalfinancialsystemstoaccuratelyestimate thecapacityofborrowerstorepay.Indeedbymid2012,thepercentageofnonperformingcar loans in Brazil had already jumped sharply. Whether in AMEs or EMEs, the need for deleveragingbyhouseholdsaddsafurtherreasontodoubtthatultraeasymonetarypolicycan sustainablystimulatetherealeconomy. Norisitdifficulttofindevidenceforthebuildupofhorizontal(sectorialmalinvestments)during the last upswing of the credit cycle. The most obvious example is seen in the construction industryinmanycountries,mostlybutnotexclusivelyintheAMEs.Evidently,thiswasclosely related to the increased spending on housing and infrastructure referred to above75. Closely related,thefinancialsectoralsoexpandedveryrapidlypriortothestartofthecrisisin2007, beforeimplodingimmediatelyafterwards.Theglobalautomotiveindustrywitnessedamassive increase in production capacity, not only prior to 2007, but also afterwards as automakers extrapolated past increases in sales in EMEs far into the future. China in particular was estimatedtohavesixmillionunitsofunutilizedcapacityin2011(twicethesizeoftheGerman carmarket)76,withdealersalsostrugglingwithahugeincreaseininventory.Finally,therewas alsoasubstantialincreaseincapacityintherenewableenergyindustry.Asaresult,thepriceof solar panels and wind powered turbines collapsed after the crisis began and many producers facedbankruptcy. Beyondtheseincreasesintheglobalcapacitytoproducefinalgoodsandservices,therewere markedexpansionsinthecapacitytoproduceintermediateandprimarygoodsaswell.Muchof thiswasdrivenbydevelopmentsinChinawhereproductivecapacitywasstillexpandingrapidly as of mid 2012 The steel and aluminium industries head a long list of sectors where overcapacity has been evident for a long time77. As for primary products, heavy investments havebeenmadeinLatinAmerica,inAustralia,andanumberofothercountriestoproduceand export basic commodities to support the development efforts in South East Asia. Should any linkinthisdemandchainprovefaulty,theseinvestmentsinprimaryproductscouldalsoprove much less profitable than is currently anticipated. Finally, there has been a commensurate increase in the capacity of the global distribution industry, not least container ships and bulk shipping,whosefuturecouldbesimilarlyexposed. 2) Misallocationsinthecreditdownswing

Increasedspendinggenerallyresultsinmoreproduction,butnotnecessarily.Supplyresponsivenessinthe constructionindustryinfactvarieswidelyacrosscountries.Forexample,theresponseintermsofnewhousing startswasmuchgreaterintheUSthantheUK,duetotheverystrictplanningandzoningrestrictionsinthelatter. 76 SeeKPMGGlobal(2012) 77 SeeEuropeanChamberofCommerceinChina(2009).Inpresentingthereport,thePresidentoftheChamber saidOurstudyshowstheimpactofovercapacityissubtlebutfarreaching,affectingdozensofindustriesand damagingeconomicgrowth,notonlyinChinabutworldwide.Notethatthiswaswrittenbeforethefurtherspurt ininvestmentspendingin2010.

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Economic downturns, whatever their cause, are always painful. Output that might have been produced is lost, and unemployment rises. Moreover, those less well off, often marginally attachedtotheworkforce,seemtosufferthemost.ThisisthefamiliarKeynesianargumentfor usingmacroeconomicstimulusinsuchcircumstancestoraiseaggregatedemand78.However,as alluded to above, pre War economic theorists thought downturns also had some positive qualities. For those concerned about rapid credit expansion and malinvestments, the downturnsimplyrevealstheunsustainabilityofthepreviousexpansionanditsinevitableend. The downturn was then a time of necessary rebalancing with resources shifting from less productivetomoreproductiveuses.Schumpeterinparticularstressedtheopportunitieswhich excessresourcesprovidedtoentrepreneurshavingnewideasandnewproductstheconcept ofcreativedestruction.Fromthisperspective,monetarypolicychoicesinadownturnshould againbalanceoffshorttermbenefitsagainstlongertermcosts. ConsistentwiththedominanceoftheKeynesianparadigm,monetarypolicyhasbeenusedwith increasingvigoroverthelastquartercenturytoaddressprospectiveoractualdownturnsinthe economy. For example, US monetary policy was eased significantly in 1987 after the stock market crash of October. It was further eased sharply in the early 1990s, after the property boomandthecollapseoftheSavingsandLoanAssociations.Inspiteofunemploymentfalling wellbelowprevailingestimatesoftheUSNAIRU,theUSfailedtoraiseratesin1997reflecting concernsaboutthepossibleglobaleffectsofthecrisisinSouthEastAsia.In1998,thefailureof LTCM led to explicit easing. This was followed in 2001 by an unprecedentedly vigorous monetary policy response to an impending slowdown, aggravated by the stock market crash and theevents of September 11. Finally, beginning in 2007, monetary policy wasfurther and dramaticallyeasedinthevariouswaysdescribedatthebeginningofthispaper. The following paragraphs will focus on the longer term, cumulative, effects of such policies. First,thereisevidencethatallowingmalinvestmentstopersistcanreducepotentialgrowth rates.Second,itcanbecontendedthattheaggressiveeasingofpolicyinsuccessivecyclesled to serial bubbles of various sorts. In effect, these serial bubbles constrained the normal process through which malinvestments would have been purged in the course of a typical cyclicaldownturn. The contention that easy monetary conditions lower the rate of growth of potential is not without counterarguments. On the one hand, some would contend that easy monetary conditionsinadownturnhelpthereallocationofrealresourcesfromlesstomoreproductive industries79.Aswell,iftheeconomyrecovers,thentheacceleratormechanismcanalsoleadto

Recall,however,thatKeynesGeneralTheory(1936)wasdirectedtotheissueofDeepSlumps.Itisnotthen clearthatKeyneswouldhaverecommendedsimilarpoliciesinthefaceofactualsmalldownturns,muchless preventiveeasingtoprecludeevenprospectivedownturns. 79 Seeforexample,Posen(2011)

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more capital investment80. These arguments, however, must also consider the various forces (consideredabove)thatarecurrentlyactingtorestraininvestment.Ontheotherhand,tothe extent that low interest rates do discourage saving, capital accumulation will be discouraged over time. Very low risk free rates, dominated by the actions of central banks, can also mislead and contribute to costly misallocations. Moreover, it is possible that easy monetary conditionsactuallyimpede,ratherthanencourage,thereallocationofcapitalfromlesstomore productiveuses. This last argument rests on the contention that banks will offer advantageous borrowing conditionstotraditionalcustomersinadownturn,evenwhentheysuspecttheyareinsolvent. Peek and Rosengreen (2003) have investigated this phenomenon in Japan, and evidence of similar behavior has emerged in both the UK and continental Europe more recently.81 Such behavioronthepartofbanksisencouragedwhentheycanborrowverycheaply,andalsowhen theyexpectthateasymoneywillleadtorecoveryandimprovedprospectsfortheirclients.In effect,lowinterestratesencourageallthepartiesinvolvedtogambleforresurrection. Evergreening of this sort helps maintain the weak, the so called zombie companies, who then continue to compete and drag down the strong. The Peek and Rosengreen study also documented how productivity growth suffered particularly in those industrial sectors most characterizedbythiskindofbankbehavior.Moreover,theperceivedneedtosupporttheweak couldalsoleadtohigherinterestchargesforthosestrongenoughtoaffordit.Finally,itmight alsoimplytightercreditconditionsforpotentialnewclientswithnewideasastohowtoadapt domesticsupplytochangingpatternsofdemandandforeigncompetition82.Sinceinnovationis nowseenasaprimarydriverofproductivitygrowth(andthuspotential)83,financialconstraints ofthissortwouldbeparticularlyworrisome.Andthiswouldbeevenmorethecaseincountries (InEuropeandJapan)wherebanksremainthedominantsourceoffinance. The Governor of the Bank of Japan has repeatedly suggested that Japans poor economic performance in recent decades has been largely due to a failure to adapt its production structure to the requirements of an aging population and the growing competitiveness of emergingAsiancountries84.Incontrasttohisadvice,andparticularlysincetheonslaughtofthis currentcrisis, governments in many AMEs have actually taken explicit measure like cars for clunkers and short time working to support existing production structures. Since the

SummersandDelong(2012) SeeBIS(2012)p42and74,foralistofsupportingreferences. 82 WiththeriseoftheEMEsandtheirdominanceoftraditionalmanufacturing,somecommentatorsevencontend thatAMEsneedtodevelopawholenew,postindustrialinformationeconomy.Evidently,iftrue,thiswould requirealotoffinancing. 83 AssumingaCobbDouglasproductionframework,unexplainedmovementsintotalfactorproductivityhavefor decadesbeenthebiggestdriverofgrowthinmostAMEs.Inrecentyears,theOECDhasincreasinglyemphasized theimportanceofinnovationinexplainingmovementsintotalfactorproductivity. 84 Shirakawa(2012a,2012b)

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countriesthatusedtheseprogramsthemostactivelywerealsorunninglargecurrentaccount surpluses at the time (eg: Germany, Japan, the Netherlands and Korea) it might also be suggested that many of the jobs saved in the short run will eventually disappear as global tradeimbalancesdecline85.Thesepolicieswerenotonlymistaken,inthattheyimpededlonger run adjustment, but they were also fiscally costly. This raises the question of whether they might not have been under taken had the governments financing costs been higher at the time. Finally,thereistheissueofserialbubbles.Mentionwasmadeaboveofthesuccessivelymore aggressive efforts made by central banks, since the middle 1980s, either to preempt downturns (eg: after the stock market crash of 1987) or to respond to downturns (eg; 1991, 2001and2008).Whatcannotbeignoredisthepossibilitythateachofthoseactionssimplyset the stage for the next boom and bust cycle, fuelled by ever declining credit standards and everexpandingdebtaccumulation.86 From the perspective of this hypothesis, monetary easing after the 1987 stock market crash contributedtotheworldwidepropertyboomofthelate1980s.Afteritcrashedinturn,the subsequenteasingofpolicyintheAMEsledtomassivecapitalinflowsintoSEAcontributingto the subsequent Asian crisis in 1997. This crisis was used as justification for a failure to raise policy rates, in the United States at least, which set the scene for the excessive leverage employedbyLTCManditssubsequentdemisein1998.Theloweringofpolicyratesinresponse, even though the unemployment rate in the AMEs seemed unusually low, led to the stock market bubble that burst in 2000. Again, vigorous monetary easing resulted, as described above, which led to a worldwide housing boom. This boom peaked in 2007 in a number of AMEs,seriouslydamagingtheirbankingsystemsaswell.However,inotherAMEs,thehouse priceboomcontinuesalongwithstillrisingandoftenrecordhouseholddebtratios.Thislatter phenomena, as well as other signs of rising inflation and other credit driven imbalances in EMEs87,reflectstheeasymonetarypoliciesfollowedworldwideintheaftermathofthecrisis. Bymitigatingthepurgingofmalinvestmentsinsuccessivecycles,monetaryeasingthusraised thelikelihoodofaneventualdownturnthatwouldbemuchmoreseverethananormalone. Moreover, the bursting of each of these successive bubbles led to an ever more aggressive monetary policy response. From a Keynesian perspective, this response seemed required to offset the effects of the ever growing headwinds associated with all the malinvestments notedabove.Inshort,monetarypolicyhasitself,overtime,generatedthesetofcircumstances inwhichaggressivemonetaryeasingwouldbebothmoreneededandalsolesseffective.This

InEuropethecarindustrywasaparticularbeneficiaryofsuchprograms.ItisalreadybeingrecognizedinFrance, ItalyandBelgiumthatsomeautoplantclosuresareinevitable.Thesubsidiariesofforeigncarfirmsoperatingin Germanymightalsobeaffected. 86 GeorgeSoros(2010)hasreferredtothisserialprocessasthedebtsupercycle. 87 ForsomeinterestingobservationsonrecentdevelopmentsinEMEs,seeHoffman(2012)

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conclusionseemsevenmorejustifiedwhenweturntotheimplicationsofeasymoneyforthe financialsector. c) Effectsonthefinancialsector Similar to the way that easy money in successive cycles encouraged imprudent borrowing, it alsoencouragedimprudentlending88.Thereareanumberofdangersassociatedwiththis.The first of these would be that lenders suffer losses severe enough to cause an eventual and markedtighteningofcreditconditions.Thiscouldoccurspontaneously,helpingprecipitatean economicslowdown,orcouldfollowuponaneconomicslowdown(ledfromthedemandside) that significantly raised loan losses. Tighter credit conditions would feed back on the real economy, aggravating the downturn. There seems clear evidence of such phenomena today, andalsointhehistoricalrecord89. Asecondconcernwouldbethateasymonetaryconditions,inassociationwithregulatoryand technical developments, would encourage over time the development of a shadow banking sector based less on traditional banking relationships and more on collateralized lending. Again,thereisclearevidenceofsuchanexpansioninrecentyears.Sincethiskindoflending seemstobeevenmoreprocyclicalthantraditionalbanklending,andsubjecttootherrisksas well90,thiswouldhavetobethoughtofasanotherunintendedconsequenceofeasymonetary conditions. A third concern is that insurance companies, and other lenders, might find it increasingly difficult to earn adequate returns on their assets. This could again imply longer termproblemsforanimportantpartofthefinancialsector. 1) Banksandshadowbankinginthecreditupswing The mainstay of traditional banking is to borrow short and lend long. With policy rates low relativetolongertermrates,andrelativetoratesincorporatingacounterpartyriskpremium, bankshaveanincentivetocreatecreditasthedemandforcreditincreases.Therateofgrowth of credit in the AMEs and the EMEs between2003 and 2007 was well above the respective growthratesofnominalincome. Moreover, there is growing evidence that banks and financial markets more generally can become overly optimistic about the risks that they run in their lending practices. Recent BIS WorkingPapersbyBorioandZhu(2008),Gambacorta(2009),Disyatat(2010)andAltunbasetal (2010)allprovideevidenceoftheimportanceofwhattheycalltherisktakingchannelofthe transmissionmechanismofmonetarypolicy91.TobiasandShin(2008aand2008b)alsoprovide

Forafulleranalysisofhowexpandingsafetynets,notleastmonetaryeasingindownturns,havecontributed tomoralhazardonthepartofbothlendersandborrowers,seeWhite(2004). 89 ReinhartandRogoff(2009)p145 90 Forafullerassessment,seeFinancialStabilityBoard(2012) 91 AlsoseeMaddaloniandPeydro(2010)

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compelling evidence that Short term interest rates are determinants of the cost of leverage andarefoundtobeimportantininfluencingthesizeoffinancialintermediarybalancesheets. Inaddition,AdrianandShinnestablishanempiricallinkbetweenhigherleverage,inducedby lower interest rates, and subsequent growth rates of housing investment and durable goods consumption. More anecdotal evidence also supports the hypothesis that low rates encourage more risk takingandsofterlendingstandards.Intheyearsleadinguptothecrisiswhichbrokein2007, lending standards dropped almost everywhere, with subprime mortgages to households and covenantlightloanstocorporationsbeingthemostegregiousexamples.Similarly,therewere sharp declines in the sovereign spreads of EMEs and of lower rated corporate and financial paper. Beginning in the middle of 2003, when policy rates in the AMEs were at their lowest level, the prices of houses in many countries, as well as the prices of other illiquid assets (including commodities), began to rise sharply. Similarly, the cost of insurance against unexpectedevents(proxiedbytheVixindex)felltorecordlowlevels.Insum,illiquiditywasin highdemandandliquiditywasforsalecheaply.Allofthesetrendswereconsistentwithacredit drivenexpansionfosteredbylowpolicyrates.92 Creditexpansionsofthissort,ifnotrestrainedbysufficientlyhighpolicyrates,eventuallyrun intotwootherconstraints.Thefirstoftheseisashortageofcapital,whichresultsinleverage ratios rising to uncomfortable levels. The second is a shortage of longer term and reliable funding to support the credit expansion. Indeed, Kaminska (2012) contends that this latter problemisaterminaldiseaseaffectingbanking,andwasgreatlyaggravatedbythesecularfall in interest rates93. However, banks took aggressive steps to confront both problems, thus allowing them to continue to meet the demand for credit expansion promoted by low borrowing costs. As noted above, this implied a deeper eventual downturn than otherwise givenbothlargermalinvestmentsandalsoastructurallyweakenedfinancialsector. Banksfirstconfrontedthecapitalshortageproblembyexploitingopportunitiesforregulatory arbitrageopenedupbytheintroductionofriskweightedassetsinthefirstBaselAccordof

Apuzzleiswhyincreasesinpolicyrates,intheUSinparticularbetweenmid2004and2007,failedtostopthe excesses.Tworeasonssuggestthemselves.First,thedynamicoftheboomwassogreatthatthemeasured increaseinpolicyrates(essentially25basispointspermeeting)wasinadequatetooffsettheexpectedgains. Second,becausetheincreasesinpolicyratesweresowelltelegraphed,therisksinvolvedinleveragedpositions weredecliningevenmorethanthespreadwasnarrowing.WiththeSharperatiorising,therewasapositive invitationtotakeonevenmoreleverage.AdrianandShin(2008)seemtotakethispointseriously.Theystate(p28) Ifcentralbankcommunicationcompressestheuncertaintyaroundfutureshortrates,theriskoftakingonlong livedassetsfinancedbyshorttermdebtiscompressed...Inthissense,thereisthepossibilitythatforward lookingcommunicationcanbecounterproductive.ThispointwasalsomaderepeatedlyinBISAnnualReports priortothebeginningofthecrisis. 93 Kaminska(2012),p.3Theconsequencesoffallingyieldswere,afterall,potentiallydeadlyforbanksif mismanaged.Notonlydidtheythreatenthemarginsbankscollectedviacheapliabilities,theyincreasingly compromisedfundingsupplyaltogether.
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1992.Slovik(2011)investigatesthebehaviorof15ofthelargestsystemicallyimportantbanks in the AMEs. He documents how the ratio of risk weighted assets to total assets fell almost monotonicallyfrom70percentofGDPin1992tojust35percentjustpriortotheonsetofthe crisis. The implication he draws is that large banks, stretching back over two decades, have been drawing back from their traditional line of business; namely to actively search for and evaluate lending opportunities and advance loans to credit worthy enterprises and households94. Instead, large banks have increasingly pursued a different business model, basedonshadowbanking,whichpromisedtoalleviateboththecapitalproblemandthelong termfundingproblemsimultaneously. Theessenceofshadowbankingistomakeloans,securitizethem,sellthesecuritiesandinsure them, and actively trade all the financial assets involved95. In effect, traditional relationship bankingisreplacedbyacollateralizedmarketsystemwiththerepomarketatitsheart.Banks thusgetriskyassetsoffthebalancesheet,reducingtheconstraintsjustnoted,whileproviding arichsourceoffeesandfurtherprofitsfrommarketmakingandproprietarytrading.However, while seemingly convenient to the financial institutions involved, shadow banking activities havesignificantexternalities(orsystemicrisks)forthefinancialsystemasawhole. A recent report by the Financial Stability Board (2012) enumerates many of these risks. Not least, is the complexityand inherent non transparency of shadow banking thus its name. With long chains of interactions involving collateral, rehypothetication96and large offsetting positionsinCDSandotherderivatives,exposuretocounterpartyriskbecamealmostimpossible toestimate.Inassociationwiththebelief(likelyjustified)thatmanyofthefirmsattheheartof thesystemaretoobigand/orcomplicatedtofail,theseattributeseffectivelyprecludedthe exerciseofmarketdisciplinetoreigninexcessiverisktaking.Aswell,theopacityofthesystem provedasubstantialimpedimenttosupervisoryoversight.Shortcomingsinthisregard,with macroeconomic implications, have been documented by Blustein (2012) as well as the IndependentEvaluationOfficeoftheIMF(2011).Shortcomingsatthemicroeconomiclevelare attestedtobytherecentnumberofcriminalinvestigationsintounacceptablekindsoffinancial behavior.97

Slovik(2011)p.6.Toputthisotherwise,theratiooftotalloanstototalassetsforDeutscheBankfellfrom85 percentin1990to27percentin2010.ForUBSthedeclinewasfrom78percentto22percent,andforBankof Americafrom58to42percent.SeeSlovikTable1. 95 ThemostcomprehensivedescriptioncanbefoundinPozsaretal(2010).AlsoFinancialStabilityBoard(2012) 96 Thiselementofmarketpracticesinnotwellknown.Assetsreceivedascollateralbyalenderarefrequentlylent outorusedascollateralbythelendertoborrowmorefunds.Knownasrehypothecation,thispracticemakesthe chainofrelatedtransactionsstilllongerandmorecomplicated.SeeSinghandAitken(2009)foraseminal discussion. 97 Considerrecentcasesofinsidertrading,moneylaunderingandthesettingofLIBOR.However,Kindelbergerand Aliber(2005)remindusthatfraudandcriminalitywerelatecreditcyclephenomenalongbeforetheriseof shadowbanking.
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Equallyimportant,apointmadebytheFSBaswellasAdrianandShin(2008aand2008b)and Geanakoplos (2003 and 2010), is that a collateral based lending system tends to be highly procyclicalinitsoperations.Essentiallythisisbecausethevalueofavailablecollateralreflects threecomponents;themarketvalueofthecollateral,thehaircutimposedontheborrowerand the velocity of turnover (rehypothecation)of the available collateral98. All three of these are likelytomovehighlyprocyclically,atendencydocumentedusingrecentdatabyGarcia(2012) andSingh(2012).Further,laterinthecreditupswing,wholeclassesofcollateralcanbejudged acceptablethatwouldnotpreviouslyhavebeensoconsidered.Indeed,asRajan(2005)has pointedout,substantialeffortsweremadetoconstructnewinstruments(likeCDOsandtheir variants)thatlookedlessriskyinthattheProbabilityofDefaultseemedtohavefallen.Thefact that the Expected Loss had not fallen commensurately, because the Loss Given Default had risen,giventhenatureofthenewinstrument,wasgenerallyignored99. Finally, the way the shadow banking system has evolved implies that the end of the boom phasecanoccurveryprecipitously.Longertermlendingtendsincreasinglytodependonshort term funding. Because such funds are not covered by deposit insurance schemes, runs can occurquicklywhenconfidenceerodesinthesolvencyofthecounterparts.Ineffect,thefamous Minsky moment is likely to be shorter, harder to predict, and even more self fulfilling than Minsky suggested. The failure of Bear Sterns and Lehmans provide good examples of these dangers.Aswell,theshadowbankingsystemhasanincreasinglyinternationalflavor.Thisnot onlyreducestransparencyandthequalityofregulatoryoversight,butalsoproducesadegree ofbalancesheetexposurethatcouldeasilyprecipitateoraggravateforeignexchangecrises. Concerns of this nature have been raised by Obstfeld (2010), Borio and Disyatat (2011) and Shin(2011). Tosumup,lowpolicyratesencourageimprudentbehaviouronthepartoflendersduringthe creditupswing.Moreover,theyhavealsocontributedtostructuralchangewithinthefinancial sector that makes it inherently more procyclical and also less likely to respond to monetary easing in the future. As with induced changes in the behavior of borrowers, low policy rates have themselves generated circumstances for lenders in which aggressive monetary easing wouldbemoreneededbutalsolesseffective. 2) Banksandshadowbankinginthecreditdownswing Whateverprecipitatestheendofthecreditupswing,thedownswingwillbecharacterizedbya reversalofalltheforcesthatpreviouslymadecreditsoeasilyavailable.Losseswillhavetobe

Singh(2011)providesevidenceofhowthispracticefluctuateswiththecreditcycle. Thisisconsistentwiththehypothesisofpsychologiststhatmosthumanssufferfromdisastermyopia.This couldbetheresultofsurvivalstrategiesbecominghardwiredovermillionsofyearsofevolution.

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absorbed,affectingprofitsandcapital100.Theappetiteforriskwilldecline,aswillthevalueof collateralasmarketpricesfall,haircutsriseandrehypothecationslows.Worse,wholeclassesof collateral (like CDOs and the bonds of peripheral countries in Europe) will be judged unacceptable by lenders. Instead, they will accept as collateral only the bonds of the highest rankedsovereigns,andeventhenonlyforshorttermloans.Perhapsstillworse,uncollaterized lending(sayunsecuredbondissuesbybanks)couldbecomealmostunavailable. Tosaythatfinancialinstitutionsnowfacecapitallossesandseverefundingchallengesistosay thattheveryproblemstheytriedtoavoid,throughtheshadowbankingmechanism,havenow reappearedinaparticularlyvirulentform.Moreover,theymustbeconfronted,notatatimeof vigorous economic expansion, but rather of contraction. This implies that both the cost of capitalandthecostoffunding(relativetopolicyrates)arelikelytobehigher.Fromasecular viewpoint,theimpliedneedtodeleveragemightbethoughtawelcomereactiontoexcessive leverage earlier on101. However, from a cyclical perspective, the worry would be a sharp tighteningofcreditconditionsforultimateborrowersthatwouldreducetheircapacitytospend anddeepenthedownturn. ThereseemslittlequestionthatthefinancialsystemsofmostAMEsfaceparticularchallenges atthepresenttime.ThesituationisperhapsworstinEuropereflectingfactorsconsideredjust below.WhiletheproblemsofEuropeanbanksarehighlighted,theinterdependenciesimplicit in shadow banking imply that financial systems in other continents might also be deeply affectedbypossibleEuropeandevelopments.Unfortunately,thisisintherealmofuncertainty ratherthanquantifiablerisk. To explain the particular challenges facing European banks, consider first the degree of imprudent lending of core Eurozone banks to the banks of peripheral countries. These loans reflectedthefallaciousbeliefthattherecouldbenobalanceofpaymentsproblemswithinthe euro zone. Closely related, European banks prior to the crisis had raised large sums in short termdollarloansandusedthemtomakelongertermdollarloansthroughtheshadowbanking system. Finding dollars to fund those positions subsequently proved particularly difficult, as money market mutual funds in particular withdrew funding.102. Second, regulatory efforts to tightencapitalandliquiditystandardsduringthecreditdownswinghavemateriallycomplicated thesituation.Recallthatmostofthemeasuresbeingimplementednowweresuggestedunder Basel3.However,theywereoriginallyscheduledtobebroughtinonlymuchlater,inorderto cushiontheeffectsonastillrecoveringeconomy.Third,theevolvingeurozonecrisis,withits

Financialinstitutionscanforatime(perhapsalongtime)avoidthisbymakingnewloanstocoverinterest payments(evergreening).Lowinterestratesencouragesuchbehavior.Sincethecrisisbegan,loandefaultrates inEuropehavebeenunusuallylow.SeeBankforInternationalSettlements(2012)GraphVI.1 101 Abodyofliteratureisnowemergingwhichsuggeststhat,beyondcertainlevelsofcredittoGDP,financial deepeningactuallyslowspotentialgrowth.SeeCecchettiandKharroubi(2012) 102 McGuireandGoetz(2009)

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implications for indebted sovereigns and even the survival of the euro, have raised further questionsaboutthefutureofEuropeanbanks. Howarefinancialinstitutionsnow respondingtotheshortageofcapital,longertermfunding and the shortage of acceptable collateral? As for capital, many banks have cut costs and retainedmoreoftheresultingprofits.Afewhaveissuednewequity.Unfortunately,therealso seems to have been a significant effort to reduce capital requirements by manipulating risk weights using internal models. As for longer term funding and the particular problem of collateral, many banks have been highly innovative in collateral mining in an attempt to obtain or create new collateral that lenders will think of as being safer. Collateral swaps betweenbanksandinsurancecompanies,betterconstructedCDOs,greaterissuanceofETFs, issuanceofcoveredbonds,andrelianceonfundingfromcorporationsintherepomarketareall increasing. Unfortunately, each of these alternative sources of funds also has significant risks associatedwithit103,notleastthatthecollateralofferedcouldbesignificantlylesssafethanit firstappearstobe. The bottom line thus remains. The poor health of the financial system in AMEs, arising from the earlier period of low rates and rapid credit expansion, could add materially to the headwindsfacingtheglobaleconomy.Asnotedabove,risingfundingcostshaveimpliedthat banklendingrateshavefallensignificantlylessthanpolicyrates.Inmanycountries,especially peripheral countries in Europe, lending standards have tightened significantly. Small and mediumsizeenterpriseseverywherehavebeenthemostaffected,ashaveborrowersinareas dominatedbycommunitybankswhoselendinggenerallylacksdiversification Shortofawholesalerestructuringoftheliabilitiesoffinancialinstitutions(linkedtorecognizing losses on the asset side of the balance sheet),it is not clear what central banks can to do to restorethefinancialsystemtohealth.Iftheproblemisinsolvencyandfearsofinsolvency,the provision of still more liquidity only postpones the day of reckoning104. Indeed, if the central bank lending is done only against good collateral, the collateral shortfall problem will be exacerbatedespeciallysincecentralbanksdonotingeneralrehypothecate105. Asforstilllowerpolicyratestohelpthefinancialsystem,thismighttemporarilyraiselending spreads and profitability. However, over time, spreads (both term and credit) will trend back

TheBankofEnglandisconcernedaboutcollateralswapsandETFs.SeeHughes(2011).OnETFs,alsosee Raswamy(2011).Onthelimitationsoftheissuanceofcoveredbonds,seeAlloway(2012a)andAlloway(2012b). Whileitseemstherecontinuestobescopeformorecoveredbondissuesatpresent,theconcernremainsthat therewilleventuallybeatippingpoint.Becausecoveredbondssubordinateotherlenders,theymightinthe endcauseuncoveredlendingtostopentirely. 104 IntheIntroductiontothispaper,explicitdebtrestructuringissuggestedasoneofthepoliciesthatgovernments mightfollowthatwouldactuallyencouragerecovery. 105 DecliningliquidityinthelongertermUSTreasurymarkethasbeenascribedtoOperationTwist.Similar commentshavefollowedonlargescalepurchasesofgiltsbytheBankofEngland.
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towards normal levels as longer term assets mature. Indeed, in the aftermath of a financial crisis, the search for safety along with tightened regulatory standards might result (in some countries) in abnormally sharp declines in term spreads due to declines in longer term governmentbondrates106.Againstthisbackground,policiesliketheFedssocalledOperation Twist,whichartificiallyreducetermspreads,alsoreducethewillingnesstolendlongevenif thedesiretoborrowincreases.107And,finallyandlikelymostimportant,stilllowerpolicyrates threatenstillmoreoftheunintendedconsequenceswhichbroughtusthecurrentcrisisinthe firstplace. 3) Otherunintendedconsequencesinthefinancialsector Giventheunprecedentedcharacterofthemonetarypoliciesfollowedinrecentyears, and the almost complete absence of a financial sector in currently used macroeconomic models, theremightwellbeotherunintendedconsequencesthatarenotyetontheradarscreen.By wayofexampleonly,futuresbrokersdemandmargin,andcustomersoftenovermargin.The broker can invest the excess, and often a substantial portion of their profits comes from this source108.Lowinterestratesthreatenthisincomesourceandperhapseventhewholebusiness model. A similar concern might arise concerning the viability of money market mutual funds, supposing that asset returns were not sufficient to even cover operating expenses. A final example of potential problems has to do with the swaps markets, where unexpectedly low policyratescanpunishseverelythosethatbetthewrongway.Thiscouldleadtobankruptcies andotherunintendedconsequences.109 A problem which has been far better recognized is the implications of low interest rates for insurance companies110. This issue was flagged at least as far back as 2000111, but in recent years a wide range of studies into this problem have been carried out112. Ernst and Young estimatethatthetop25lifecompanieswouldseenetinvestmentincomedeclineby51basis points (from a 2010 level of 5.01 percent) if interest rates remained at the level of October 2011forthreeyears.Companieswouldbemostaffectedwhenheavilyinvestedinbonds,when the duration of the assets was short (relative to the duration of liabilities), and when

Theflatteningofyieldcurveshasalreadyledtoanarrowingofinterestspreads.SeeBankforInternational Settlements(2012)TableVI.1 107 SeeBillGross(2012).Thisisparticularlyperniciousifitthwartslongertermlendingtofundthelongerterm investmentthatmanyAMEsreallyneed. 108 SeeMeyer(2012) 109 SeeHaddockandBarnes(2012).Theycontendthat,priorto2007,manyhighlyleveragedpropertydealsinthe UKusedswapstominimizetherisksofrisingfinancingrates.Indeed,manyoftheseswapshadamaturitylonger thantheunderlyingloanitself.Nowmanyofthesedealsneedtoberestructured,butlowpolicyrateshaveraised thecostofbreakingtheswaptoprohibitivelevels.Thisisanotherexampleofhowlowpolicyratescanimpedethe purgingofmalinvestmentsinthedownswingofthecreditcycle. 110 Theseareverysimilartotheimplicationsforpensionfundswhichwerediscussedabove. 111 Dickson(2001) 112 Antolinetal(2011),Frenchetal(2011),StandardandPoors(2011)andRamaswamy(2012)
106

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companies had little room to maneuver on the liability side because of previous contractual agreements. Suchadeclineinportfolioreturnsissignificantandhasalreadyledtocertainreactionsonthe partoftheinsurancecompaniesmostaffected.Variously,dividendshavebeenlowered,premia havebeenraised,payoutstotheinsuredhavebeenreduced(wherepossible),andcompanies havewithdrawnfrombusinesslinesthatnolongerseempossible.Inconductinganassessment oftheproblemsfaced,andthereactionstodate,StandardandPoorssaidthatitsawnoneed tochangeratingsinthenearterm.Thisiscomforting. However,leftunassessedwerethreeotherrisksthatcouldproveimportant.First,whatwould betheeffectsofinterestratesstayinglowformuchlongerthanthenexttwotothreeyears? Second, how might this interact with calls for more capital and expensive, new monitoring proceduresincompaniesjudgedtobeofsystemicimportance?Third,andcloselyrelated,what isthelikelihoodthatsomeinsurancecompaniesmightgambleforresurrectionbysubstantially increasingtheirrisktaking.Evidentlythisisapossibleoutcomenotjustconfinedtoinsurance companies, but to all financial institutions who suffer losses in a low interest rate environment113.Unfortunately,itisgenerallyimpossibletoassessthispossibilityuntilsuchrisks actuallymaterialize.Bythenthedamage,perhapssystemic,hasalreadybeendone. d)Effectsoncentralbanksandgovernments Ultra easy monetary policies, whether very low policy rates or policies affecting the size and compositionoftheirbalancesheets,canalsohaveunintendedandunwelcomeimplicationsfor centralbanksthemselves.Someoftheseeffectsaremoretechnical.First,withverylowpolicy rates,thelikelihoodrisesthatnormalintermediationspreadsinprivatemarketswillfallsofar thatthesemarketswillcollapse.Thecentralbankmaythenfinditselfasthemarketmakerof last resort. The current interbank market might fall into this category. Moreover, a similar experience in Japan in the 1990s indicates that restarting such private markets is not easy. Second, deeper questions can arise about central banks operating procedures in such an environment114.Third,withcentralbankssoactiveinsomanymarkets,thedangerrisesthat thepricesinthosemarketswillincreasinglybedeterminedbythecentralbanksactions.While there are both positive and negative implications for the broader economy, as described in earlier sections, there is one clear negative for central banks. The information normally provided to central banks by market movements, information which ought to help in the conductofmonetarypolicy,willbeincreasinglyabsent.Finally,withpoliciesbeingessentially

113 114

ForadiscussionofthetradinglossesrecentlysufferedbyJPMorgan,seeTett(2012) SeeBankforInternationalSettlements(2012)BoxIVb.

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unprecedented, wholly unexpected implications for central banks (as with others) cannot be ruledout115. Beyond these technical considerations, the actions undertaken by AME central banks pose a clearthreattotheirindependenceinthepursuitofpricestability.First,ascentralbankshave purchased(oracceptedascollateral)assetsoflowerquality,theyhaveexposedthemselvesto losses. If it were felt necessary to recapitalize the central bank116, this would be both embarrassing and another potential source of influence of the government over the central banks activities. Second, the actions of central banks have palpably been motivated by concerns about financial stability. Going forward, it will nolonger be possible to suggest that monetary policy can be uniquely focused on near term price stability. Third, by purchasing governmentpaperonalargescale,centralbanksopenthemselvestothecriticismthattheyare cooperatingintheprocessoffiscaldominance117. It is easier to identify these possible implications for central banks than to assess their desirability.Onrecapitalization,itisnotatallclearthatcentralbanksneedpositivecapitalto carry out their responsibilities118. On central banks being overly concerned with financial stability,manyeconomistswouldarguethatthiswaspart(indeedthecore)ofthetraditional mandateofcentralbanks.Theywouldnotethat,sincefinancialinstabilitycanleadtodeflation (whichisnotpricestabilityeither),theconcernsaboutpriceandfinancialinstabilityaresimply twosidesofthesamecoin119.AdrianandShin(2008)eveninsistthatthelinkisgrowingever stronger, given how policy rates drive the leverage cycle in the modern world of shadow banking.Finally,supposethatcentralbankpurchasesofgovernmentpaperarearesponsetoa marketdrivenrunthatcouldbecomeselffulfilling120.Isthisnotexactlythekindofsituation

Inmid2012,somecommentatorssuggestedtheECBshouldstartpayingnegativeinterestratesonreserves heldattheECB.TheinitialECBresistancetothissuggestionwasbasedinpartonthisconcern.Anotherworry, arisingfromrecentDanishexperience,wasthatbankswouldthenhavetorecouplossesbyraisingratesonloans. Inthisway,monetaryeasingmightprovecontractionary. 116 Leijonhufvud(2009)makestherelatedpointthat,inchoosingwhotosupportandwhonot,centralbanksare makingchoiceswithdistributionalimplications.Issuesofdistributionfallmorenormallyintherealmofpoliticsand willattracttheattentionofpoliticians. 117 Hanoun(2011)expressesconcernthatthefocusofcentralbanksonpricestabilitywillbedilutedbyfinancial dominance,fiscaldominanceandalsoexchangeratedominance.Thislastconcernreferstothefearoffloating, referredtoabove,thathasextendedthecreditdrivenproblemsintheAMEstotheEMEsaswell. 118 Thecentralbanksofmanycountrieshaveoperatedwithnegativecapitalfordecades;e.g.,Chile,Jamaicaand others. 119 Thisauthor,andBorioandothersattheBIS,havebeenmakingthispointformanyyears.Thepractical implicationisthatpricestabilitytargetsshouldextendoverahorizonlongenoughtoallowimbalancestounwind. Thus,toleanagainstacreditbubbleistoleanagainstsomecombinationofpossiblenearterminflationary pressuresand/orthepossibilityofexcessivedisinflation(orevendeflation)overthemediumterm.SeeWhite (2006a).Operationally,thisimpliesthatseparatingthepricestabilityfunctionfromthefinancialstabilityfunction atcentralbanksislogicallywrong.SeeWhite(2012a).Issing(2012)remindsus,however,ofsomeimportant politicalconsiderationsthatcouldqualifythisconclusion. 120 Theproblemisoneofmultipleequilibria.Asovereignmaybesolventgivenreasonableinterestrates,butnotif arunpushesupratesbeyondsomelimit.
115

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when central banks ought to intervene? Evidently, such considerations are receiving a great dealofattentioninthecontextoftheEurozonecrisis. What are the implications of ultra easy monetary policy for governments? One technical responseisthatitcouldinfluencethematuritystructureofgovernmentdebt.Withapositively slopedyieldcurve,governmentsmightbetemptedtorelyonevershorterfinancing.Thiswould leave them open to significant refinancing risks when interest rates eventually began to rise. Indeed, if the maturity structure became short enough, higher rates to fight inflationary pressure might cause a widening of the government deficit sufficient to raise fears of fiscal dominance.Inthelimit,monetarytighteningmightthenraiseinflationaryexpectationsrather thanlowerthem.WhilethisdynamicwasseeninthepastinsomeLatinAmericancountries,in thiscrisisthematuritystructureofthedebtinmanyAMEshasactuallybeenlengthenednot shortened. Amorefundamentaleffectongovernments,however,isthatitfostersfalseconfidenceinthe sustainability of their fiscal position. In the last few years, in spite of rising debt levels, the proportionofgovernmentdebtservicetoGDPinmanyAMEshasactuallyfallen.Citingaswell theexampleofJapan,manycommentatorsthuscontendthattheneedforfiscalconsolidation can be resisted for a long time. Koo, Martin Wolf of the Financial Times, and others are undoubtedlyrightinsuggestingthatadebtdrivenprivatesectorcollapseshouldnormallybe offset by public sector stimulus. What cannot be forgotten,however, is the suddenness with whichmarketconfidencecanbelost,andthefactthattheJapanesesituationishighlyunusual inanumberofways121. Whatiscleareristhatexitingfromaperiodofultraeasymonetarypolicywillnotbeeasy.In thisarea,theJapaneseexperienceoverthelasttwodecadesisinstructive.Centralbanksusing traditionalmodelswillhesitatetoraiseratesbecausegrowthseemssubnormal.Further,the recognitionthathighershortratesmightcauselongerratestospike,withuncertaineffects onfinancialstability,willalsoinducecaution122.Governmentswillalsofirmlyresisthigherrates, because they might well reveal that the level of government debt had indeed risen to unsustainablelevels.Further,onthebasisofrecentexperience,theentirefinancialcommunity (with its formidable capacity for public communication and private lobbying) will oppose any tightening of policy as too dangerous. Their motives in this regard are questioned below. Presumablyasharpenoughincreaseininflationwouldleadtoatighteningofpolicy.However,

TheJapanesecrisisofthe1990sbeganwithaveryhighhouseholdsavingrate,averystronghomebiasfor portfolioinvestmentandtheworldslargesttradesurplus.Contrastthis,forexample,withthealmostopposite positionoftheUStoday.AmarkedshiftinmarketconfidenceinUSTreasurydebtwouldthenseemlikelytolead toadollarcrisisaswell. 122 ThismightbeparticularlythecaseintheUS.Recalltheturmoilinthebondmarketswhenrateswereraisedin 1994.Recallaswelltheconcerntoavoidfinancialinstabilityimplicitinthemeasuredincreaseinpolicyrates between2004and2007.Further,becauseoftheproblemofconvexityhedging,whichisuniquetotheUnited States,theremightwellbeconcernsthatraisingpolicyratescouldhaveundesiredconsequences.

121

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bythenalotoffurtherdamagenotleasttothecredibilityofcentralbanksmightwellhave beendone. e)Effectsonthedistributionofincomeandwealth Incomeinequalityhasrisensharplyinalmosteverycountryintheworldinrecentyears.This applies equally to AME and EMEs123. Moreover, after many years when distributional issues werelargelyignored,thesetrendsarenowreceivingincreasedattention.Whileargumentscan easily be made for some degree of inequality to foster growth124, there is a sense almost everywhere that recent trends have gone too far. Wilkinson and Picket (2009) suggest that greaterinequalityhasmanyundesirablesocialeffects.Ithasalsobeensuggestedthatgreater inequalitycanleadstoaconcentrationofpoliticalpowerinthehandsofthosewhowishtouse itfortheirownpurposes.Inthelimit,suchtrendscallintoquestionthelegitimacyofthewhole democratic process. Further, by raising perceptions of unfairness, the trust that underpins all transactions in a market system can also be eroded. Evidently, these are crucially important socialissues. Givenitsglobalincidenceandsecularcharacter,risingincomeinequalityislikelydeeplyrooted in technological change and globalization, both of which threaten the less well educated. Nevertheless, it is also worth asking whether, to some degree, this might be another unintended consequence of ultra easy monetary policy. Not only has the share of wages (in total factor income) been declining in many countries, but the rising profit share has been increasinglydrivenbythefinancialsector.Itseemstodefycommonsensethatatonepoint40 percentofallUScorporateprofits(valueadded?)camefromthissinglesource. Tosimplifyadescriptionofhowsuchaprocessmightwork,distinguishbetweenthreeclasses ofpeople.Class1(entrepreneursandfinanciers)arethosewhoarerichenoughtosave(equity) andtheyinvestonaleveragedbasisusingfundsborrowedfromothersavers.Thissecondclass ofsavers(Class2)isalsorelativelywelloff,butmoreriskadversethanthefirstclass.Class3 consistsofthelesswelloffwhoessentiallyborrowfromtheothers.Itisofinteresttoseewho fares relatively well (and relatively badly) in the boom bust phases of the credit cycle, and also how shadow banking practices play into this. As argued above, both constitute the unexpectedconsequencesofultraeasymonetarypolicies. Intheboomphaseofthecycle,withinterestratelowrelativetoexpectedrewards,members ofClass1speculate,usingleverage,andgenerallymakesubstantialprofitsasassetpricesrise and the economy expands. The momentum of this process continues even after policy rates begintorise.Speculationisalsoencouragedbythesafetynetfeaturesincreasinglyprovidedby

123 124

SeeOECD(2011) Theclassicalargumentisthatricherpeoplesavemoreandthisprovidesthebasisforcapitalaccumulation.

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governments125. Moreover, those in the financial sector systematically exploit knowledge asymmetries to increase both fees and gains from market movements. This process of extraction is facilitated by the inherent non transparency of the shadow banking system. Finally, members of Class 1 use their political influence to enhance these safety net features and to drum up support for the safety and soundness of the shadow banking system upon whichtheyincreasinglyrely126. MembersofClass2alsoprofit,especiallyasinterestratesrise,sincetheyarenetsavers (creditors)withpredominantlyshorttermassets.Class3memberssufferfromhigherinterest ratesastherecoverycontinues,buttotheextenttheyhaveborrowedtobuyrealassets (especiallyhouses)theyalsoseemtogainasthepricesofthoseassetsrise.Rajan(2010) contendsthatgovernmentsactivelyencouragedthisprocess127toallowlowerincomepeople tocontinuetoconsume,evenastheirincomesandjobprospectswerebeingfurthersqueezed bytechnologicaldevelopmentsandglobalization. Inthebustphaseofthecycle,assetpricescollapseandClass1speculatorscanlosepart (thoughrarelyall)ofthewealthaccumulatedearlier.Sharplyeasiermonetaryconditionsease theirburdenmaterially.Again,thereislobbyingtoensurethattheotherformsofsupport promisedearlierbygovernmentsactuallymaterializes.MembersofClass2bearthemain burdenofthistransferfromcreditorstodebtors,eitherdirectly(astheirfinancialassetsearn verylittle)orindirectlyduetolowerpensionsandhigherinsurancecost.Asdebtors,members ofClass3alsobenefitfromultraeasymonetarypolicy128.Overall,however,theysufferthe mostbecausetheirnetwealthisverylow,theiraccesstofurthercreditdisappears,andthey arethemostliabletolosetheirjobsinthedownturn.Ironically,ifRajansthesisiscorrect,the policiesoriginallydesignedtohelpthepoorhavehurtthemthemost. Thisstoryishighlystylizedandperhapsnottrueincertainrespects.Nevertheless,itseemstrue enoughtowarrantfurtherinterdisciplinaryresearchintothepotentialredistributive implicationsofultraeasymonetarypolicy.

D. Conclusions

ThesewouldincludetheGreenspanput,andtheassumptionthatsomefirmsweretoo big/complex/interrelatedtobeallowedtofail.AnotherimportantadvantageisthatlendersintheUSandEU,with loanssecuredonfinancialcollateral,havebankruptcyprivileges.Thatis,inthecaseofbankruptcy,theholdersof collateralcanimmediatelyseizeitandsellit,thusjumpingthenormalqueueofcreditors.SeePerotti(2012)and JohnsonR(2010).FisherandRosenblum(2012)andothersfeelthatbanksthatcannotbeallowedtofailina disorderlyfashionshouldbebrokenup.Needlesstosay,thissuggestionhasprovencontroversial. 126 Fortwopowerfulworksspeakingtotheseissues,seeJohnsonS(2009)andWedel(2009) 127 IntheUS,themassiveexpansionoftheremitofGovernmentSponsoredEnterprises(especiallyFannieMaeand FreddieMac)providestrongsupportforRajansposition. 128 Thiswouldbelimited,however,ifthemortgagewerefixedrateandlongterm.IntheUS,refinancing opportunitieswouldalsoberestrictedifthevalueofthepropertyfellbelowthevalueofthemortgage.
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Thecaseforultraeasymonetarypolicieshasbeenwellenoughmadetoconvincethecentral banksofmostAMEstofollowsuchpolices.Theyhavesucceededthusfarinavoidingacollapse ofboththeglobaleconomyandthefinancialsystemthatsupportsit.Nevertheless,itisargued inthispaper,thatthecapacityofsuchpoliciestostimulatestrong,sustainableandbalanced growthintheglobaleconomyislimited.Moreover,ultraeasymonetarypolicieshaveawide variety of undesirable medium term effects the unintended consequences. They create malinvestments in the real economy, threaten the health of financial institutions and the functioning of financial markets, constrain the independent pursuit of price stability by centralbanks,encouragegovernmentstorefrainfromconfrontingsovereigndebtproblemsin a timely way, and redistribute income and wealth in a highly regressive fashion. While each medium term effect on its own might be questioned, considered all together they support stronglythepropositionthataggressivemonetaryeasingineconomicdownturnsisnotafree lunch. Lookingforwardtowhenthiscrisisisover,theprincipallessonforcentralbankswouldseemto be that they should lean more aggressively against credit driven upswings, and be more prepared to tolerate the subsequent downswings. This could help avoid future crises of the currentsort.Ofcoursethecurrentcrisisisnotyetover,andtheprincipallessontobedrawn from this paper concerns governments rather more than central banks. What central banks havedoneistobuytimetoallowgovernmentstofollowthepolicies129thataremorelikelyto lead to aresumption of strong, sustainable and balanced global growth. If governments do notusethistimewisely,thentheongoingeconomicandfinancialcrisiscanonlyworsenasthe unintendedconsequencesofcurrentmonetarypoliciesincreasinglymaterialize. BIBLIOGRAPHY
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Forafullerdescriptionofrecommendedpolicies,seeWhite(2012)

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