Is There Any Reason to Fear Low Interest Rates?
Paul Krugman tells us: Paul Krugman: @paulkrugman: "The American Economic Association has a new discussion forum set up by Olivier Blanchard. First up is the question of whether low interest rates are leading to excessive risk-taking https://www.aeaweb.org/forum/311/have-low-interest-rates-led-to-excessive-risk-taking..." So I mossed on over and left three comments: one on the forum, one on secular stagnation, and one on whether there is any reason to fear low interest rates:
Is There Any Reason to Fear Low Interest Rates?: Have low interest rates led to excessive risk taking?: I suspect that the right way to make the accurate point that this line of discussion is hunting for is to focus not on the amount of risk but on, rather, who is bearing the risk...
Think of it this way:
Let me first outline what is the wrong focus—on the quantity of risk being carried: In the financial market there is a demand for risk-bearing capacity by firms and others who want to borrow but who cannot guarantee that they will be able to repay. The higher is the price of risk—the greater the risk premium interest rate spread over short-term Treasuries they must pay--the less they will borrow. There is also a supply of risk-bearing capacity by savers and financial intermediaries who want to lend, and are willing to accept and bear some risk in return from getting more than the short-term Treasury rate. The higher is the price of risk—the greater the risk premium interest rate spread over short-term Treasuries they must pay--the more they will be willing to lend.
When the Federal Reserve undertakes quantitative easing, it enters the market and takes some risk off the table, buying up some of the risky assets issued by the U.S. government and its tame mortgage GSEs and selling safe assets in exchange. The demand curve for risk-bearing capacity seen by the private market thus shifts inward, to the left: a bunch of risky Treasuries and GSEs are no longer out there, as the government is no longer in the business of soaking-up as much of the private-sector's risk-bearing capacity. And this leftward shift in the net demand to the rest of the market for risk-bearing capacity causes the price of risk to fall, and the quantity of risk-bearing capacity supplied to fall as well. Yes, financial intermediaries that had held Treasuries and thus carried duration risk take some of the cash they received by selling their risky long-term Treasuries to the Fed and go out and buy other risky stuff. But the net effect of quantitative easing is to leave investors and financial intermediaries holding less risky portfolios because they are supplying less risk-bearing capacity.
How do we know that they are holding not more but less risky portfolios? We know because we know that supply curves slope up, and if they were holding more risky portfolios in total—supplying more risk-bearing capacity to the market—the price of risk would have not fallen but risen, and interest rate risk spreads would be not lower but higher, wouldn't they? At least, that is the case as long as the supply curve for risk-bearing capacity slopes up, like a good supply curve should.
Perhaps those who claim that there are big risks to quantitative easing regroup. Perhaps they claim that financial intermediaries are perverted, and that the lower is the price of risk the greater is the amount of risk-bearing capacity they supply to the market because they lose their jobs if they don't make at least three cents on every dollar of assets in a normal year in which risk chickens come home to roost. But in that counterfactual world, the Federal Reserve's adoption of quantitative easing policies triggered an enormous expansion of the quantity of risk-bearing capacity demanded by firms and households and a huge private-sector lending boom as firms issued enormous tranches of risky bonds and as firms and households took out risky loans. In that counterfactual world, employment in bond underwriting tripled as 85billionamonthinQEwasmore−than−offsetbyanextra 120 billion a month in private-sector bond issues. In that counterfactual world, we saw a rapid recovery of housing construction and a thorough equipment investment boom as far across the U.S. as they eye could see.
That didn't happen. So what are the risks of QE, really?
Let me now analyze what is the right focus::
Commercial banks traditionally accept deposits, put the deposits in long-term Treasuries or similar low-risk high duration assets, rely on the law of large numbers and on deposit insurance to allow them to always hold their long-term Treasuries or other low-risk high duration to maturity, and so have a profitable business model as long as they focus on what their core competence is: running a commercial banking business with branches, ATMs, and a well-collateralized loan portfolio.
When commercial banks cannot do this profitably, they need to find higher return assets to invest in. The problem is that they have no expertise in judging those higher return assets—hence they are highly likely to get adversely selected as they try to find them.
The result is that they are likely to lose money. And then somebody will have to eat the losses.
To the extent that organizations whose business models become unprofitable as a result of low rates and QE and so take on risks excessive for them because they have no expertise in judging such risks do so by investing government-insured deposits, this is not a source of systemic risk to the economy: it is only a source of financial risk to the Treasury.
To the extent that organizations whose business models become unprofitable as a result of low rates and QE and so take on risks excessive for them because they have no expertise in judging such risks do so by investing non-insured deposits, this could be a source of systemic risk to the economy depending on where the funds are coming from, and how highly leveraged the organizations that these funds are being drawn from are.
At least that is what I think a coherent and possibly accurate worry might be......
Secular Stagnation: What role, if any, does secular stagnation play in the flat growth of wages since the recovery?: I think Ed Lambert is correct. "Secular stagnation" is probably not the best label for the worry. The worry is that financial markets have gotten themselves wedged into a situation in which frequently and for sustained periods of time it is the case that the full-employment real safe short-term Wicksellian neutral rate of interest turns out to be less than the negative of the central bank's inflation target. In a flexible-price full-employment economy, the economy deals with this and maintains full employment by having the price level drop instantaneously and discretely whenever this occurs in order to generate the extra inflation needed to get the market rate at the zero lower bound to its value needed for full employment, the real safe short-term Wicksellian neutral rate of interest. This was one of the major (but I think often overlooked) points of Krugman (1998) https://www.brookings.edu/wp-content/uploads/1998/06/1998b_bpea_krugman_dominquez_rogoff.pdf
But in a sticky-price economy, things get messy when frequently and for sustained periods of time it is the case that the full-employment real safe short-term Wicksellian neutral rate of interest turns out to be less than the negative of the central bank's inflation target...
That worry is correlated with low expected productivity growth, which is correlated with low real wage growth. But they are not the same thing...
The Forum: Olivier Blanchard: Not a question, but welcome to the new forum. Let it be informative and civilized. Its success depends on all of us Andrew Stevens: "I just want to say thank you to AEA leadership for making EconSpark a reality. Between this, the AEA Professional Code of Conduct, and the #EJMinfo movement, I feel that our profession is taking tangible steps to cultivate a respectful, constructive, and transparent professional culture. Let's continue to build upon this momentum as an academic community."
J.BRADFORDDELONG: I second the motion...
#monetarypolicy #secularstagnation #publicsphere #weblogging #economicsgoneright #finance #monetaryeconomics
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