Central banks around the world had made a habit of preventing economies from getting into recessions by simply cutting interest rates the moment they had a slight whiff of the economy slowing down. This would lead to consumers going on a borrowing binge and buying things. And the economy would be up and running again. But this time around, this tried and tested formula has not worked.
“Central banks are not genuinely independent. They are in effect slaves to the developments in the markets,” says George Cooper, author of The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy (New Age International Publishers, 2009, Rs 295).
Currently, Cooper is a principal of Alignment Investors, a division of BlueCrest Capital Management Ltd. He has worked as a fund manager at Goldman Sachs and as strategist for Deutsche Bank and JPMorgan. Cooper spoke to DNA about the failure of conventional monetary policy during this crisis, the West’s load of debt, and whether he sees any way out. Excerpts:
Central banks around the world have cut interest rates to almost 0%. But that hasn’t quite propped up consumption yet. Why?
Consumers in the West have realised that they already have too much debt. So, cutting interest rates has helped them service that debt because of the lower interest cost, but they have wisened up and realised that it’s very dangerous to keep increasing debt for yourself. What people were hoping would happen, is that you lower the cost of debt and the demand would go up. But in this case, there has been a realisation that people are already overleveraged. So in this case, the interest rate cutting has failed.
In a way, this is a result of trying this trick too many times. We cut interest rates aggressively in previous cycles in order to encourage more debt into the system. The more you do that, eventually you reach a point where the amount of debt becomes so big that further interest rate cuts don’t work. It needs interest rates to be cut to negative levels, which of course, you cannot do. So we have run into what economists call the ‘zero percent bound’ which means you cannot cut rates to negative levels and negative level is what you need to encourage more debt. So essentially, conventional monetary policy has broken down.
“Monetary policy is like Pavlov and his dog,” you remarked recently.What did you mean?
You know the story of Pavlov and his dog [Ivan Pavlov was a Russian scientist who first demonstrated classical conditioning using dogs]. Similarly, as soon as you start to go into an economic contraction, monetary policy comes into the picture and central banks start to cut interest rates and they signal to the private sector ‘We are going to cut interest rates fast enough to encourage more credit to encourage to borrow’. So as we go into a recession, central banks start to cut interest rates and they train the dog — the private sector — to start borrowing immediately. But that hasn’t happened this time around.
What does seem to be happening is that speculators are borrowing money at very low rates and investing in various asset markets around the world. So would you say central banks all over the world are helping inflate more asset bubbles?
As things stand right now, I would say we don’t yet have major asset bubbles. However, we are certainly heading in that direction. If these zero interest rates remain in place, almost certainly we will end up with new bubbles which will then burst and create new problems.
If central banks are to be believed, then the likelihood is that they are going to leave rates very low for a very long time and the result will be, yes, we will have new bubbles. One of the problems with this sort of policy is that you cut interest rates in order to support the consumer sector, but unfortunately the money often gets used in a different sector, the sector that doesn’t need support. In this case, the liquidity is going into areas like developing economies, India and China. And if it were to be allowed for too long, then you will end up with a bubble as a result.
Why do central banks ignore bubbles while they are building up? Greenspan ignored the dotcom bubble. Again, between him and other central bankers around the world, they ignored the housing bubble…
Essentially it’s a political problem. While the bubble is inflating, job creation, corporate profits, economic activity etc is very strong and of course, politicians like to take credit for that. And businesses like that sort of condition. If the central bank tries to correct that, the politicians can get blamed and naturally, the politicians press the central banks not to apply that. Really, in truth, the central banks are not genuinely independent. They are in effect slaves to the developments in the markets.
You write in your book that “The idea that markets are always correctly priced remains a key argument against central banks attempting to prick asset price bubbles. Strangely, however, when asset prices begin falling the new lower prices are immediately recognised as being somehow wrong and requiring corrective action on the part of policy makers.” How does one explain that dichotomy?
Central banks say they must ignore asset prices and change in asset prices. If that is correct, why do they act when asset prices fall? They didn’t know that they were wrong to start with — they can’t know when the prices fall. The practical aspect as to why they do it is effectively the same answer as the previous question. They respond to falling asset prices because that leads to contracting credit, contracting economic activity, higher unemployment and intense political pressure.
So central banks are acting, or trying, to continuously push credit into economies for political reasons. But of course the result of that if they are successful, they push the economy to get over-indebted, which is exactly what they shouldn’t be doing. It’s essentially a war between politics and good central banking.
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