Academic journal article The Cato Journal

Adverse Effects of Unconventional Monetary Policy

Academic journal article The Cato Journal

Adverse Effects of Unconventional Monetary Policy

Article excerpt

Following the recent waves of financial crises in the advanced economies and a prolonged period of low interest rates, major parts of the world economy are experiencing low growth, a rise in financial volatility, and low rates of inflation. Specifically, in Japan and in large parts of die eurozone the crises persist. In large parts of the world, unconventional monetary policies--that is, ultra-low interest rates and large-scale asset purchases, also known as "quantitative easing" (QE)--are seen as important determinants of employment and growth. The announced exit from unconvendonal monetary policy in the United States, where growth appears more robust, has clouded the growth perspectives of many emerging market countries. The Chinese growth engine, which was a main driver of world growth during the 2000s, has begun to stutter--and emerging market corporate bond markets have come under pressure.

Macroeconomists have identified several reasons for the recent wave of financial crises in the advanced economies. One strand of literature explains financial crises as result of a random or exogenous shock, amplified by the irrationality of human action (Keynes 1936, De Grauwe 2011), asymmetric information and financial constraints (Bernanke, Gertler, and Gilchrest 1996). Another strand of literature suggests that a savings glut--caused by a higher saving propensity of the aging populations in Germany, China, and Japan--has contributed to a fall in (natural) interest rates in advanced economies (Bernanke 2005, Summers 2014, von Weizsacker 2014).

On the contrary, assessments (implicitly) based on the Taylor rule suggest that overly expansionary monetary policies during the 2000s sowed the seeds for financial exuberance and therefore the current crisis (Taylor 2007; Jorda, Schularick, and Taylor 2015). Adrian and Shin (2008), Brunnermeier and Schnabel (2014), as well as Hoffmann and Schnabl (2008, 2011, 2014), have shown that overly expansionary monetary policy can contribute to financial market bubbles that lead to crisis. Selgin (2014), Selgin, Lastrapes, and White (2012), as well as Howden and Salerno (2014), see public central banks at the root of macroeconomic instability.

Depending on the view of the very roots of the crisis, policy recommendations point in different directions. One side emphasizes the need for unconventional monetary policy to stabilize the financial system--for example, by easing collateral constraints to maintain growth and employment (Draghi 2014, Bernanke 2014). In contrast, the other side sees ultra-low interest rate policy and QE as major sources of distortions and bubbles. These critics demand a timely exit from unconventional monetary policy to prevent further distortions caused by boom and bust in the financial markets.

This article contributes to the second strand of literature. We discuss the developments during the last three decades against the backdrop of the monetary overinvestment theories of Wicksell (1898), Mises (1912), and Hayek (1929, 1937). In particular, we elaborate on channels through which ultra-low interest rate policies can contribute to a decline in investments and growth in the world economy.

Monetary Overinvestment Theories and Boom-and-Bust in Financial Markets

In order to model boom-and-bust cycles based on the overinvestment theories of Wicksell, Mises, and Hayek we distinguish between four types of interest rates. First, the internal interest rate it reflects the (expected) returns of (planned) investment projects. Second, Wicksell's natural interest rate in is the interest rate that balances the supply (saving) and demand (investment) of capital.1 Third, the central bank's policy interest rate [i.sub.cb] shall represent the interest rate that commercial banks are charged by the central bank for refinancing operations. Fourth, we define the capital market interest rate [i.sub.c] as the interest rate set by die private banking (financial) sector for credit provided to private enterprises. …

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