Australian economyConflict of interest: have low cash rates created the ‘everything bubble’? | Australian economy

Twenty years ago, an Australian young economist was destined to be a household name. He issued a warning to all central banks.

“[L]owering rates or providing ample liquidity when problems materialise but not raising rates as imbalances build up, can be rather insidious in the longer run,” he said.

“They promote a form of moral hazard that can sow the seeds of instability and of costly fluctuations in the real economy.”

Philip Lowe (the future Reserve Bank governor) stated so in a paper he coauthored while on secondment in Switzerland at the Bank for International Settlements with Claudio Borio.

The two presented their report to a March 2002 conference hosted by BIS – dubbed “the bank for central banks” – on how risks could grow even over times of apparent calm.

Financial imbalances (e.g. asset bubbles) that may arise during periods of low inflation are a particular concern. In some circumstances, it would be appropriate for banks to take pre-emptive action “to preserve both financial and monetary stability”.

How central banks should act – and what they actually do – is at the heart of a fascinating if somewhat alarming new book by UK-based economic commentator Edward Chancellor.

The Price of Time explores both the history of interest rates and their role in society. Central banks, much like the nursery rhyme about “an old lady who swallowed a fly”, seem inured to solve each bout of market turmoil in a way that begets bigger instability in the future.

The warning by Borio and Lowe that authorities should be alert to the dangers of speculation – and the moral hazards that result when bad decision-makers get used to being rescued – is a constant theme running through the book.

This work is also timely as an independent panel is currently in the middle of a review on the RBA and its operations. It is expected to be completed in March.

That interest rates might be climbing in Australia, the US, New Zealand and elsewhere doesn’t diminish Chancellor’s case. While nominal rates might be lower than the Covid crisis’s record lows, they still fall well below inflation and are therefore negative in real terms.

A favorite quote of the author is by Jeremy Stein (an economist from Harvard University who served one-term on the board for governors of the US central banking, the Federal Reserve).

Firm regulation of markets was all very well but monetary policy “gets into all the cracks”, Stein said. As investors seek to make a profit on their investments, excessively low interest rates create asset bubbles.

“All these extraordinary low interest rates [have] got into everything,” Chancellor told Guardian Australia. “And if we say we have the everything bubble, it sort of follows then that you’re going to have the everything bust.”

It’s perhaps surprising the purpose and perils of interest rates continue to confound experts and public alike. We all intuitively know that someone lending money or assets to another person deserves a reward.

Ancient Mesopotamians “charged interest on loans before they discovered how to put wheels on carts”, Chancellor writes. Clay tablets dating back more than 4,000 years reveal borrowers offered up collateral – from homes, land and slaves to even the wife of an ancient borrower – as surety for repayment.

While the history of interest down the millennia is fascinating, the book’s main point is to highlight the snowballing challenges of the past quarter century.

Long-Term Capital Management was a huge US hedge fund with exposures estimated at $US1tn ($A1.5tn). It collapsed in September 1998. In an attempt to prevent market contagion the Fed reduced its interest rate. This became a model for other central banks’ responses to stressors such as the global financial crisis, and the Covid pandemic supply shocks.

“The total calculated cost of each crisis is greater than the previous ones,” Chancellor says. And “the geographical reach of them is more extensive”.

China is what prompted the author, however, to look at the origins of market distortions, and the role that interest rates play in this.

China is the country that has led the greatest expansion of lending ever, despite keeping interest rates artificially low over the past decades and especially after the GFC in 2008. According to Chancellor, China alone has accounted for half of all global investment since then.

As the Guardian has noted recently, the value of property in China is now double that of the US and triple Europe’s. That’s despite China having annual economic output of only about three-quarters as large as those two regions.

New apartment blocks have sprouted up in dense forests, whereas high-speed railways and tunnels to remote locations are becoming more expensive.

“Because interest rates neither reflect the return on capital nor credit risk, China’s economy has suffered from the twin evils of capital misallocation and excessive debt,” Chancellor wrote.

Because of China’s increasing economic role and tight control over banks, people may have forgotten about the dangers in China. Or, “simply because China was able to sail through the last crisis without too much apparent damage”.

Chancellor is not in the practice of making predictions but China, he says, has set itself on “a highly unsustainable path”. The challenges facing Xi Jinping the Chinese president as he tries to revive confidence and navigate the economy with rolling Covid lockdowns are daunting.

And as for that Borio-Lowe paper, Chancellor says they were on the money: “If you looked at real estate booms and credit booms, and put them together, you get what [they call] high-cost recessions.”

“It’d be interesting to confront [Lowe] with this research that he wrote,” he says, noting that the RBA under Lowe had likely acted in a way “contradictory” to his research with Borio on the dangers of allowing asset bubbles to inflate.

As to where Lowe now stands on the issue of overly low interest rates – the cash rate sat at a record low of 0.1% for 18 months until May 2022 – a spokesperson provided a short answer: “We are unable to help on this one.”