In 2002, at the end of a two-year stint at the Bank for International Settlements (BIS) in Switzerland, Reserve Bank of Australia Governor Philip Lowe made a point for which he is still remembered in the economic salons of the world, and which he is now trying to put into practice.
He and a BIS colleague Claudio Borio wrote in a prescient paper: “…lowering rates or providing ample liquidity when problems materialise but not raising rates as imbalances build up, can be rather insidious in the longer run. They promote a form of moral hazard that can sow the seeds of instability and of costly fluctuations in the real economy.”
It’s an obvious point, made when the US Federal Reserve was slashing interest rates in the wake of the dot-com bust, but since forgotten by most central bankers, including Dr Lowe, after they were mugged by events.
BIS might be described as the central bankers’ gamekeeper. Borio stayed on there and now heads the BIS’s monetary and economic department. Philip Lowe on the other hand, having briefly served as gamekeeper, returned to being a poacher.
In fact Borio has remained a critic of central banking practices since the GFC, while his partner in scepticism back in 2002 went on to practise what he and Borio back then preached against.
In a new book, The Price of Time: The Real Story of Interest, British financial journalist Edward Chancellor writes this of Borio:
“A few months after the Lehman bankruptcy, Borio was warning about the dangers of keeping extreme monetary policies in place for too long.
“Over the following years, he stood apart from other monetary economists in alerting the world to the unintended consequences of zero interest rate policy and … other monetary innovations.”
‘Low rates beget lower rates’
Chancellor spends Part 2 of his book examining Borio’s thesis that “low rates beget lower rates”. We hope Philip Lowe and, more importantly, his successor, have read it.
Towards the end of his new book, A Brief History of Equality, Thomas Piketty writes that the only true limit to monetary policy is inflation.
‘‘… if inflation flares up,’’ he writes, ‘‘… then that means the limits of monetary creation have been reached and that it is time to rely on other tools to mobilise resources (starting with taxes).’’
Piketty also points out that the “monetary weapon” has been used frequently to save banks and bankers, but there is much more hesitation when it comes to saving the planet, reducing inequality and relieving the public authority of debt.
And here we are, with low rates having begotten lower rates, banks and bankers saved, the planet under threat, inequality much worse, debt out of control and inflation flaring up.
And once again central banks, including Lowe’s Reserve Bank, have kept extreme monetary policies in place for too long, against Borio’s advice. Now they are groping hurriedly for the neutral interest rate, at which the economy hums along, neither too fast nor too slow, but just right, while trying to persuade us, and themselves, that this time they’re going to hit it perfectly and then tighten the screws just enough.
Just wait: It’ll be a soft landing this time for sure.
In a recent speech Dr Lowe explained that the neutral rate is “at least positive in real terms”, that is higher than inflation, by which he did not mean 6.1 per cent, the current rate of inflation in Australia. He was talking about inflation expectations, which he put at about 2.5 per cent.
Ah-ha, cried the financial markets, starved for certainty: The neutral rate must be more than 2.5 per cent, so the RBA is taking the cash rate beyond that.
But a paper published last month, written by Graeme Wheeler, a former governor for the Reserve Bank of New Zealand and Bryce Wilkinson, a one-time New Zealand Treasury official, says the neutral interest rate, along with the other tools of central bankers, “are not observable. No one knows the true values”.
The flaw in economic modelling
In essence, the duo say that’s because there is always something different coming along to mess up their nice models.
Wheeler and Wilkinson go on to say “the economic and financial consequences of mismanaging monetary policy during the past two years and the corrective actions needed to address them will be felt in all economies around the world”.
Their paper’s introduction, written by Canadian economist William White, even asserts that “a central theme (of the paper) is of central bank hubris”, although Wheeler and Wilkinson don’t actually use that word.
White goes on to say that “the root of the central banking problem is what a philosopher would call an ontological error. Central bankers have fundamentally misread the nature of the system they are trying to control”.
Ontology is the study of existence and reality. The reality that White, Wheeler and Wilkinson accuse central banks of misreading is that “during the initial phase of the COVID pandemic, (they) failed to appreciate how much supply potential had been reduced by illness and lockdowns’’.
Blind to the obvious
“As a result, they failed to see how easily inflation might be triggered by still more monetary expansion, particularly as an adjunct to unprecedented fiscal expansion.”
It must have all seemed so simple back in 2002, when the 40-year-old Lowe sat down with Borio to write about imbalances and moral hazard in the wake of a bog standard bubble and bust.
Since then there have been two decidedly non-standard existential threats to the global financial system and economy, and now critics are lining up to accuse them of hubris, complacency and mistakes.
Jonathan Chancellor reports that Dr Lowe’s erstwhile collaborator, Claude Borio, was asked how central banks can get back on track.
“If I were you,” he replied, “I wouldn’t start from here.”
Alan Kohler writes twice a week for The New Daily. He is also editor in chief of Eureka Report and finance presenter on ABC news
