Are low interest rates storing up more trouble for the future? This column argues that low interest rates have been necessary to sustain large current-account imbalances. With global imbalances unlikely to be redressed any time soon, low interest rates may be the best option for a while longer – but this policy is not without its risks.
In its annual report, the Bank for International Settlements (BIS) rightly insisted on the dangers arising from central banks’ rates being kept “low for long” (BIS Annual Report 2009/10). The study reminded us that such policies distorted the perception of risk while they encouraged a search for yield that laid the ground for the financial crisis.
The question asked by the BIS last June was “Do the risks of a repeat of such policies outweigh the rewards?” The report seemed to hint they do. Since it was written, the incoming information on the current state of the developed economies and their fiscal tightening plans have led markets to adjust their expectations of the (already distant) date at which monetary tightening will start even farther into the future.
Should this necessarily be as worrying as the BIS warnings seem to imply? To answer this, we need to understand the full role that low rates are playing in the working of today’s globalised financial system. More than ever, this role goes well beyond the mere stimulation of credit demand.
Low rates are not only influencing the flow of new lending but also helping the system carry the risks attendant to the stock of loans already made. Precisely because they encourage risk-taking, low rates are the cornerstone supporting the global financial system’s new and fragile equilibrium after its appetite for risk was dramatically diminished by the “subprime shock”.
Low rates have managed to induce private agents to finally accept taking on the outstanding risks that they had previously been trying to shed since the start of the subprime crisis in 2007 as the attitude to risk suddenly stopped being one of complacency. This is not a meagre achievement since the stock of risks to be taken on was – and still is – massive. Until mid-2007, the ever-increasing demand for risk of the years preceding the financial collapse had been met by a correspondingly increasing supply. But when the demand for risk vanished, the accumulated supply remained and finding somebody to carry it became a serious problem.
The fact that the demand for risk was, for many years, artificially inflated by perverse microeconomic behaviour did not prevent it from being answered by a supply that was real indeed – consisting mainly of mortgage loans granted to US households – and of macroeconomic origin (associated directly with the growing global imbalances of the last decade).
Recalling the current-account imbalances
To understand the key role low interest rates are now playing in the newly found equilibrium of the financial system, in recent research (Brender and Pisani 2010) we focus on the current-account imbalances and the risk-taking patterns underlying them.
The excess savings generated in the surplus countries were lent to deficit countries’ borrowers. But this transfer of savings was far from being direct – after all, Chinese households did not lend to American households! It was intermediated by the global financial system.
