Have central banks beaten the Global Financial Crisis?

19 September 2016

Central banks have exhausted the option managing the fallout from the Global Financial Crisis, argue Graeme Wheeler and Anil Kashyap. Then there is China.

Almost a decade after the Global Financial Crisis, nations are running out of policy options to deal with its aftermath. A range of unorthodox measures have been introduced, including quantitative easing, forward guidance, and negative interest rates. But how effective have these unconventional policies been?

This was a question put to the Governor of the Reserve Bank of New Zealand, Graeme Wheeler, and Professor Anil Kashyap of Chicago Booth, by Business School economist Professor Prasanna Gai.

"If you look at forward guidance, the problem is how do you anchor it? It tended to be through either time-contingent or state-conditioned requirements. And that is problematic. By and large it hasn't been very successful," said Wheeler.

He said quantitative easing – in which central banks buy securities from the private sector, and inject cash into the economy – had perhaps been more effective due to the sheer scale involved, but had reached diminishing returns in its ability to induce additional spending, and therefore economic growth. In addition, these programmes created significant distortions in securities markets and were generating negative financial spillovers for other countries – especially those experiencing greater economic growth and where interest rates were higher. However, the cost had been high. The balance sheets of the Federal Reserve, the European Central Bank, and the Bank of England are now equivalent in size to 20-30 per cent of GDP – up from about 10-15 per cent of GDP prior to the GFC, while the Bank of Japan's balance sheet stands at about 90 per cent of GDP.

"A key policy issue is: how do you unwind these balance sheets? It is an issue that the US and the other central banks are going to have to face."

On the issue of negative interest rates, Wheeler was "highly sceptical".

"We are very much in uncharted waters and there is a great deal of uncertainty whether it can generate much additional lending, and therefore spending, though it does undoubtedly squeeze bank profitability," he said.

"The central banks with negative interest rates are in countries that combined account for a quarter of world output. You are rapidly approaching the limits of monetary policy once you get into negative interest rates to the extent that we have."

Professor Kashyap, who is a consultant to several banks in the US and Europe, took a broadly similar view.

"I think the damage has been to keep the interest rates low for so long," he said.

"If you had asked the central bankers in 2008 what their reaction would be if interest rates were still low in 2016, they would say 'we failed'. Now it is inconvenient to say that.

"I don't see traditional inflation exploding any time soon, but I do see asset markets getting dislocated, and maybe reversing, with bad consequences."

As for China, Wheeler said the largest single worry was the build-up of debt.

"The Chinese economy is roughly 13 per cent of world output, and over the past 6-7 years, debt – particularly corporate debt – has increased to about 60-70 per cent of GDP. That is unparalleled. You have never seen a major economy with that rapid a build-up of debt," he said.

Much of that debt had gone into the shadow financial sector, he said, and monetary policy in the country continued to be expansionary, with more money being printed.

But two of the big things China has going for it are urbanisation and technology catch-up, said Wheeler. First, its urbanisation rate is still only about 53 per cent, and the government’s plans to increase that over the next two decades will provide enormous stimulus. And second, some international surveys rank China as low as 70th or 80th in the world in terms of technology in the corporate sector, and so it has great potential to improve performance.

Kashyap saw the Chinese government's ability to maintain social control in exchange for delivering economic prosperity being undermined by a faltering economy.

"Since 2010, things slowed down in the rest of the world and they reached the limit of how far they could go with the usual model. They have needed a new playbook, and it is not clear how they do it," he said.

"They are likely to be stuck on 5 per cent growth for a long time, which sounds good, but people in the rural areas still have miserable lives compared with those in the cities. When it looks inevitable that your kids will have a better life, people will tolerate it. But if it slows down just a bit you will lose the backing of the public, and that is scary."

Kashyap said when the Soviet republics transitioned from being state-planned economies to market economies no governments managed to survive the process.

"China is trying to do this without having the incumbent government lose control. No one else has ever pulled it off."

Reserve Bank Governor Graeme Wheeler and Professor Anil Kashyap spoke at a Dean's Distinguished Speaker Series event hosted by the Business School in August, 2016.

Anil Kashyap

Anil Kashyap is the Edward Eagle Brown Professor of Economics and Finance at the University of Chicago Booth School of Business.

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