Home > Uncategorized > Borio and Disyatat: beware, money matters (and not just because of debts)

Borio and Disyatat: beware, money matters (and not just because of debts)

Claudio Borio and Piti Disyatat are concerned about low interest rates. Hmmm… At this moment, the Euro Area is deleveraging – despite ultra low interest rates, the German economy is doing only moderately well, at best, despite ultra low-interest rates, while the level of unemployment in countries like Greece and Spain is almost 20%-point above the level where any meaningful ‘Phillips curve’ (i.e. a relation between unemployment and nominal wages) still exists – despite ultra low interest rates (well, not for Greek and Spanish companies, of course). And at the moment house prices are, on average, slowly declining, while before 2009 dislocating house price inflation was arguable not so much caused by lower interest rates but by lending deregulation.

Still, their warnings should be taken serious – as there is no such thing as a natural rate of interest. As an example of ‘malinvestments’ during the boom phase associated with a subsequently unsustainable debt overhang as well as idle capital, a graph of house completions in Ireland (how could Irish economist ever miss that bubble, why do mainstream economists sometimes still argue that bubbles do not exist – read Borio and Disyatat) is added (house completions in the entire UK reached a peak level of 219.000 in 2006/2007). See also the latest J.W. Mason blogpost about interest rates, which more or less states that people are not searching for yield – but use their trust in money, the monetary system, the guarantee of the cyclical dynamics of money as well as prevailing monetary yields as a foundation to act upon (possibly guided, to an extent, by ‘animal spirits’, M.K.?) – which fits into the Borio/Disyatat story (or the other way around). 


The prevailing view is that the downward trend (of interest rates, M.K) largely reflects a fall in equilibrium or ‘natural’ interest rates, driven by changes in saving and investment fundamentals …. In other words, a higher propensity to save in emerging economies, together with investors’ growing preference for safe assets, has increased the supply of savings worldwide, even as weak growth prospects and heightened uncertainty in advanced economies have depressed investment demand.

Conspicuously absent from the debate, however, is the role of monetary and financial factors in explaining the trend decline in real rates. After all, interest rates are not determined by some invisible natural force – they are set by people. Central banks pin down the short end of the yield curve, while financial-market participants price longer-dated yields based on how they expect monetary policy to respond to future inflation and growth, taking associated risks into account. Observed real interest rates are measured by subtracting expected inflation from these nominal rates.

Thus, at any given point in time, interest rates reflect the interplay between the central bank’s reaction function and private-sector beliefs. By identifying the evolution of real interest rates with saving and investment fundamentals, the implicit assumption is that the central bank and financial markets can roughly track the evolution of the equilibrium real rate over time.

But this is by no means straightforward. For central banks, measuring the equilibrium interest rate – an abstract concept that cannot be observed – is a formidable challenge. To steer rates in the right direction, central banks typically rely on estimates of unobserved variables, including the equilibrium real rate itself, potential output, and trend unemployment. These estimates are highly uncertain, strongly model-dependent, and subject to large revisions. … Financial-market participants are as much in the dark as central banks. The focus on fundamental saving and investment determinants of interest rates is entirely logical from the perspective of mainstream macroeconomic models, which assume that money and finance are irrelevant (‘neutral’) for the output path in the long run … But successive crises have shown that money and finance can have long-lasting effects. Not only can financial factors – especially leverage – amplify cyclical fluctuations, but they can also propel the economy away from a sustainable growth path [see the graph, M.K.]. By influencing decisions to invest, variations in financial conditions affect the evolution of the capital stock, and hence, future economic fundamentals. An expanding capital stock during booms may help to constrain inflation and obviate the perceived need for monetary-policy tightening. At the same time, large changes in relative prices that typically occur in financial booms divert resources into surging sectors in ways that are not easily reversible.

  1. June 29, 2014 at 3:44 am

    The way Borio and Disyatat discuss equilibrium or “natural” interest rates is just academic diversion. How can anyone talk about “equilibrium” rates, when it is obvious that interest rates are manipulated by central banks? Central banks do not know or care about equilibrium; they want to increase economic growth.

    By pushing cash rates to nominal (and real) negative levels (suggested by Summers) and by driving bond rates down through quantitative easing, central banks are driving nearly all accumulated savings into the stock markets and other asset bubbles, supposedly for the “wealth effect”.

    The “wealth effect” is a statistical nonsense, because financial wealth depends on valuation as well as earnings growth. Causality runs from earnings growth (at constant interest rates) to increased asset values, and not the other way around. Increasing valuation through lowering interest rates has no impact on earnings or economic growth. Higher stock prices have not led to increased corporate real investments.

    Since the 1% has already benefited from the rise in the stock market in recent years (as already measured), the rich will be selling to the pension funds of the 99% in the coming months. As the stock markets are already over-valued (due to economic stagnation and artificially low rates), it will be the final phase of wealth transfer to the rich, who will be holding most of their wealth in hard assets, when stock markets inevitably crash due to earnings disappointment.

    Welcome to six years of Keynesian “short-term” monetary stimulus, unscientific economics and the eventual economic collapse:


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