Commentary Type

Show Steel and Raise Rates or the Financial System Will Fracture

Op-ed in the Financial Times


Raising interest rates is always harder than cutting them. When investors are bleeding and workers fear the chop, promises of cheap money sound like the hoofbeats of arriving cavalry. But the trauma does not end for everyone at the same time. When the rescuers depart, some complain they are being abandoned too soon.

Pity the Federal Reserve, then, which is widely expected to start increasing rates by the end of the year—or had been expected to, until a fierce bout of selling began in emerging markets and spread to stock exchanges around the world. There will be calls for central banks in the United States and elsewhere to delay long-flagged increases in interest rates. Yet they must not blink.

Monetary policy cannot just react to the latest inflation data if it is to promote financial stability and sustainable economic growth.

The case for waiting does not rest on market movements alone. Since there is no sign of inflation, it is argued, there is no need to raise rates. And since the recovery has always seemed fragile, there is no sense in raising them. The case for caution was being made when markets were rising. Its appeal will only grow now that markets are faltering.

Yet monetary policy cannot confine itself to reacting to the latest inflation data if it is to promote the wider goals of financial stability and sustainable economic growth. An overreliance on extremely accommodative monetary policy may be one of the reasons why the world has not escaped from the clutches of a financial crisis that began more than eight years ago.

The origins of today's market panic relate to recent policy choices. One of the factors behind the stock market slide is the stalling of growth in China. Official data, which paint a reassuring picture of steady growth, are widely considered to be unreliable. Look at what is happening in individual industries, however, and the picture is more troubling. Chinese consumption of smartphones shrank for the first time in the second quarter of this year, according to data from Gartner. The sales projections of many Western technology companies have followed suit.

The slowdown in the Chinese economy has its roots in decisions made far from Beijing. In the past five years, central banks in all the big advanced economies have embarked on huge quantitative easing programs, buying financial assets with newly created cash. Because of the effect they have on exchange rates, these policies have a "beggar-thy-neighbor" quality. Growth has been shuffled from place to place—first the United States, then Europe and Japan—with one country's gains coming at the expense of another. This zero-sum game cannot launch a lasting global recovery. China is the latest loser. Last week's renminbi devaluation brought into focus that since 2010, China's export-driven economy has labored under a 25 percent appreciation of its real effective exchange rate.

Exchange rates aside, long periods of accommodative monetary policy have led to a misallocation of resources. The extent of this will be impossible to measure for many years but, in the places where credit growth has been most dramatic, there are strong hints.

Accommodative monetary policy was supposed to spur investment in productive activities at home. Instead, companies and banks hoarded cash. Much of the extra credit instead financed housing purchases at home, or was funneled into loans for companies and governments in emerging markets. According to the World Bank, corporates and sovereigns in emerging economies collectively sold $1.5 trillion in new bonds in the five years to 2014, almost three times the rate between 2002 and 2007. Although today's attention is on the weakness of stock markets in America, Europe, and Japan, turmoil in the distant debt markets where investors from developed countries have placed their cash will be of more lasting concern.

There are two silver linings to the dark clouds. First, because of the highly concentrated flow of international credit flows, today's crisis may come to resemble the Asian financial crisis of 1997. It was brutal and contagious but regionally contained in comparison to the global and systemic crisis that began in 2007. Second, despite many protests, emerging markets long ago decided the international financial system is inherently unstable and built up reserves to help them weather the storm.

Still, that fragile and dysfunctional financial system is a serious problem. It will remain so as long as the institutions that are supposed to manage international spillover effects from monetary policy lack legitimacy, credibility, and capital. And if the advanced economies continue to rely on near-zero interest rates to fuel growth, they will only make that predicament worse.

More From