Is it even possible to have lower interest rates?

The Bank of England's chief economist has warned we may yet face another financial crisis

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The Independent Online

The tail wagged the dog. If you want a stark illustration of how power is shifting in the world economy, try this: had it not been for the slowdown in growth in China, the US Federal Reserve would almost certainly have increased interest rates last Thursday. “Heightened uncertainties abroad,” was the phrase used by Janet Yellen to describe what tipped the Fed to holding off – but the only uncertainties that matter to the world’s largest economy are those in the second-largest one. Could you imagine US policy being affected by uncertainties in Greece? Er, no. 

If the aim had been to calm financial markets, the Fed had the reverse effect, for investors concluded that if the Fed was really worried about China, then they should be too. Expect the next couple of months to be anxious ones. You can make a decent case for thinking that a slowdown in China is rather good news for the rest of us: we don’t export that much to them and slower growth would mean lower energy and commodity prices, and, crucially, less pressure on the environment. But that is not the way things looked at the end of last week.

So what lies ahead? I suppose the biggest question is whether the mental model of most of us is right: that there will still be a few more years of moderate economic expansion, even as monetary policy tightens and interest rates go up. There was a challenge to this rather comfortable mainstream view by Andy Haldane, chief economist for the Bank of England, in a speech in Portadown in Northern Ireland last Friday.

It was strong against-the-grain stuff. Try this: “Were the downside risks I have discussed to materialise, there could be a need to loosen rather than tighten the monetary reins as a next step to support UK growth and return inflation to target.”

Gosh. So maybe the next move in rates would be down rather than up, and since you really cannot have much lower interest rates, presumably this would also mean more quantitative easing. Haldane goes into the practical problems of loosening monetary policy that is ultra-loose already, but for most of us the meat in what he said is not so much what the Bank might do but rather why it might need to do it.

The idea he articulated was that we might be heading into a third downward leg in a trilogy of financial crises. The first he dubbed the Anglo-Saxon crisis of 2008-09, the second the Euro-Area crisis of 2011-12, and the third would be the Emerging Market crisis of 2015 onwards. The common elements would be the slug of liquidity surging round the different financial regions, first inflating and then deflating credit flows and asset prices. The order of magnitude, he argues, is roughly the same for each. While it is too soon to know how serious the contagion from this third leg might be for the world economy as a whole, the headwinds are unlikely to abate quickly.

This is a really interesting way of looking at what is happening now and it carries the seductive notion that bad news comes in threes. But is it right?

If he is and there is another downward leg to the recovery, we are all in big trouble. There is certainly some sort of pause happening and there may well be an emerging-market financial crisis, just as there was in 1997. But there seem to me to be two main ways in which this idea of there being a three-stage crisis is misleading.

The first is that the 2008-09 crisis was not an Anglo-Saxon one, but one in which Europe also was heavily involved. There was an asset bubble in much of Europe as well as in the UK and the US. European banks were complicit in that. As a result, the dip in output in most European countries was pretty much the same as in the US. It is true that there was a second leg to the downturn in Europe in 2011-12, but that was the result of the rigidities of the eurozone and a poor policy response to the problems of the fringe countries that had got themselves into a mess. In any case, that dip had only limited contagion: despite its close ties to Europe, the UK managed to avoid a double-dip recession. Looked at overall, the 2011-12 crisis was not nearly as bad as the 2008-09 one.

The second reason is that even if the emerging markets head into a big dip, while that will push down headline global growth, there will be a compensating boost to real growth in the developed world from lower-than-otherwise energy and commodity prices. We are starting to get the rise in living standards now that we should have got three or four years ago. Just as China and India managed to avoid much of the fallout from our problems in 2008-09, we will avoid most of the fall-out from whatever happens in China now.

If this is right, then interest rates in the US and here will surely go up – and soon. If not, well, near-zero rates are with us for a long while yet.

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