Raising interest rates is always harder than cutting them. When investors are bleeding and workers fear the chop, promises of cheap money sound like the hoofbeats of arriving cavalry. But the trauma does not end for everyone at the same time. When the rescuers depart, some complain they are being abandoned too soon.
Pity the US Federal Reserve, then, which is widely expected to start increasing rates by the end of the year – or had been expected to, until a fierce bout of selling began in emerging markets and spread to stock exchanges around the world. There will be calls for central banks in the US and elsewhere to delay long-flagged increases in interest rates. Yet they must not blink.
The case for waiting does not rest on market movements alone. Since there is no sign of inflation, it is argued, there is no need to raise rates. And since the recovery has always seemed fragile, there is no sense in raising them. The case for caution was being made when markets were rising. Its appeal will only grow now that markets are faltering.
Yet monetary policy cannot confine itself to reacting to the latest inflation data if it is to promote the wider goals of financial stability and sustainable economic growth. An over-reliance on accommodative monetary policy may be one of the reasons why the world has not escaped from the clutches of a financial crisis that began more than eight years ago.
Origins of panic
The origins of today’s market panic are in recent policy choices. One of the factors behind the stock market slide is the stalling of growth in
China
. Official data, which paint a reassuring picture of steady growth, are considered unreliable. Look at trends in individual industries, however, and the position is more troubling.
Chinese purchases of smartphones shrank for the first time in the second quarter of this year, according to data from Gartner. The sales projections of many western technology companies have followed suit.
The slowdown in the Chinese economy has its roots in decisions made far from Beijing. In the past five years, central banks in all the big advanced economies have embarked on huge quantitative easing programmes, buying financial assets with newly created cash. Because of the effect they have on exchange rates, these policies have a beggar-thy-neighbour quality. Growth has been shuffled from place to place – first the US, then Europe and Japan – with one country's gains coming at the expense of another.
This zero-sum game cannot launch a lasting global recovery. China is the latest loser. Last week’s devaluation of the yuan brought into focus the fact that, since 2010, China’s export-driven economy has laboured under a 25 per cent appreciation of its real effective exchange rate.
Exchange rates aside, long periods of accommodative monetary policy have led to a misallocation of resources. The extent of this will be impossible to measure for many years but, in the places where credit growth has been most dramatic, there are strong hints.
Accommodative monetary policy was supposed to spur investment in productive activities at home. Instead, companies and banks hoarded cash.
Loans to emerging markets
Much of the extra credit instead financed housing purchases at home, or was funnelled into loans for companies and governments in emerging markets. According to the
World Bank
, corporates and sovereigns in emerging economies collectively sold $1.5 trillion in new bonds in the five years to 2014, almost three times the rate between 2002 and 2007. Although today’s attention is on the weakness of stock markets in the US, Europe and Japan, turmoil in the distant debt markets where investors from developed countries have placed their cash will be of more lasting concern.
There are two silver linings to the dark clouds. First, because of the concentrated flow of international credit flows, today’s crisis may come to resemble the Asian financial crisis of 1997. It was brutal but regionally contained in comparison with the global and systemic crisis that began in 2007. Second, despite many protests, emerging markets long ago decided that the international financial system was inherently unstable and built up reserves to help them weather the storm.
Dysfunctional financial system
Still, that fragile and dysfunctional financial system is a serious problem. It will remain so as long as the institutions that are supposed to manage international spillover effects from monetary policy lack legitimacy, credibility and capital. And if the advanced economies continue to rely on near-zero interest rates to fuel growth, they will only make that predicament worse. Copyright The Financial Times Limited 2015
Avinash Persaud is a fellow of Peterson Institute for International Economics and author of Reinventing Financial Regulation
