yellen vs. the bis: whose thesis makes better sense?

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    A S Y M P O S I U M O F V I E W S

    For the first time since the mone-tarist vs.Keynesian debate of the1970s, the economic policy worldis in stark intellectual disagreement. Atissue is the role of monetary policy andfinancial bubbles. The most recentannual report of the Bank forInternational Settlements highlights thelimitations of monetary stimulus by theworlds major central banks and thedangers ahead from financial bubbles.States the BIS report: [L]ow interestrates can also have the perverse effectof incentivising borrowers to take oneven more debt, making an eventualrise in rates even more costly if debtcontinues to grow. [L]ow interestrates do not solve the problem of highdebt. Federal Reserve Chair JanetYellen has been quick to counterattack,

    arguing that the extraordinary monetarymeasures taken by the major centralbanks since the 2008 financial crisisreflect the prudent policy choice. StatesYellen: [W]hether its because ofslower productivity growth or head-winds from the financial crisis ordemographic trends so-called equi-librium real interest rates may be at alower level than weve seen histori-cally. Former Treasury SecretaryLarry Summers adds his thesis that theeconomys foundational underpinningsare so weak, financial bubbles may beperpetually necessary for the world toachieve sustainable growth.

    Which side offers the more crediblepolicy guide in coming years for theindustrialized world economies? TheBIS or the Yellen thesis?

    More than twenty noted observers weigh in.

    Yellen vs. the BIS: Whose Thesis

    Makes Better Sense?


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    The central banksobsession withshort-run stability is misplaced.

    HANS-WERNER SINNPresident, Ifo Institute for Economic Research, and Professor of Economics and Public Finance, University of Munich

    Our banks are no longer what they were a hundredyears ago, when they needed a third of their assetsas equity capital to convince creditors to lend themmoney. Under the increasing protection of informal bail-out guarantees by governments and formal deposit insur-ance schemes, they have become highly leveragedgambling machines with typically only 2 percent to 5 per-cent equity on their balance sheets, investing in overly riskyand correlated assets, distributing the profits to shareholderswhen they come, and relying on bail-outs when systemicrisks materialize. Given that policymakers do not dare riskthe collapse of the economy in such cases, they see no alter-native to opening taxpayers wallets.

    In the current financial crisis, even central bankshelped avoid the losses by providing ample liquidity andtaking fiscal risk-absorbing measures. The Fed tripled itsbalance sheet by printing money to buy huge volumes ofassets from private portfolios to sustain their market valuesand protect the banks and other financial institutions fromequity losses (quantitative easing). And the ECB allowedthe central banks of Europes six crisis countries (Greece,Ireland, Portugal, Spain, Italy, and Cyprus), which represent30 percent of the eurozones GDP, to print three-quartersof its entire money stock, lending it to local commercialbanks at below-market interest rates against bad collateral,often even no-investment grade. These policies allowedthe banks to gain fat and rescued many zombie banks.However, while aiming at short-run stability, both the ECBand the Fed became part of the commercial banks long-run gambling strategy. They turned into powerful bail-outinstitutions, more powerful than all the direct fiscal bail-out and rescue funds taken together. The central bank bail-outs rescued the banks, but encouraged them to again investthe funds savers entrusted to them in dubious uses that oth-erwise would not be profitable.

    Some say this is no problem, as central banks canabsorb risks without burdening taxpayers. But this is not

    true, as taxpayers will either have to compensate for themissing profit distributions of the central banks to therespective governments or will have to bear the cost of out-right fiscal transfers to borrowers (such as some local gov-ernments in Europe) to prevent the losses frommaterializing on the central banks balance sheets. Seenthis way, the central banks free-of-charge lender-of-last-resort insurance is a hidden subsidy for risky and unprof-itable investments with taxpayer money, which results inthe usual welfare and growth losses for the economy.

    There clearly is a trade-off in central bank policiesbetween short-run stability and long-run efficiency of thecapital market in terms of allocating savings efficientlyto rival uses, and it is hard to judge whether central bankshave found the right balance between alternative goals.My impression is that they have been leaning too muchtowards the short-run stability goal, because their mind-sets were captured by the interests of the financial indus-try, and because reckless public borrowers were oftenover- represented in their decision-making bodies. Thisbias has minimized the probability of a short-term finan-cial crash, but it will also lead to long-run stagnation ofthe Japanese type, impose substantial risk on public bud-gets, undermine the stability of society, and reduce theWestern worlds dynamism. A policy of harder budgetconstraints placing more weight on long-run incentivesmight serve society better.

    Forget the BISadvice. Yellen makesmore sense.

    SEBASTIAN DULLIENProfessor for International Economics, HTW Berlin-University of Applied Sciences, and Senior Policy Fellow,European Council on Foreign Relations

    At the moment, central banks should continue to run avery lax monetary policy until the major developedeconomies have reached a self- sustained point in theeconomic recovery. The notion that central banks shouldkeep their interest rates at an elevated level because excessliquidity could cause new speculative bubbles and endangerfinancial stability is misguided on at least three counts.


    First, empirically, the link between low interest ratesand financial market bubbles is highly shaky. If we lookat the large bubbles of the twentieth century, at least twomajor ones cannot be associated with particularly low inter-est rates. The stock market bubble in the late 1920s devel-oped at a time of moderate real interest rates. While theFed lowered its discount rate to 3.5 percent for a while in1927, this was not very low in real terms as prices wereactually falling. Moreover, the Fed reversed course prettyquickly at that time, so interest rates did not remain thatlow for long. Also, the stock market bubble of the 1980sdeveloped against the background of rather high interestratesthe federal funds target rate was between 6 percentand 8 percent when stock market prices took off in the sec-ond half of the 1980s. There is no convincing evidence thatlow interest rates in an environment of sluggish growthactually produce bubbles.

    Second, there is no real alternative to low interest ratesnow. No matter whether we have moved towards a funda-mentally lower equilibrium interest rate or whether we arein a prolonged cyclical weakness, low interest rates arewarranted. If we are faced with lower equilibrium interestrates, then keeping central bank rates excessively high willultimately push the economy into deflation. If equilibriuminterest rates have not changed, but we are only in anextended cyclical trough, then keeping interest rates highwould prevent a swift recovery.

    Third, what really endangers debt sustainability andfinancial stability is deflation, not low interest rates. If theopponents of lax monetary policy fear that low interestrates lead to higher debt levels, they should remember thatdebt sustainability is about the relationship between nom-inal debt and nominal income. Deflation is a process whichmost certainly brings up the debt-to-income ratio as debtsare fixed in nominal terms while nominal incomes contractin a deflation. If one compares the United States and theeuro area in the years just after the global economic andfinancial crisis after 2008, one can see that the U.S. econ-omy deleveraged much more quickly than the euro areabecause the U.S. Federal Reserve was running a moreexpansionary monetary policy than the European CentralBank.

    Thus, acting on Yellens hypothesis clearly makesmore sense than following the BIS advice.

    Policymakersshould avoid thetrap of a monetaryillusion.

    JACQUES ATTALIPresident, PlaNet Finance, and former President, European Bank for Reconstruction and Development

    In 2001, in the aftermath of the dot-com bubble bursting,the U.S. Federal Reserve decided to lower its rates inorder to spur economic activity and employment. Globalgrowth then resumed, fueled by the rising indebtedness ofall actors. On the U.S. real estate market, a housing bubbleand a credit bubble built up.

    In 2008, the bursting of these bubbles triggered a newglobal crisis. To address its consequences, the central banksof advanced economies have resorted to a set of conven-tional and unconventional monetary decisions which havebrought their policy rates close to the zero bound, and theirbalance sheets to an aggregate $10 trillion.

    Today, all of them are, to some extent, facing the sameconundrum: engaging in policy normalization too earlymight stifle a fragile recovery, while maintaining an accom-modative stance for too long may favor the build-up offinancial imbalances in the long run, which has happenedoften enough in the past, according to the BIS.

    Hence the debates on the necessity and desirable pace