The malinvestment crisis

Rates should be raised, even at risk of recession

By Philip Cross

If it’s five years into the crisis, we must be in ­Austria.

William White was the head of research and then deputy governor at the Bank of Canada, before leading research departments at the Bank for International Settlements and the OECD. So he knows a little bit about macroeconomics. He solidified his stellar reputation by being one of the few economists to warn that the U.S. housing bubble would result in a financial crisis.

The essence of White’s latest paper, “Ultra-Easy Monetary Policy and the Law of Unintended Consequences,” published by the Federal Reserve Bank of Dallas, is that, contrary to the hand-wringing of some commentators, central banks are not out of bullets in the fight against persistent stagnation in much of the developed world. Instead, he says that central banks should call a ceasefire, not due to a lack of ammunition, but because the bombardment from easy-money policies is causing more “friendly fire” casualties to their own troops than it is inflicting on the enemy.

White weighs the desirable short-term effects of ultra-easy monetary policy against its undesirable long-term impacts, which after five years are becoming increasingly evident. The stimulative effect of easy monetary policy on demand growth in North America and Europe has been disappointing, while its impact on supply is slowly corroding potential long-term growth.

In his analysis, White tries to reconcile the competing analyses of John Maynard Keynes and the Austrian school of business-cycle thought, best known to most readers by its champion, Friedrich Hayek. White says the cuts to interest rates to stimulate demand were appropriate at the worst of the economic crisis in 2008-09. However, after five years of easy money, he now shares the Austrian concern that low interest rates are counterproductive for growth by distorting resource allocation (“malinvestments,” as Hayek somewhat inelegantly put it).

Despite White’s attempt, however, it seems to me that the views of Keynesians and Austrians are irreconcilable. True believers of the Austrian school predicted that expansionary monetary policies would be ineffective even in the short run because the fundamental problem was that labour and capital were deployed to produce the wrong goods, like housing in the U.S., not because of a shortfall of demand.

The undesirable effects of ultra-easy monetary policy are aptly summarized: “They create malinvestments in the real economy, threaten the health of financial institutions and the functioning of financial markets, constrain the ‘independent’ pursuit of price stability by central banks, encourage governments to refrain from confronting sovereign-debt problems in a timely way, and redistribute income and wages in a highly regressive fashion.” Not exactly the party line heard from the mouths of central bankers like Ben Bernanke and Mark Carney.

The distorting effects of persistently low interest rates can be seen in everyday life. They threaten the health of financial institutions by encouraging overinvestment in markets like housing in Canada, which could go sour, and causing the investment income of insurance companies to plummet. Low interest rates prevent the destruction of poor investments needed to free up resources. Programs like “cash for clunkers” and other subsidies to the auto industry “support existing production structures” instead of encouraging growth in innovative areas like smartphones or the oil sands. This is partly why you can read simultaneously about labour shortages in Western Canada and persistent joblessness in the industrial heartland of Central Canada.

Low interest rates encourage governments to go massively into debt, as we are seeing in the U.S. and Europe, which could prove problematic when interest rates return to normal levels. They penalize savers and investors in growth companies, while rewarding debtors and investors in staid dividend-paying companies, the very opposite of the incentives that economics says maximize long-term growth.

Most controversially, White poses the question of whether resisting every slowdown in growth increases the likelihood that an eventual downturn would be exceptionally severe. This follows a train of thought among some economists going back nearly a century that the business cycle is both inevitable and not inherently evil. It is more important to avoid extreme events like depressions than to undertake the impossible task of keeping the economy on an even keel at all times. This goes against the basic instincts of our society to try and eliminate every form of risk from our lives, which results in more extreme risk-taking. Is hockey a safer sport with all the new equipment players wear that encourages an attitude that they are invulnerable to injury? The results say no.

White’s conclusion is that monetary policy should be tightened, even at the risk of dampening growth in the short term. Policymakers, and ultimately society, should tolerate more slowdowns or even mild recessions, if that is needed to prick bubbles such as those in the U.S. stock and housing markets in the past decade. If you read only one paper on economics this year, this
should be it.