The low-interest-rate trap

Cross-posted from VoxEU

By Francesco Giavazzi, Professor of Economics at Bocconi University and author (with Alberto Alesina) of “The Future of Europe: Reform or Decline”, and Alberto Giovannini, Chief Executive Officer, Unifortune SGR SpA and Principal Policy Advisor of the European Commission’s Clearing and Settlement Advisory and Monitoring Group (CESAME)

Should the crisis spur central banks to change how they conduct monetary policy? This column argues that strict inflation targeting, which ignores financial fragility, can produce interest rates that push the economy into a “low-interest-rate trap” and increase the likelihood of a financial crisis.

There is a fundamental flaw in the way central banks set official interest rates. This flaw has created what might be called the “low-interest-rate trap”. Low rates induce excessive risk taking, which increases the probability of crises, which in turn, requires low interest rates to keep the financial system alive. The flaw behind all this is the failure of central banks to take account of the probability of financial crises when setting interest rates.

Liquidity crises

By its very nature, every modern financial system is continually stalked by financial crises. The essence of a financial crisis is the breakdown of the process of “liquidity transformation”. Such breakdowns occur whenever providers of the short-term funds fear that their ability to access their money at short notice may be impaired by the behaviour of other market participants trying to do the same. This makes liquidity needs correlated, even in the absence of significant outside disturbances. This source of fragility has long been recognised. Indeed, the Federal Reserve System was conceived precisely as an institution capable to dealing with liquidity crises more effectively.

Liquidity crises are a disruptive and self-magnifying phenomenon especially in the present-day financial system characterised by:

* Multiple layers of markets and intermediaries (which magnify information asymmetries);
* Capital-saving trading techniques like dynamic hedging, and;
* Gigantic development in the use of securities and derivatives, which have multiplied counterparty risk and the risk of contagion.

Central banks have fallen behind market developments

Central banks have not kept sufficiently in touch with many of these developments. The liquidity crises of yesteryear hit banks – institutions that central banks knew well. But developments in securities markets mean that central banks have lost the ability to obtain the information they need to map out systemic risks among regulated banks and also beyond them. This is a problem because liquidity breakdowns produce spikes in the demand for means of payments and riskless stores of value – assets that only central banks can provide.

The need for a monetary policy “re-think”

Has the crisis taught us anything about how central banks should set monetary policy? There was not much that we did not know about how central bankers should behave once a crisis has developed; central bankers should be flexible in a financial crisis. And indeed in this crisis flexibility has been critical at avoiding a financial meltdown and an even deeper recession. But what about monetary policy in “normal times”? Has the crisis dented central banks’ recent faith in inflation targeting’?

Apparently not, according to a number of recent speeches given by Fed Chairman Ben Bernanke. While acknowledging the importance of monetary-policy transmission channels that work through financial markets, Bernanke has argued that central banks continue to pursue price stabilising policies (without prejudice to economic activity). The mainstream view in the central banking community is that the pursuit of price stability remains their main task, and that financial stability is something for regulators – not central banks – to deal with. Regulators, after all, have more appropriate tools, such as policies aimed at discouraging leverage (through high capital requirements) and decreasing aggregate risks, for example with rules on derivatives trading.

We understand this view. It is the product of an important intellectual and institutional evolution that has brought about the independence of central banks, as well as the technique of inflation targeting. A narrow mandate, coupled with independence, safeguards central bankers from undue influences from special interests, making them more effective. These developments deserve credit for the long period of low inflation and high growth experienced in the advanced economies before the crisis.

But the crisis has taught us that central banks, when they set interest rates, should also be concerned about the fragility of the financial system. Interest rates should reflect the value of liquidity, and this should take into account the fact that crises are spikes in the value of liquidity. If they fail to do so, central bankers run the risk keeping interest rates too low – specifically, keeping them below the shadow price of liquidity – which is the value of liquidity when you take into account the probability of spikes that come with crisis-linked liquidity shortfalls. Underpricing liquidity in this way makes crises more likely.

In other words, since in the event of a crisis the price of liquidity goes up, central bankers should keep policy rates higher than those they would set with the sole objective of price stability. Such a deviation from simple inflation targeting would have the important effect of signalling to all financial market participants that liquidity is not as abundant as they perceive in normal times, but can dry out unexpectedly and dramatically. By charging the “true” price of liquidity (i.e. its shadow price), central banks will help dampen excessive risk taking.

The low-interest-rate trap

Strict adherence to inflation targeting can produce interest rates that are too low, pushing the economy into a “low-interest-rate trap.” Low interest rates induce too much risk taking and thus increase the probability of crises. Crises, in turn, require low interest rates to prop up the financial system. In a weakened financial system raising rates becomes extremely difficult, so central banks remain stuck in a low-interest-rate equilibrium, which in turn induces excessive risk taking.

What we have experienced in the past few years closely resemble this paradigm. A more resilient financial system requires better regulation, but it also requires some fresh thinking on the way central banks set interest rates.

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  1. Brian McCarthy

    How is this really different from the Austrian view that fiat currencies backed by central banks are inherently unstable. The current crisis is really at its essence the result of decades of accumulated moral hazard fostered by the existence of the free “liquidity put.” And the Fed’s response to date? MORE FREE LIQUIDITY PUTS!!!

    1. Mark

      Any currency that has maturity mismatch is inherently unstable. That mean ALL currencies, since ultimately all currencies end up being credit based, and there will always somebody in the business of doing maturity transformation (making long term debt liquid)

      Central banks, and fiat currency have nothing to do with it. Financial crises happened even under the gold standard, and ESPECIALLY without a central bank.

      The post is similar to Austrian view, but the flaw of the Austrian view is that that they think the free market would magically solve the problem if the gumbermint would just get out of the way, even though there is strong historical evidence that flies in the face of that view.

  2. Tom Crowl

    From the piece:
    “It is the product of an important intellectual and institutional evolution that has brought about the independence of central banks, as well as the technique of inflation targeting.”

    I’d suggest that this ‘evolution’ needs a bit of evolving…

    While the idea of a neutral body (or bodies) as a core principle behind the creation of Central Banks may be of value… it’s certainly not possible under the present configuration.

    ALL economics is political.

    There’s an unavoidable bias related to the ‘boundaries’ of biological altruism, proximity (geographic, social, phychological, etc) and natural human community size (Dunbar’s Number).

    The metastasizing of the financial services industry is a reflection, in part, of this problem. (This inherent problem for scaled ‘social organisms’ in fact is at the root of the birth of Authoritarianism with the rise of settled agriculture.)

    The Economics discipline (and finance in general) has lost track of the fundamental issue driving its existence… at root it’s NOT about currencies and rates. (They’re important but can be very misleading elements since they’re tied to unavoidable flaws in our necessary but imperfectable currencies)

    It’s about the metabolism of a civilization. Both economists and politician have confused the map for the territory.

    Ayn Rand & Alan Greenspan: The Altruism Fly in the Objectivist Ointment

    Compensation and the Social Network

    Decision Technologies: Currencies and the Social Contract

    Personal Democracy: Disruption as an Enlightenment Essential

    1. readerOfTeaLeaves

      I was really struck to read the comment drawing analogies between our current economic problems and metabolism, as this post prompted me to think about metabolism, but from a different perspective.

      I’ve recently had conversations with someone who follows research related to metabolism and metabolic dysfunctions, who tries to understand how chemical messages go awry in ways that then cascade throughout the body.

      It turns out that metabolic dysfunctions appear to impede the body’s production of specific amino acids critical to cognition and ‘learning’. In other words, metabolic dysfunctions translate into cognitive impairments, or so it now appears — evidently, metabolic dysfunction interferes with the formation of several amino acids (in the brain) that have now been identified as important for cognition and learning.

      Here’s the bit of this post that prompted me to think about ‘metabolism’:

      * Multiple layers of markets and intermediaries (which magnify information asymmetries);

      * Capital-saving trading techniques like dynamic hedging, and;

      * Gigantic development in the use of securities and derivatives, which have multiplied counterparty risk and the risk of contagion.

      Those are fundamentally ‘information problems’.
      If a system has more ‘information demands’ because of increased complexity, while at the same time that system is having some kind of ‘metabolic dysfunction’, then it would be worth surmising whether one ‘symptom’ would be that the system – in this case, central banks –
      it would appear to ‘get dumber’ the more out-of-whack the system becomes.

      (I’m interested in ‘learning’, so the medical research is a bit beyond me, although this post prompted me to recall the main points from a recent conversation.)

      I have no idea how valid ‘metabolic research’ of human biology is as a template for thinking about economic problems. However, the idea that as a system becomes less stable, it becomes ‘less smart, but more stupid’, then one key place to intervene would be to address the information (cognition) issues.

      I certainly don’t want to trash up Yves’s (and Ed’s, and Richard’s) threads with off-topic nonsense, but it’s worth noting that from two quite different perspectives, two comments on this thread were prompted to link this post to what might be termed ‘economic metabolism dysfunction’. And from two rather different perspectives: one being cultural-societal, the other perspective originating in the biosciences and human health (and learning-education).

      1. i on the ball patriot

        Human biology makes for an apt template for thinking about economic problems, but first don’t buy into the separation of economics, or any other disciple for that matter. ALL of Life Is politics, it is ALL about sharing life’s pie …

        Think of the central banks and their lackey sell out; economists, government, and media, as a malignant brain tumor of deception that now controls the flow of blood to the bodies arteries, veins and capillaries …

        Essentially what has happened is the blood supply system has been hijacked by a cancerous tumor of deception in the brain and the brain now sends blood supply only to favored locations in the body, locations that the cancerous tumor of deception deems necessary for it to survive and to reconfigure the body to its liking. The cancerous tumor of deception, guided by elite thinking that is twisted and clouded by the core cancer within it, perceives the body as overweight, running out of nutrients, unsustainable, and so robust that it threatens the survival of the cancer of deception itself.

        The body, now with its blood supply so sporadic, and its cells in various locations dying off, reacts by sending the same old remedial signals to the brain, in the form of endless remedial plans, not realizing of course that the brain has been overtaken by a very malignant cancer of deception and is NOT listening.

        The solution is twofold;

        1. The body must realize that the cancerous tumor of deception is correct about its perception of the body over consuming beyond its nutrient supply and so must go on its own sustainable crash diet.

        2. The body must also realize that the cancerous tumor of deception in the brain, in spite of its correct perceptions about over consumption in the body and attempting to correct that over consumption, is going about it in a malignant and devious way and so the tumor must be excised immediately. A cancerous tumor of deception in the brain can never be Too Big To Excise, as ultimately IT WILL DESTROY the entire body. The body must cease sending the same old time wasting remedial signals to the brain and instead go into ‘perceptive shock’ that will manufacture proteins of perception that will travel to the brain and attach themselves to, and destroy, the cancerous tumor of deception. This is one of Mother Nature’s very common remedies.

        ‘Perceptive shock’ will include election boycotts that will send a very strong message to the cancerous tumor of deception in the brain that the perceptive proteins are being manufactured and on the way and unless they cease their deceptively fascist ways, they, and their sell out lackey collaborators, may end up in the same boat as Mussolini …

        Deception is the strongest political force on the planet.

      2. Raging Debate

        The pyramid paradigm of top-down must change to circular. The mathematics involved to use computers to handle the heavy flow of information requires Quantum Computing to establish a circular paradigm. In a circular paradigm, all information flows to the periphery and back again meaning each unit within the paradigm is informed.

        The repetitive result of building another Golden Calf for the Keynesians to worship is decentralization. Solve the foundational pyramid and mankind evolves to a more stable system. I dabble in this area but it is foolhardy to tell the high priest Aaron he has to melt that calf down into individual gold units to make it through the dry desert. They will be forced to detonate the calf with TNT so to speak meaning the usual – world war. A most disorderly way to move forward. This time it will be three steps back and one forward instead of two.

        1. NOTaREALmerican

          Re: The repetitive result of building another Golden Calf for the Keynesians to worship is decentralization.

          Did you mean centralization? Seems the Keynesian Golden Calf just keep getting bigger and bigger make it easier and easier for the smart amoral scumbags to steal the loot.

          It would seem that decentralization is what none of the state-ists want. Perhaps (even) a functional democracy (or Republic) can only work in a decentralize structure.

          Assuming that sociopaths are the highest form of human evolution it would seem their objective would be to centralize as much as possible allowing for their greater control over the resulting pile of loot.

          1. The Rage

            Give me a break. Statism is a merchant caste myth. You can ‘decentralize” the state all you want and watch centralization of the merchants.

            Either grow a brain or kill yourself. Your so deluded into totalitarianism and the desire for plutocratic dictatorship, you can’t even see right.

      3. NOTaREALmerican

        Re: metabolism and metabolic dysfunctions (and economics).

        It might be an interesting way to view the problem but I think there’s a fatal flaw in fully understanding it.

        As somebody (above) said: All economics is political. But this is only half true. The missing piece is: All politics is applied psychology.

        Economics is just the measurement of humans lying to each other (deception) and to themselves (self-delusion).

        Perhaps understanding how a “metabolic dysfunctions” (cancers or disease) is similar to sociopaths (the most advance evolution of humanity) and will provide some interest analogies, but I suspect the tools used to fight cancers and disease will be much different than what is needed to fight off sociopaths (I’m not sure there is a way to fight them actually).

  3. Captain Teeb

    “How is this really different from the Austrian view that fiat currencies backed by central banks are inherently unstable.”

    It isn’t.

    When all this is over, economists will win fame and fortune by re-hashing the Austrians in Keynesian/Monetarist terms, just as Milton Friedman did by restating Irving Fisher.

  4. Siggy

    “but it also requires some fresh thinking on the way central banks set interest rates.”

    There is the nexus of the problem. Should central(sovereign) banks be attempting to set interest rates? And, in that attempt are they not enaging in currency manipulation that typically means debasement and continuous loss in purchasing power?

    How is that we have gains in productivity and still have rising prices and loss of purchasing power? Is there not something very wrong about what has transpired over the past 40 years?

    This problem is all about the money supply as it exists as a fiat currency and excess credit money. Fix the currency and control the extension of credit and you may get to a less dangerous and less volatile economic structure.

  5. Fair Economist

    I strongly agree with the principle that low interest rates encourage wasteful and risky lending. I’m not so sure I agree with the policy proposals, partly because I’m not sure what they are. Increasing interest rates during a slowdown risks deflation, which brings a host of problems from debt deflation in a low-growth environment (it’s fine in a high-growth environment because nominal interest rates remain positive; but we’re talking about a slowdown here).

    I *would* say central banks should err on the side of excess restraint during booms; then, excessive interest rates risk only delays in growth but insufficient interest rates risk setting the stage for a financial crisis. To balance the mild risk to the high side to the extreme risk on the low side requires setting interest rates higher than a more straightforward median estimate would suggest. This in the inverse of wise money policy during a slowdown; during slowdowns the extreme damage of debt deflation exceeds the mild damage of moderate inflation so central bankers should err towards loose money.

    VowEU doesn’t point out the real and direct damage from wasteful lending during booms, as opposed to the indirect liquidity risk from all those bad loans in the system. To be fair, that would just further support their point.

  6. killben

    “it also requires some fresh thinking on the way central banks set interest rates”

    Central banks need fresh thinking in a lot of areas including setting interest rates.

    Definitely low interest rates would lead to excessive risk-taking even by risk averse individuals (and savers) if continued for a long period of time.. why because he is earning next to nothing leads him to deploy it in risky assets. The natural consequence of this is increasing demand (not naturally because people want the risky asset) and thereby increasing the price of the risky asset and thereby leading to a bubble.

    Since the risk averse individuals and savers will move very slowly towards the risky assets, it is likely they will the ones who will be boading the “Bubble Express” LAST. So what happens ….they get burnt the most … further leading to destroyed wealth because these savers would have contributed to investment but for the misguided policies of central bank .

    That is why it is sheer folly to keep the interest rates low for too long .. you need not know economics for this .. a bit of common sense will do ..

    But you know the central banks live in their own world .. they come down to set policies ..

  7. Ronald

    I recently watched a science program discussing the idea of time travel which would require traveling at the speed of light a slight problem but the show left the impression that the problem would be overcome sooner or later . Modern economics suffers similar spates of idealism whenever growth hits a down draft suddenly we need better faster models to propel modern life which makes for interesting university lectures but getting the reigning world power to give up its current economic structure requires something like traveling at the speed of light.

  8. Jim Haygood

    Although the authors fail to mention it, before the Federal Reserve was founded in 1913, overnight rates (the price of liquidity) invariably soared during financial crises, such as the Panic of 1907. Liquidity is more costly when risk is high and willingness to lend is low.

    Central banks have inverted the natural order of markets by pushing short-term rates to the floor during crises. Short-changed savers become speculators in seeking the ‘fair rate of return’ they believe themselves entitled to.

    Essentially the authors argue for ‘more enlightened central planning’ of interest rates. Like ‘military intelligence,’ that’s an oxymoron. Central planners are not, and never can be, enlightened. But despite the mountains of evidence surrounding them, our European friends cannot be disabused of this childlike magical belief.

    1. NOTaREALmerican

      Re: But despite the mountains of evidence surrounding them, our European friends cannot be disabused of this childlike magical belief.

      Who doesn’t believe, right now?

      The EU, China, & US are all doing exactly the same things for exactly the same reason. Centralized planning.

      It’s natural for the peasants to want the really really really really smart adults that run things – and understand how really really hard economics is – to help them plan their future and get-things-right.

  9. Chris of Stumptown

    “The mainstream view in the central banking community is that the pursuit of price stability remains their main task, and that financial stability is something for regulators – not central banks – to deal with.”

    But Fed officials have opposed moving their resgulatory function elsewhere. Their position is that working with banks as a regulator provides valuable knowledge of the economy.

    The problem is that they do not actually want to regulate. They simply want the benefits of being a regulator. They don’t want to regulate, but they don’t want to give up their regulatory authority.

    1. Raging Debate

      Correct, they want to own the world but not have to manage it. Now that they own most of it, the results on the ground demonstrate this point with crumbling infrastructure and mass joblessness in the West. If energy independence was one solution, where is it? It doesn’t exist, that requires writing and executing business plans oh the horror…

  10. steehead23

    Karl Denninger over at Market Ticker has suggested that aggregate credit growth should not exceed GDP growth as a better Fed policy than the broad prices and employment edict in the Federal Reserve Act. Because most credit is paid for by wages, I believe that aggregate credit should not grow faster than total wages, preventing growth in the financial sector itself, pushing credit growth. Now, this too is an imperfect criterion because in a growing economy, one would expect credit to “lead” employment as capital improvements in factories and machines precede employment, but such an approach would avoid credit spikes and credit crises, even if it would somewhat stymie growth.

    1. The Rage

      You will need a strong “public” institution to do that. Before the FED, “levering” up was the norm of the day and continued to be to the 29 crash. It wasn’t to the 80’s that “levering” up become popular or even tolerated by public institutions again.

      Yet, we never hear that.

  11. killben

    Here is an excerpt from this link on Huffington Post ..

    “Typically, during crises, the Federal Reserve also lowers interest rates and the cost of bank borrowing so as to make this risk-free profit spread to banks even greater. In the current financial crisis, the Federal Reserve has lowered interest rates to almost zero percent per annum thus assuring that the banks can profit enormously by doing almost nothing, not lending and sitting on risk free Treasury investments. While good for the banks, one can see how damaging this lack of credit extension can be to an economy trying to recover from an economic crisis.”

    This further explains the Fed’s bags of tricks and why low interest rates … it is all to save the banks .. in the guise of saving americans .


    Do you really need such an entity is what every american should ask!!

  12. Chimpman

    If anyone was at all serious about being rewarded for risk (interest) on their money deposited in still insolvent banks, they would immediately withdraw (yank) their funds, never to return until an acceptable and logical rate of return was installed, and then only in a proven (IRA approved) bank. Leaving funds in these shaky institutions (at -1%) smacks of a society too mentally encumbered to do anything clever at all (except blog). Really, after all the debate that exposed this huge fraud perpetrated on us all, how can there not be a bank run. And why have you lost your right (balls) to demand a modest compensation for all the risk still apparently in place worldwide? There are very compelling reasons for a bank run; No trust in the system, a central bank out of control, a government that refuses to tax as much as it continues to spend, bankers continuing to get away with not compensating depositors. So the answer has to be, remove your deposits. By the way, as any bank run gets messy, this one would be colossal and would work best placing yourself somewhat close to the front of the line.

  13. craazyman

    It seems that a liquidity crisis is the surface of a real or imagined solvency crisis, which itself is brought on by extended periods of low interest rates (inter alia res) when savers can’t get a “fair” return on their hard earned dough and go out the risk curve and become speculators. So if regulators can’t regulate (ipso facto et sui generis) then it seems that having a backup method of keeping order is not a bad idea. Not sure exactly how these guys could have written all this and not mentioned solvency in relation to low rates, but I do like the academic dodge about regulators regulating so the Fed can focus on doing what the Fed does. That is pretty good, as if one mouth drinks while the other mouth eats even though both mouths are really on the same head. Kind of weird to think about that one . . .

  14. Jim

    Bank loans to business persons were never low nor was the loan to value more than 60 to80 percent. The system failed because to many ninjna (no income,no job,no assets)loans were made and bundled as low risk AND virtually guaranteed by credit default swaps. This cancerous lending contaminated and spread the cancer to legitimate loans. These easy loans prompted builders to build condos and banks to finance same,all at the same time once a builder begins a highrise condo he and
    the lender are committed. Hundreds of thousands of such were built in a two year period. This also happened In 1988-90 . remember
    the RTC .lenders have short memories.

    year period


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