The uncomfortable permanence of these temporary measures

Das Capital: In may be that low interest rates and QE cannot be reversed easily, if at all

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Central banks have convinced themselves that low interest rates and quantitative easing (QE) policies are temporary. It is reminiscent of Ashly Lorenzana’s definition of addiction in her journal Sex, Drugs & Being an Escort: “When you can give up something any time, as long as it’s next Tuesday”. It isn’t necessarily so that these policies can be reversed easily, if at all.

Withdrawing fiscal stimulus would lead to sharp slowdowns in economic activity. Reduction in government services and higher taxes accelerate contraction in disposable incomes, especially in an environment of stagnant wages and uncertain employment. In turn, this leads to a sharp contraction in consumption. Slower growth, exacerbated by high fiscal multipliers, makes it difficult to correct budget deficits and control government debt levels.

As this debt grows, financing difficulties trigger a financial crisis or force reliance on the central bank monetising its debt.

Low interest rates and QE are also hard to change. Normalisation of rates and cuts in central bank purchases of government bonds risk reduced availability of funding and financial disruption. 

Low rates allow over-extended companies and nations to maintain or increase borrowings rather than reducing debt levels. Levels of debt encouraged by low rates become rapidly unsustainable at higher rates.

Central banks also cannot sell government bonds and other securities held on their balance sheet. The size of these holdings means disposals would lead to higher rates, resulting in large losses for the central bank as well as other banks and investors. The reduction in liquidity would exacerbate this by sharply tightening the supply of credit, destabilising a fragile financial system.

If sustained, a 1 per cent rise in rates would increase the debt servicing costs of the US government by around $170bn (£110bn). A rise of 1 per cent in G7 rates would increase the interest expense of the G7 countries by around $1.4trn.

Higher interest rates would also affect indebted consumers and corporations. In the US, a 1 per cent rise in interest rates, according to a McKinsey Global Institute study, would increase household debt payments from $822bn to $876bn, a rise of 7 per cent. In the UK, a 1 per cent rate change would increase household debt payments from £96bn to £113bn, a rise of 19 per cent.

The central question is for what period and to what extent current policies can be continued. The stock of private sector domestic savings limits the amount of government debt, ignoring foreign borrowing and debt monetisation by the central bank. If a nation has accumulated large foreign investments, then income and capital from these can finance the government for a time. Ultimately, reliance shifts to the ability of the central bank to monetise debt and finance the government –but there may be limits to this. 

The balance sheet expansion required by QE programmes exposes a central bank to the risk of losses on its holdings of securities from defaults or (more realistically) higher yields – ironically, if the economy recovers and rates rise. In theory, there is no limit to the size of the losses a central bank can incur. But there may be practical constraints.

The US Federal Reserve has $54bn in capital supporting assets of around $4trn. The European Central Bank has €10bn in capital supporting assets of €3trn. The Bank of England has £3.3bn in capital supporting assets of £397bn. In effect, a small change in asset values would significantly impair their capital bases.

Seigniorage revenues constitute another possible limit to debt. Seigniorage is the difference between the value of money and the cost of producing it – the difference between interest earned on securities acquired in exchange for money created by central banks, and the cost of producing and distributing that money. A central bank is considered solvent so long as the discounted value of seigniorage income is greater than its other liabilities in the long run.

The ultimate constraint remains preservation of the status of the currency as a medium of exchange or accepted store of value. Central banks would not risk a currency becoming unacceptable for normal commercial transactions, as with Zimbabwe and other similar cases.

While central banks have not reached the limits of their capacity to act, they retain scope for action. But existing policy does not address the real issues and may not be capable of restoring economic health. Addicted to monetary morphine, central banks believe there is no alternative.

Satyajit Das is a former banker and author of ‘Extreme Money’ and ‘Traders, Guns & Money’