Barry Eichengreen: «A relatively small change in exchange rates could lead to negative equity capital for the Swiss National Bank.»
The world economy is not resilient enough for higher interest rates, warns Barry Eichengreen, Professor at the University of California in Berkeley. Negative interest rates however undermine the banking system and therefore inhibit economic growth. Still, there will be no helicopter money to come to the rescue, predicts the economic historian Eichengreen. He gave a speech at a conference by CFA, the community of investment professionals, in Rueschlikon near Zurich.
Mr. Eichengreen, it appears as if central banks and governments keep muddling through. Where is the world heading to?
They are indeed muddling through. A lot of people imagine dramatic responses to the slow growth of the global economy, and their current favourite is helicopter money. I don’t think that’s likely in the US, in Europe or elsewhere, for political reasons. In the absence of dramatic responses, there will be modest use of fiscal policy where there is space to use it.
Government debt is very high already.
In Italy and Spain, there will be a slightly larger budget deficit or a slightly smaller budget surplus than previously planned. There may be additional infrastructure spending in the United States. In Japan, there is likely to be a delay in the second increase in the Value Added Tax. It is muddling through rather than any dramatic change in economic policy.
Are such cautious measures sufficient?
Muddling through is feasible. It’s not optimal, but it’s feasible if the global economy continues to grow. However, if the economy lapses back into a recession, this year or sometime later, muddling through is no longer good enough. I’m not predicting a recession but I’m worrying about that. And I don’t think that there is the political will to do more. Since central banks have already cut interest rates to zero and governments are reluctant to do anything more dramatic in terms of fiscal policy, this means a very serious recession indeed.
Even in a severe recession, central banks would not introduce helicopter money?
Helicopter money is really deficit spending financed by the central bank. It would be fiscal policy through the backdoor. If there is a recession, governments would have to acknowledge that and say: «We, your elected representatives, take responsibility for an increase in public spending or cutting taxes», rather than say «we abrogate all responsibility and leave it to the unelected technocrats of the central bank to effectively run fiscal policy». I don’t think this would be politically viable.
Why not, if it could be helpful?
There would be very strong political resistance. In Germany, helicopter money would be equated to hyperinflation. In the United States, it would be seen as the definitive demonstration of the Feds tendency to overstep its statutory rules. The one place one could conceive helicopter money to happen would be Japan, but certainly not elsewhere.
Currently the economy is growing, and it’s already eight years since the financial crisis. Is the world economy really still too fragile to deal with higher interest rates?
Absolutely. There is much attention to whether the Fed might raise the policy rate by one quarter of one percent. That by itself is not enough to make a big difference. But people who want to normalise interest rates think about a series of rate increases that ultimately will result in a normal level at around 4%. I think the world economy is too fragile to get there any time soon. Global growth is as low this year as it has been since the crisis.
Is there still a danger of deflation?
The threat of deflation is not yet entirely passed. The Fed should remain on hold this summer, even though the US economy can probably survive one modest 25 basis point increase. But it would be a mistake to embark on a series of interest rate increases in the US, and an even greater mistake for the European Central Bank and the Bank of Japan to do the same.
Deflation is not always bad, is it?
The Bank for International Settlements, BIS, in Basle argued that there can be good deflation and bad deflation. And many people have exaggerated the prevalence of bad deflation. If you look at the historical evidence, there have been periods when deflation has been associated with robust economic growth, and other periods where it has been associated with recession and crisis. We have looked at that issue as well, including different measures of inflation, both producer prices and consumer prices.
What is the current type of deflation?
Basically, when deflation results from a positive supply shock, as an increase in productivity, it’s not a big problem. Firms can service their debt because they are becoming more productive. I don’t think that very many people would argue that what we have been experiencing since the global financial crisis has been a positive supply shock. That might have been the case some years before that, when China opened to the world economy and we had the great moderation. Now, the proper way of understanding deflation is a negative demand shock, and we know from history that this can be highly damaging. I regard evidence of deflation at the moment as highly worrisome. It’s associated with a weakness of demand, there is no strong productivity growth worldwide at the moment.
Inflation is far away from the central bank’s target of 2%, but they insist in achieving it, first and foremost the ECB. Is this credible?
If you state a goal and then you only take half measures, you do lose credibility. What lesson do you draw from that? That you shouldn’t state a target, or when you state a target, you should really do whatever it takes to achieve it. Central banks that take half measures lose credibility. In the US, we had three rounds of Quantitative Easing, and only QE 3 really worked to get inflation up towards 2%, because it was an open ended commitment where the Fed said, we will keep doing it until it has the desired effect. Now finally the ECB has made an open ended commitment to continue to do securities purchases even after September, if inflation is not yet up to 2%. So I would say: If central banks have not succeeded they need to do more. And we should be patient.
Negative interest rates should help to achieve the inflation target.
We are still trying to figure out how negative interest rates work. The early evidence is not favourable. The Japanese case is the most dramatic one, where the adoption of negative rates seems to have been associated with a decline in inflation and growth, and a perverse strengthening of the yen.
Why did the markets react adversely to the negative rates in Japan?
Negative interest rates are bad for interest rate margins and the profitability of banks, and therefore for bank lending. This is a serious problem. When you injure the banking system, when you undermine its health, you don’t get economic growth. Should deflation really be fought – trying to stimulate demand to get growth going and prices up – by destroying the help of the banking system? My conjecture is that negative interest rates are not a productive way to fight deflation, that they are perversely counterproductive because they damage the banking and financial system. Economies can’t grow without a healthy, functioning banking system, and negative interest rates are inconsistent with that. In Japan, the strong yen is a symptom of deflation.
If neither negative rates nor helicopter money, what could central banks do?
They can buy Exchange Traded Funds and mortgages and engage in further securities purchases of various sorts. Those measures do not have the same negative impact on banks.
Would you advise the Swiss National Bank to abandon the negative interest rates?
I would advise the SNB to rely more on securities purchases and forward guidance and less on negative rates. Securities purchases are a better option than negative rates. The SNB might purchase a wider range of securities.
The SNB gave up the currency floor but continues to intervene to weaken the Swiss Franc. Can Swiss monetary policy be independent at all?
Having a flexible exchange rate doesn’t insulate you from the rest of the world. Once upon a time economists made that argument, that if you have a flexible exchange rate you can choose your own monetary policy. But that’s not true. You can have large capital inflows that feed asset bubbles, that lead to a big negative impact on exporting sectors, on tourism and the like. There is no perfect solution for a country like Switzerland, no perfect monetary policy for a central bank like the SNB. That’s the 21st century reality for a relatively small and very open economy.
So if the ECB did more, as you recommend, the SNB would have to do more as well?
I suspect so. Balance sheet considerations shouldn’t govern what a central bank does. The central banks should take their responsibility for hitting the inflation target as their first priority, getting economic growth going at potential as their second priority, and balance sheet considerations come after that. I’m not saying that they are irrelevant, but they should not be allowed to become the priority.
Unlike the Fed or the ECB, the SNB has large foreign assets and therefore bears a big exchange rate risk. Is there a limit for the size of its balance sheet?
No, there is no relevant limit. The worry is that a central bank takes losses on its foreign assets or mortgages and ends up with negative equity capital. However, a central bank can operate with negative capital for a period of time, lots of central banks have. Three that spring to mind are Chile and Israel, countries with good monetary policy, and the Check Republic, a country with reasonably good monetary policy.
What about long term negative capital of a central bank?
Having negative capital for some time is like a swimmer holding his breath. You can do that for some time, it’s not a fatal condition. Eventually, you have to come up for air. To restore your credibility, you have to have positive capital again. Central banks can rebuild their capital through the so called seignorage: They provide expanding amounts of money to an expanding economy. In the worst case, the government can recapitalise the central bank. In Switzerland, the money is supposed to flow in the other direction, from the SNB to the cantons, rather than from the cantons to the SNB. I’m just saying that in the worst case, those transfers could be reversed.
The SNB has only 10% equity capital left.
So a relatively small change in exchange rates could lead to negative capital. Is that a catastrophe? The answer is no. Is there a solution? Yes, it would start with seignorage and end with the fiscal authorities recapitalising the SNB.
This is not exactly a bright outlook.
What is the alternative? Letting the Swiss Franc appreciate is not a solution. Switzerland is recovering from a global financial crisis in a situation where its central bank has an enormous balance sheet that it would prefer not to have. The US is recovering and the Fed has not foreign assets but some long term securities on which it could take losses. This is simply more evidence that financial crises are costly, someone ends up with the bill. Because we relied heavily on monetary policy to respond to this crisis, it’s the central banks that end up with the bill. And if that’s a problem, we as tax payers should pay for it.