The RBA’s head of economic research, John Simon, delivered a strong rebuttal of those who think the current low global interest rates settings are a source of risk for the global economy and financial stability.
Simon says the experience of the financial crisis – and the low interest rate environment that preceded it – was not a good example on which to base any analysis of the impact of low rates, because they are not inherently unstable. Rather, the pre-GFC years saw interest rates inappropriately low given the strength of the global economy at the time.
Speaking at the Paul Woolley Centre for the Study of Capital Market Dysfunctionality Conference, Simon neatly demolished the argument proffered by Reserve Bank of India governor Raghuram Rajan that “investment managers have incentives to take risks that are hidden from investors in pursuit of higher yields – the so-called ‘search for yield’.”
The ‘search for yield’ argument is, as set out by Rajan, an argument that nominal benchmarks are embedded in many financial market decisions. For example, he argued, that life insurance companies have written contracts with minimum guaranteed nominal returns in them; that funds managers have mandates with nominal targets. When inflation or real interest rates fall, it gets harder to reach those nominal targets and, instead of choosing a more sensible benchmark, they take on more risk.
The evidence is “weak and anecdotal” he says, noting that “there is better evidence of increased risk-taking by banks in low interest-rate environments.”
That very much sounds like a pre-condition leading to the GFC.
He added that another manifestation of the “search for yield” argument leading to the GFC is noted monetary economist John Taylor’s hypothesis that “interest rates lower than was consistent with historical patterns (that is, below the level predicted by the Taylor Rule) stimulated the US economy excessively and simultaneously contributed to a search for yield”.
Taylor says, “interest rates were set inappropriately low” which when combined with “lax regulatory policy” contributed to a “strong but fragile US economy.”
That’s important to Simon’s overall argument as to why low interest rates are not of themselves dangerous. It’s the appropriateness of interest rate settings that’s important, relative to the economy, rather than the level.
Of course the other big argument argument proffered in the wake of the GFC was that it was all the fault of Asia and emerging markets. Under the secular stagnation thesis there was, is, “an excess of global savings relative to the available productive investments”.
Simon said the argument runs that:
This excess of savings drives down the interest rate. However, because of a combination of structurally lower equilibrium interest rates and the zero lower bound, it is not possible for the interest rate to fall far enough to equalise demand and supply. As a result there are excess funds looking for a home. Larry Summers has argued that this makes economies inherently bubbly. In a world where there are few productive investment opportunities, reflecting depressed economic conditions, asset purchases look particularly attractive. And this can contribute to a self-reinforcing cycle as the resulting asset-price increases become justification for greater investments in assets – ‘rational’ bubbles may be prone to forming.
Simon says that’s not an argument for not taking rates lower, and while he recognises the arguments do have some merit, he says that “sometimes risk taking is the point” of lower rates.
“Indeed, that’s one of the ways lower interest rates stimulate economic activity. They do this by encouraging the granting of loans to entrepreneurs who couldn’t previously get funding because the returns were too uncertain or too low. And none of the papers I’ve read can separate appropriate or desired risk taking from inappropriate and undesired risk taking,” he said.
Think: RBA governor Glenn Stevens and his famous “animal spirits” speech.
Simon sought to answer the implied question that if more risk taking is desired, and only “too-much risk taking is the problem”, then how do you identify too much?
He cites an ECB study that finds the “most robust early warning indicator of banking crisis onset, that is, the one that appears most consistently in predictive models, is rising domestic private credit”.
Increasing household debt and decreasing corporate interest rate spreads also show up as indicators, he said. Low interest rates didn’t show up as a predictive variable.
Now of course these indicators represent increased risk tolerance by households, the banks who lend to them, and investors who are buying the corporate debt.
That sounds like the very situation people are worried about in the global economy’s low interest rate regime right now.
But, Simon says his own study of Australian bubbles shows “while credit and leverage were present in all of them, low interest rates were not.”
Going further, he adds that that the ’80s stock market bubble was associated with rates that would appear now a crushingly high – 10%, then approaching 20% during the decade.
He argues the high rates of the ’70s and ’80s are historically aberrant and as such low rates didn’t lead necessarily to financial crises.
In sign to why the RBA, and APRA, clamped down on investment lending in Australia, Simon says leverage and lax regulation played more of a role than low interest rates on their own.
“While some countries managed the environment well, this was clearly not universal. Thus, one can conclude that even in buoyant low interest rate environments, appropriately calibrated prudential policy can help to restrain risk taking by financial institutions,” he said.
He concludes that Taylor might be onto something noting that “inappropriately low interest rates – that is, low interest rates during times of strong economic growth – combined with inadequate prudential supervision can contribute to a build-up of risk that is ultimately destabilising”.
Cue APRA, and the tightening of lending rules and bank capital requirements for mortgage lending.
Again, it’s not low interest rates we need to look at Simon says, but rather leverage. Not just personal leverage but also banking leverage and he clearly comes down on the side of the appropriateness of the interest rate settings relative to economic growth.
“In sum, in 2007 we experienced a combination of factors that each contributed to the financial crisis. The world economy was growing strongly, but contained inflation led many central banks to keep interest rates low. In some economies prudential regulation was clearly inadequate to contain a deregulated banking sector. Together, these contributed to a highly leveraged financial sector. And the rest, as they say, is history,” he said.
Take that Ben Bernanke and your silly idea that central bankers had washed away the business cycle in the “Great Moderation.”
Simon says the world could “probably do with a bit more entrepreneurial risk-taking” as long as it’s not leveraged speculation. But adds, “chastened by the experience of the financial crisis, prudential regulators the world over are raising standards. Here in Australia, a few months ago the Australian Prudential Regulation Authority announced that it would be increasing capital charges on some mortgage lending and the major banks have increased their investor loan interest rates to slow growth in line with APRA measures.”
So he says “while it never pays to be complacent, there are few early-warning indicators for a financial crisis despite the prevalence of low nominal interest rates. In any case, low interest rates are a poor indicator of future problems and, given currently weak global growth, entirely appropriate. Thus, I think, concern over the current low levels of interest rates expressed by John Taylor and those who worry about the search for yield are probably overdone.”
And now we know why APRA and the RBA have been so hard on Australia’s banks.
The growth in investment lending and the banks expansion of their lending books, while capital held was falling, were the alarm bells that signalled a bubble.