Central Banks Put a Safety Net Under Financial Markets 2/18/18, 10:20 PM

Published on Mises Institute (https://mises.org)

Central Banks Put a Safety Net Under Financial Markets

January 26, 2018 - 11:40 AMThorsten Polleit [1]
Topics:
Money and Banks [2]Money and Banking [3]

Most early business cycle indicators suggest that the global economy is pretty much roaring
ahead. Production and employment are rising. Firms keep investing and show decent profits.
International trade is expanding. Credit is easy to obtain. Stock prices keep moving up to ever
higher levels. All seems to be well. Or does it? Unfortunately, the economic upswing shows the
devil’s footprints: central banks have set it in motion with their extremely low, and in some
countries even negative, interest rate policy and rampant monetary expansion.

Artificially depressed borrowing costs are fueling a “boom.” Consumer loans are as cheap as
ever before, seducing people to spend increasingly beyond their means. Low interest rates push
down companies' cost of capital, encouraging additional, and in particular risky investments –
they would not have entered into under "normal" interest rate conditions. Financially strained
borrowers – in particular states and banks – can refinance their maturing debt load at extremely
low interest rates and even take on new debt easily.

By no means less important is the fact that central banks have effectively spread a “safety net”
under financial markets: Investors feel assured that monetary authorities will, in case things
turning sour, step in and fend off any crisis. The central banks’ safety net has lowered investors'
risk concern. Investors are willing to lend even to borrowers with relatively poor financial strength.
Furthermore, it has suppressed risk premia in credit yields, having lowered firms’ cost of debt,
which encourages them to run up their leverage to increase return on equity.

The boom stands and falls with persisting low interest rates. Higher interest rates make it
increasingly difficult for borrowers to service their debt. If borrowers’ credit quality deteriorates,
banks reign in their loan supply, putting even more pressure on struggling debtors. Also, higher
interest rates cause asset prices – stock and real estate market prices in particular – to come
down, putting the banking system under massive strain. In fact, higher rates have the potential to
turn the boom into bust.

The US Federal Reserve (Fed), at the beginning of the 21st century, hiked interest rates, putting
an end to the "New Economy Boom." Stock markets collapsed. As a reaction, the Fed delivered
hefty interest rate cuts – and triggered an unprecedented credit boom that burst in 2007/2008
and developed into a global economic and financial crisis. Then, the Fed lowered interest rates to
record low levels and run the printing press on a colossal scale to keep financially overstretched

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states and banks afloat. The question is: will it be different this time?

Sound economics tells us that the boom-and-bust cycle has one root cause: fiat money. The US
dollars, euros, Japanese yen, Chinese renminbi or Swiss franc: They all represent fiat money.
Central banks hold the fiat money production monopoly, and they increase the quantity of fiat
money relentlessly through bank lending — through loans that are not backed by real savings.
As mentioned above, the issuance of fiat money distorts market interest rates and prices, and
thus plays havoc with peoples' savings, consumption, and investment decisions.

A destructive side effect of fiat money is that the economy’s level of debt keeps rising over time:
The growth of credit keeps outpacing production gains. This is because in a fiat money regime,
credit-financed investments fall short of their expected profitability, and credit-financed
consumption is unproductive. Quite a few investments turn out to be “flops. The economy gets
caught in a debt trap. Credit-financed consumption and government spending make it even
worse. To be sure: it has become a problem on a global scale.

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In an attempt to prevent the day of redemption, central banks slash interest rates to ever lower
levels to keep the system going. Once interest rates are lowered, however, they typically cannot
(for political reasons, I should hasten to say) be brought back to pre-crisis levels – as this would
make the debt pyramid, and with it the economy and the financial system, come crashing down.
It is this economic insight that explains why interest rates show a marked trend decline over the
last decades in all countries that have adopted fiat money.

The Fed, the world leading central bank, is on an interest rate hiking spree, though. Since
December 2015 it has increased its Federal Funds Rate from 0.0 – 0.25 to 1.25 – 1.50 percent in
December 2017. So far, higher rates have not done any damage to the US or international
business cycle, or at least so it seems. How high can the US interest rate go without bringing the
boom to its knees? To answer this question, we would need to know the height of the “natural
interest rate” level. What does that mean?

The natural interest rate is the interest rate that emerges in an unhampered market through the
supply of savings and the demand for investment. Unfortunately, however, the natural interest
rate is unobservable, its height is unknown. If it is very low, rising Federal Funds Rates might
quickly bring about a situation in which borrowing costs are “too high,” and the economy falls
over the cliff. If, however, the natural interest rate is relatively high, a higher Fed interest rate may
slow down the economy, but not necessarily push it into recession.

You may hope that the Fed, and all the other central banks, have learned their lesson and will,
this time, master the delicate balancing act of bringing the interest rate to the “right” level: the
level where the economy is doing just fine. Such hope, however, is built on sand. The reason is
not just a lack of knowledge on the part of policymakers: they do not, and cannot, know where
the level of the natural rate of interest is and set its interest rate accordingly. The real reason is
that the natural interest rate level is a no-go area for central banks.

In a fiat money regime, the boom can only go on if and when the market interest rate is below the
natural interest rate level. If, for instance, the Fed raises its interest rate to, let alone above, the
natural interest rate, the boom comes to a shrieking halt. So either the Fed keeps borrowing
costs artificially low, and the boom continues. Or it brings it in line with the natural interest rate,
and the boom turns into bust. Unfortunately, there is no middle ground. That is the uncomfortable
truth of the Fed’s interest rate policy.

We are thus left with two scenarios. First: The central banks will succeed in keeping the boom
going – which is the case if and when they keep their interest rates at artificially suppressed
levels. This, however, will come at the high price of growing malinvestment, speculative bubbles,
and – due to a relentlessly increasing quantity of money – an ongoing loss of purchasing power
of money. Second: Central banks will, by raising interest rates “too much”, put an end to the
boom and turn it into bust.

Even if the first scenario unfolds, however, the boom can be expected to come to an end
eventually – as it is relatively unlikely that there will be a continuous sequence of "favorable
conditions" (such as, say, positive productivity shocks) coming to the rescue, postponing the
boom from turning into bust forever. To put it differently: In a fiat money regime, the scenario that
the boom turns into bust is not a question of if but of when. This is an insight which Ludwig von

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Mises (1881 – 1973) put succinctly:

“There is no means of avoiding the final collapse of a boom brought about by [circulation- [4]]
credit expansion. The alternative is only whether the crisis should come sooner as the result of a
voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the
currency system involved.”1

It is impossible to predict when business will deteriorate with a fair degree of precision. There is
no formula according to which the timing of the boom turning into bust could be calculated. In
view of political attempts to keep the boom going, however, the probability of a continuation of
the inflationary boom seems to be higher than the probability of an immediate deflationary bust –
as central banks appear to be determined to “fight” any new crisis with even lower interest rates
and even more money printing, through which currencies will be debased.

1. Mises, L. v. (1998), Human Action, p. 579.

Source URL: https://mises.org/wire/central-banks-put-safety-net-under-financial-markets

Links
[1] https://mises.org/profile/thorsten-polleit
[2] https://mises.org/topics/money-and-banks
[3] https://mises.org/austrian-school/money-and-banking
[4] https://wiki.mises.org/wiki/Circulation_credit

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