The bubble argument should certainly be taken seriously. After all, the response to the collapse in equity prices at the beginning of the decade was a series of interest rate cuts on either side of the Atlantic which certainly contributed to the emergence of the subsequent housing bubble. At the time, the Americans were terrified that their economy could "do a Japan". Their fear of deflation seemed to justify the strong monetary medicine which was subsequently handed out.
There is, though, an interesting lesson to be drawn from that episode. The interest rate cuts didn't reignite an equity bubble – in fact, equity valuations have persistently fallen over recent years – but, instead, contributed to rapidly rising prices, and associated increases in indebtedness, in an entirely different asset class. Companies, which had been borrowing heavily in the late 1990s, were only really interested in paying down debt. It was households who succumbed to the interest rate bait and creditors who, in a mad hunt for yield, happily purchased all sorts of new-fangled housing-related assets with no real regard for the associated risk. As they did so, housing markets boomed.
If interest rate cuts threaten the formation of yet another bubble, where might we spot it? Who, in current circumstances, is likely to be both willing and able to borrow or to invest? Companies certainly won't be keen. After all, on either side of the Atlantic, the chill winds of recession are all too obvious, reflected in persistent stock market declines. Households, faced with falling house prices and bank managers who no longer smile, aren't likely candidates.
One bubble possibility is to be found in the emerging markets. Commodity-producing nations, notably the Middle Eastern oil producers, have benefited from huge increases in income which have left them with balance of payments current account surpluses. Those surpluses need to be invested somewhere and, while Manchester City may be attractive, there simply aren't enough football clubs to go round.
Where else might these rich nations invest? A re-run of the 1970s would suggest investment in other emerging markets. Back then, oil surpluses found their way ultimately into Latin America. Could the same happen again? Despite their recent woes, might emerging market assets reignite? And, if recipient countries were then to boom, would that produce a huge impetus for US, UK and eurozone exports?
While the mechanism might exist, it is difficult to imagine that a rise in exports to booming emerging markets alone would allow the developed world to break free of its economic shackles. Rapid growth in the US and the UK, after all, has ultimately depended on home-grown debt and not on irresponsible behaviour elsewhere in the world.
At this stage, the only credible candidate for heading off on the road to excess leverage is government. The credit crunch has closed off the borrowing option for the majority of would-be debtors in the private sector. Cautious investors these days are increasingly prepared to lend only to the public sector, which is why government bond yields are so ludicrously low. Governments, after all, have one big advantage over the private sector during recessionary downswings. They are seen to be creditworthy. Only they have the coercive power of taxation.
Governments, though, are reluctant borrowers these days. Ageing populations suggest fiscal profligacy is a thing of the past. Although budget deficits will inevitably rise in the months ahead, I don't think these increases mark a return to the big borrowing and big interest rates of the 1970s and 1980s. Think, instead, of Japan's experience in the 1990s, when big budget deficits were accompanied by very low interest rates, persistently declining land prices and very little in the way of economic growth.
Japan's experience suggests that, sometimes, interest rate cuts simply don't work. It is not difficult to see why. When a bubble bursts, asset prices, by definition, collapse. Even if interest rates do fall to 0 per cent, there is not much point borrowing if you and everybody else think asset prices are more likely to fall than rise. Why buy a house, for example, if you think house prices are persistently falling (one reason why last week's stamp duty announcements from the UK Government were met with such derision)?
Where, I suspect, the interest rate sceptics are right is in the idea that we have lived beyond our means for far too long. But does this mean that interest rate cuts now are inappropriate? In one sense, yes, because interest rate cuts create the illusion that, despite our collective profligacy, we can all be bailed out by the central bank. But, in a more worrying sense, no, because much depends on the likely impact of lower interest rates. Monetary policy works a bit like the lights in your kitchen. Flick the switch and, in normal circumstances, everything is illuminated. What happens, though, if a number of light bulbs have gone? Then, flicking a switch doesn't have quite the same effect.
The issue, then, is not so much whether interest rates should come down but, rather, whether reductions will be both effective (by boosting demand) and safe (by avoiding inflationary risks). Japan's experience in the early 1990s suggests that, in the aftermath of a bubble, only the second of the conditions is likely to be met. From an inflationary point of view, rate cuts may be safe – because banks are simply unable to lend – but, from a demand perspective, rate cuts may be ineffective – again, because banks are unable to lend.
At the time, it wasn't clear what Japan's policymakers should do. People forget that in the early 1990s inflation in Japan was, by the country's own exacting standards, relatively high. The Bank of Japan initially held off from cutting interest rates, not so much because it wanted to punish greedy investors but rather because inflation was seen to be the main problem.
In hindsight, the Bank of Japan's reluctance to cut interest rates looks to have been a mistake. The Federal Reserve certainly thinks so. In a paper published in 2002 (Preventing Deflation: Lessons From Japan's Experience in the 1990s), the Fed argued that Japan's failure to spot the threat of deflation left interest rates too high for too long, thereby ultimately adding to deflationary pressures.
I'm not so sure. I find it difficult to believe that an absence of decent economic growth over many years simply reflected the Bank of Japan's failure to shove interest rates down another couple of notches.
Nevertheless, the Bank of Japan's experience shows that one of the biggest economic threats is our lack of knowledge about the future. Central bankers simply can't be sure as to what will happen to economies in a year or two years' time – which is why the Bank of England, for example, presents its projections in the form of fan charts. Interest rate cuts may seem like too easy an answer and, at a time of elevated inflation, perhaps they'd provide the wrong signal. Nevertheless, rate cuts should not simply be seen as the fastest way of igniting yet another bubble. In current crunchy circumstances, rate cuts will, at most, only reduce the pain. They certainly won't give any pleasure.
Stephen King is managing director of economics at HSBC
stephen.king@hsbcib.com
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