The summer issue of The International Economy magazine contains a feature that deserves some attention, even from those who don’t fully understand all the intricacies of economics. It is a cover package called “The Great Bubble Debate,” and it explores the doctrinal conflict that has emerged between Federal Reserve chair Janet Yellen and the Bank for International Settlements, which is an organization of the world’s central banks that “fosters international monetary and financial cooperation” and provides banking services to central banks.
The settlement bank’s recently released annual report argues that the Fed’s current monetary stimulus policies, coupled by similar policies at other central banks, could create another major financial bubble that could prove disastrous when it bursts. The report states that persistently low interest rates, like those maintained by the Fed since the Great Recession, “can also have the perverse effect of incentivizing borrowers to take on even more debt, making an eventual rise in rates even more costly if debt continues to grow….[L]ow interest rates do not solve the problem of high debt.”
Yellen fired back with what Bernard Connolly of Connolly Insight called “a direct attack” on the BIS, referring to the settlements bank obliquely—and “somewhat dismissively,” in Connolly’s view—as “certain quarters.” Yellen argued that the extraordinary monetary measures taken by the major central banks since the 2008 financial crisis reflect necessary and prudent policy choices as the industrial nations struggle to shed the lingering effects of that crisis.
The magazine package consisted of Connolly’s article plus thumbnail analyses from twenty-three experts from around the world, and it reflected a powerful and intensifying intellectual clash. As the magazine puts it in introducing its package, “For the first time since the monetarist vs. Keynesian debate of the 1970s, the economic policy world is in stark intellectual disagreement.”
It isn’t the purpose of this report to sort out that stark intellectual disagreement, but rather to highlight it and signal its significance in the sometimes-shrouded policy world. Embedded in the debate may lie keys to understanding just how precarious the international economy really is.
As Connolly describes the BIS argument, it is essentially that the present extremely low interest rates pose two dangers. First, they serve to bring spending forward from the future “and thus create a potential future ‘hole’ in demand which will produce a need for even lower rates, and so on.” Second, they can undermine financial stability by encouraging savers, investors and financial intermediaries to engage in "reach for yield" behavior—taking on ever more risky investments. Connolly adds, “And although the BIS does not say so explicitly, its view implies that sub-‘normal’ rates must involve a Ponzi game and eventually lead to another financial crisis.”
Yellen countered that various factors—slower productivity growth, “headwinds from the financial crisis” and demographic trends—require what are in essence historically low “so-called equilibrium real interest rates.” Former Treasury secretary Larry Summers has bolstered her position by arguing that the global economy’s fundamental foundation may be so weak that financial bubbles are required on an ongoing basis to sustain global growth.
The thumbnail analyses from experts run the gamut from dismissing the BIS outlook outright to embracing it whole. John H. Makin, resident scholar at the American Enterprise Institute, sums up the disagreement neatly. The question in today’s “low volatility, yet largely trendless, global economy,” he says, is this: “Will we witness the bursting of the ‘mother-of-all-bubbles’ that creates global economic chaos,” as the BIS suggests? “Or…will the current Yellen Federal Reserve path of holding the federal funds rate at zero for a ‘considerable period’…enable the Fed to successfully exit its extraordinarily easy money policy?”
Makin expresses some sympathy with the BIS warning, but suggests a move to raise interest rates in the current climate—the proverbial “cold shower”—could simply be too risky, with today’s lingering low demand. Perhaps, he suggests, there is merit in “an overextended warm bath of monetary accommodation”—at least for now.
Sebastian Dullien, economic professor at HTW Berlin-University of Applied Sciences, goes further, suggesting “there is no real alternative to low interest rates now,” irrespective of whether we have moved into a new era of “lower equilibrium interest rates” or are in a prolonged cyclical slump.
Connolly suggests that both the BIS and the Fed are right and wrong, and therein lies a dilemma that may be unresolvable. He suggests that the BIS may underestimate the declines in output and employment that could attend efforts to avoid or minimize the risk of future bubbles by raising interest rates. But the Fed probably underestimates the risk of deferring an economic downturn by means that could merely increase its magnitude when it eventually occurs. He adds: “Tough: that is what a capitalist system is like once it has been badly distorted by monetary policy.”
That’s what the Fed did prior to the 2008 financial crisis with its loose policies that fostered the real-estate bubble. It’s impossible to predict whether the current Fed, under Yellen, will create another bubble of the kind that the BIS is warning about. But The International Economy is right to bring attention to this debate and its powerful implications. One thing that even an economist could predict is that this debate is going to grow over time and enter the consciousness of Americans who follow such things closely. Let the debate begin in earnest.
Robert W. Merry is political editor of The National Interest and the author of books on American history and foreign policy. His most recent book is Where They Stand: The American Presidents in the Eyes of Voters and Historians.
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