The chorus of optimistic forecasts is growing. The Federal Reserve’s Beige Book reported moderate growth from November to the end of 2013, and that “the economic outlook is positive in most districts.” The World Bank predicted the developed world is on the brink of “self-sustained recovery” for the first time in five years, and expects the U.S economy to grow as much as 3.2 percent this year.
The corollary to improved economic conditions is that the monetary spigots that have been left open for so long to keep interest rates so close to zero, both in the United States and in the European Union, will likely be turned off. In fact, the Federal Reserve has already begun to talk of “tapering” its monthly purchases of financial assets from the current level of $85 billion.
However, the long-term effects of expansive monetary policy might not be easy to reverse painlessly. These effects are not limited to the obvious danger of inflation. Prolonged low interest rates can, under certain circumstances, encourage banks to undertake increasingly risky loans. New studies show that this risk is not merely theoretical, and that long periods of expansive monetary policy, which forces down interest rates, can lay the groundwork for the next financial crisis.
The Federal Reserve under Ben S. Bernanke’s leadership has justified the successive rounds of quantitative easing on the grounds that low interest rates would encourage investment and jump-start the economy by reducing the cost of borrowing. That hoped-for scenario has failed to materialize in this recovery, the most lackluster since the end of World War II.
The policy is grounded in Mr. Bernanke’s scholarship. Unfortunately, the perspective that has driven this policy choice is limited, and singularly fails to take into account the effect of persistently low interest rates on not only borrowing by potential investors, but on lending decisions of banks.
As interest rates fall with expansive monetary policy, they reduce the bank’s rate of return on its loan, which increases the incentive to cut back on costly monitoring. Because they have limited liability, banks will tend to take excessive risk, which is then passed on to depositors (or the Federal Deposit Insurance Corporation, and through the FDIC to taxpayers) and bondholders in an environment where low interest rates prevail for a long time. This is explained by International Monetary Fund economists Givoanni Dell‘Ariccia and Luc Laeven, and Boston University’s Robert Marquez, in a recent study.
In a study of Austrian banks, University of North Carolina economist Paul Gaggl and Oesterreichische Nationalbank economist Maria Teresa Valderrama found that the European Central Bank’s low-interest policy from 2003 through 2005 was a key factor in explaining the increase in riskiness of bank loan portfolios. When banks make loans, they must incur some costs to screen applicants to determine how risky making the loan would be. Through the screening of applicants, banks can then decide what the profit-maximizing loan portfolio would be. If banks had complete information, they would make the largest loans to the safest borrowers. However, they do not have complete information.
When they must pay high interest rates to depositors, they make loans carefully. If, however, they are flush with funds owing to the central bank pumping money into the system, the incentives for caution diminish. Now, they get less bang for any dollars they spend on getting information on the quality of the borrower. Loans are made to borrowers who would not be considered good credit risks in the absence of expansive monetary policy. Entire loan portfolios begin to take on imprudent risk.
In the case of Austria, the European Central Bank held down interest rates to 2 percent between June 2003 and December 2005. Mr. Gaggl and Ms. Valderrama find the average expected default rate increased by 40 percent. They point out that bank portfolios will not suffer when interest rates fall if economic activity is falling at the same time. The danger comes when there is an “improvement in economic activity together with sufficiently low and unchanged interest rates.”
This might be where we are now — and highlights the dangers of discretionary policy. Attempts at timing the stimulus, both monetary and fiscal, largely have been failures. The recent uptick in economic activity, and especially in the real-estate sector, should be treated as warning signs of another possible bubble.
The long run of expansive monetary policy and near-zero interest rates has done little to add to stability to the system. The taper, if it is coming, might well be too little, too late.