Abstract
The impact of global banking on financial stability and the connected post-crisis challenges have been under-researched before the crisis. We interpret ‘global banking’ as ‘global central banking’, focus on the role of international monetary policies and global liquidity for financial stability and identify imponderables emerging in this context. Central banks continue to stress that they will keep interest rates low for a prolonged period, in spite of negative side effects such as deferred bank balance sheet repair. We show that it is crucial to cope with these challenges to return to and ensure global financial stability in the future.
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Notes
In addition, some important business climate indicators such as those produced by the European research institutes Ifo, INSEE und ISTAT are turning upwards and monetary conditions in the euro area are currently very accommodative.
However, since the end of summer 2013 there seems to have been some reversal, as interest rates on Government debt, for example in Germany and the UK, have started increasing again (Braunberger, 2013).
Also more generally, market- and survey-based indicators of long-term inflation expectations have remained rather stable and are approaching central banks’ inflation goals. See BIS (2012, Graph IV.10).
At this juncture it should be noted that it is hard to imagine that an economy’s real interest rate should ever reach zero in equilibrium. As long as human desires are not fully satisfied, there is always something to gain from investing a part of current income, thereby increasing future income. As a consequence, there should always be a positive real interest rate in the medium-to-long run, and this is what we should basically define as a ‘low interest rate environment’.
Nevertheless, Japan still faces problems of low inflation rates. The reason why such a massive deflationary scenario could emerge in Japan is frequently attributed to policy mistakes such as the lack of an exit strategy that specifies when and how to get back to normal (Svensson, 2003). Furthermore, negative nominal rates might cause ‘unintended consequences’. For example, the Danish experience of negative nominal rates was that banks increased lending rates to compensate for these negative rates (Danske Bank, 2013).
See also Mayer (2014) who points out some lack of theoretical and empirical support of the Summers thesis and offers as an alternative explanation the fall-out from the recent credit boom-bust cycle.
Here, we refer to the situation before the Fed announced its tapering, and to a scenario in which this announcement is not anticipated as credible and sustainable by the markets. For different scenarios see the section ‘Additional risks when conducting the exit’. For the relationship between monetary and financial market liquidity, see ECB (2012, p. 57).
The ‘beggar thy neighbor’ policy must not necessarily become public immediately. For example, the US sold its QE as a policy, in essence aiming to lower interest rates within the US economy and thus foster spending and investment – to stimulate ‘aggregate demand’, not least with benefits arguably accruing to the rest of the world.
However, in the following paragraphs we show in different ways (eg, alluding to the term structure of interest rates) that the argument for credit misallocation is significant here, although banks borrow short.
As sovereign bonds are classified as risk-free, banks do not have to hold equity capital for these assets. However, if doubts about the sustainability of public finances emerge, as was the case in several countries of the EMU, the liquidity of the banking system is threatened. These (large) banks may then have to be bailed out by governments, which in turn aggravates government debt levels. In consequence, issuing new sovereign bonds becomes more costly and banks can no longer purchase them. Accordingly, there is a need to break this vicious circle of banks and sovereigns destabilizing each other and to disentangle the fate of the banks and that of government debt.
See, for instance, IMF (2013a, pp. 109ff.), based on bank-level data for the US. The required data are available for relatively few banks in the euro area, Japan and the United Kingdom, which renders a conclusive analysis more difficult. Earlier studies have delivered evidence for delays in balance sheet repair in Japan since the 1990s. See Peek and Rosengren (2003) and Caballero et al. (2008). We discuss these studies briefly in the following. Bundesbank (2014) refers to the Greek case. And ECB (2013b) mentions an ‘unfinished balance sheet repair’ in the UK (p. 20) and an ‘ongoing process of balance sheet repair’ in the euro area (p. 26).
Note in this context that the more recent flattening of the yield curve in the US and in the UK has been accompanied by a drop in the commercial banks’ net interest margin (BIS, 2012, Table VI.1).
The term ‘fiscal dominance’ refers to a regime where monetary policy ensures the solvency of the government. Hence, the traditional tasks are reversed: monetary policy stabilizes real government debt while inflation is driven by fiscal policy needs. In the conventional view, fiscal dominance entails the famous ‘unpleasant monetarist arithmetic’. In the words of Sargent and Wallace: ‘…the monetary authority … must try to finance with seigniorage any discrepancy between the revenue demanded by the fiscal authority and the amounts of bonds that can be sold to the public’ (Sargent and Wallace, 1981).
Under a ‘financial repression’ regime, governments aim at reducing the burden of their public debt by repressive measures aimed at financial markets, steadily high inflation rates and low nominal interest rates. In the past, such policies were widespread in many countries and have also been seen as a viable option of public debt reduction due to the high levels of debt accumulated during the European debt crisis. Although financial repression can result in a significant reduction of debt levels, it can have severe negative effects on private savers and investors for whom yields become low or negative and who, due to legal enforcement, do not have any options of evading financial repression.
See, for details, Belke (2013a, 2013b). In general, the debate about when to exit should not be about a precise date but about the macroeconomic conditions which have to prevail to be able to begin a removal of unconventional policy measures. These circumstances include an economic recovery and picking up bank lending. However, particularly data concerning economic activity becomes available only with a time lag. Thus, it seems obvious that there will be a vivid discussion about the right time to phase out the expansionary policy tools.
The Fed has reduced its $85 billion-a-month bond purchase program by the small amount of $10 billion since the start-of-year 2014, which implies lower growth of the Fed’s balance sheet.
This pattern is employed by the IMF only as a ‘scenario’ and may not necessarily correspond with actual GDP growth.
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Acknowledgements
This paper is based on an internal briefing paper prepared by the author for presentation at the Committee on Economic and Monetary Affairs of the European Parliament for the quarterly dialogue with the President of the European Central Bank, February 2013, in Brussels. The authors are grateful for valuable comments received from Paul Wachtel and other participants at the 2012 Symposium ‘Global Banking, Financial Stability, and Post-Crisis Policy Challenges’ in Maastricht, NL.
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Belke, A., Verheyen, F. The Low-Interest-Rate Environment, Global Liquidity Spillovers and Challenges for Monetary Policy Ahead. Comp Econ Stud 56, 313–334 (2014). https://doi.org/10.1057/ces.2014.14
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DOI: https://doi.org/10.1057/ces.2014.14
Keywords
- global liquidity
- central banks and their policies
- financial repression
- financial stability
- low interest rates