The Other Danger from Loose Monetary Policy; Artificially Low Interest Rates Could Trigger the Next Financial Bubble

Article excerpt


The chorus of optimistic forecasts is growing. The Federal Reserve's Beige Book reported moderate growth from November to the end of 2013, and that the economic outlook is positive in most districts. The World Bank predicted the developed world is on the brink of self-sustained recovery for the first time in five years, and expects the U.S economy to grow as much as 3.2 percent this year.

The corollary to improved economic conditions is that the monetary spigots that have been left open for so long to keep interest rates so close to zero, both in the United States and in the European Union, will likely be turned off. In fact, the Federal Reserve has already begun to talk of tapering its monthly purchases of financial assets from the current level of $85 billion.

However, the long-term effects of expansive monetary policy might not be easy to reverse painlessly. These effects are not limited to the obvious danger of inflation. Prolonged low interest rates can, under certain circumstances, encourage banks to undertake increasingly risky loans. New studies show that this risk is not merely theoretical, and that long periods of expansive monetary policy, which forces down interest rates, can lay the groundwork for the next financial crisis.

The Federal Reserve under Ben S. Bernanke's leadership has justified the successive rounds of quantitative easing on the grounds that low interest rates would encourage investment and jump-start the economy by reducing the cost of borrowing. That hoped-for scenario has failed to materialize in this recovery, the most lackluster since the end of World War II.

The policy is grounded in Mr. Bernanke's scholarship. Unfortunately, the perspective that has driven this policy choice is limited, and singularly fails to take into account the effect of persistently low interest rates on not only borrowing by potential investors, but on lending decisions of banks.

As interest rates fall with expansive monetary policy, they reduce the bank's rate of return on its loan, which increases the incentive to cut back on costly monitoring. Because they have limited liability, banks will tend to take excessive risk, which is then passed on to depositors (or the Federal Deposit Insurance Corporation, and through the FDIC to taxpayers) and bondholders in an environment where low interest rates prevail for a long time. …