«Within the next decade, negative interest rates will be in every central bank’s tool kit.»
Few people know as much about financial crises as Kenneth Rogoff. Together with his colleague Carmen Reinhart, the highly influential professor at Harvard University is the author of «This Time Is Different: Eight Centuries of Financial Folly», one of the most important studies on the financial crisis of 2008 and its impact on the economy and society. So what’s the big lesson nearly ten years after the traumatic fall of the investment bank Lehman Brothers? In which way was this crisis different than other big shocks in the history of finance? Und most importantly: What’s next for the global economy?
Professor Rogoff, since the outbreak of the financial crisis nearly ten years have passed. How do grade this recovery when you look at other big busts in the history of finance?
In my research with Carmen Reinhart we found that after a deep systemic financial crisis, it often takes the economy eight to ten years to recover. Now, it’s been a decade and I think we are in a recovery period where we are going to get some reversion to mean in terms of productivity growth and other things. That means we are going to get above average productivity growth and rising investments for several years as the economy normalizes.
That sounds encouraging. Is this long period of anemic growth finally behind us?
I feel that the OECD and the IMF are going to be marking up their global growth forecast most of the time in the next few years. They have been marking down their forecasts for nine years in a row. For example, the IMF marked its global growth forecast 27 times in a row down and this October was the first time they raised their outlook.
What’s the most important thing to watch now?
The single most important thing is that investment continues to pick up. Seeing some recovery in investment would support the idea that there is more life in the recovery. There has been a deep, long lasting dip in global investment. That’s a big part of the explanation why interest rates are so low. So the most important question is whether the recent pick up in investment will continue.
In the US, the last recession ended nearly nine years ago. Aren’t we already in the late stage of this economic cycle?
I think that’s nonsense. A financial crisis has a very unusual recovery. So you can’t just count years and compare it to a typical recession. Also, if we had a recession right now it would be a much more normal recession. In any given year, there is a probability of around 15% for a recession and there is no reason to suppose that the odds are greater than 15% today. On the contrary: There is a very good chance that growth outperforms most of the time the next few years.
So is there nothing that was different with this financial crisis?
No, it fit right in. Financial crises leave such distinctive footprints in the data that you see very similar characteristics across time. In many ways, this was a garden variety of a systemic financial crisis: The way it happened, focused on the housing market, and the very slow recovery. In many quantitative benchmarks this financial crisis was very normal compared to other deep systemic financial crises. But if there was something different it was the European debt crisis. It was another whole layer on top of the financial crisis.
What do you mean by that?
This was absolutely the biggest financial crisis since the Great Depression when some countries experienced very bad crises. In this context, the very slow recoveries in Europe are significant. For instance, the Greek financial crisis ranks comfortably in the top 15 worst financial crises during the last hundred years. Greece’s experience was as bad as anything anyone experienced in the Great Depression. Also, the crisis that Italy, Spain, Portugal and Ireland experienced fit into the hundred biggest financial crises on record. On the other hand, it’s important to note that these countries are very wealthy compared to where the world was in the 1920s and 1930s. So even these financial crises were very severe, they took place on a much higher wealth level. What’ more, all in all this time they were handled better.
A big part of the response to the financial crisis were the bailouts of big banks like Citigroup, Royal Bank of Scotland or UBS. How healthy is the financial system today?
In most countries the banking system is pretty sound today. But then again, the level of regulation has tightened up so much that banks are not making loans as easily as they did. That makes it hard for medium and small businesses to get loans as easily as they did in the past. So the banking system is healthy in the sense that it’s less fragile than it was in 2007. But it’s less healthy in terms of being able to fund growth. Therefore, we need to improve the regulation of banks. In this respect, I like the ideas of Stanford Professor Anat Admati, and her German co-author Martin Hellwig who advocate having a much simpler regulation for banks but requiring more equity financing. I think that’s an extremely good idea and it would be much better than the way we’re doing things right now.
Does that mean we don’t have to worry anymore of another financial crisis?
Of course, there are still issues with the Eurozone. But the only country which is sort of in a different place in the cycle and which is important is China. China is probably the place most at risk of having a significant downturn in the near term. It’s certainly the leading candidate for being at the center of the next big financial crisis.
Why does China concern you so much?
I have great respect for the Chinese authorities and they are working very hard to not have a financial crisis. Also, it will be different because there is no truly private company in China. So government guarantees are triggered much more quickly than they are in the western economy. Nevertheless, I still think that’s the most fragile large region in the world at the moment. The big problem is that the Chinese economy is still very imbalanced, relying much too heavily on investment and exports. In addition to that, China is very credit dependent. So if China were to run into financial difficulties or just experience a slowdown in the rate of credit growth that could produce a lot of problems. And if China were to run into its own kind of financial crisis it would probably produce a growth crisis which could produce a political crisis.
But high levels of debt are not only a problem in China. Today, the debt levels in most western countries are even higher than at the eve of the financial crisis.
The debt levels are very high, but we also have phenomenally low interest rates. So the debt levels are highly sustainable if interest rates stay this low. I’m talking about real interest rates, inflation adjusted interest rates. And the likelihood is that they will stay very low for a long time. That’s what the markets are predicting. So if real interest rates stay very low, I don’t think there is any near-term vulnerability outside of China.
Why are interest rates still so low?
Economists don’t fully understand why interest rates have fallen as far as they have. We have lots of papers, lots of studies on it. But there is a large part we don’t know. For example, let’s suppose the United States and Europe, meaning Germany, France and northern Europe, started growing much faster. That could raise global interest rates. In this case, what could happen to countries like Italy if they didn’t grow as fast as the rest of the world? In such an environment we could certainly see big debt problems in countries like Italy. That’s a classic debt crisis pattern like in the 1980s when Latin America ran into trouble. It happened because the rich world was growing very fast and the highly indebted Latin American countries suddenly couldn’t meet their payments. But at the moment, Italy doesn’t have such problems because interest rates are so low. So no one cares.
There’s also a lot of complacency among investors at the stock market. How imminent is the risk of a correction with equity valuations as rich as they are today?
Most of it is interest rates being so low. You can do some simple calculations that suggest the low level of interest rates explains a large part of the high stock market valuation. The stock market is vulnerable to having real interest rates go up. But I don’t think it’s an exceptionally high risk right now. The stock market is high for the same reason debt is high which is that interest rates in many ways are at record lows compared to free market areas. We also had very low interest rates in other periods like in the 1950s and in the 1960s. But at that time, there was tremendous financial repression and control of the markets by governments. That’s much less true today.
Then again, since the financial crisis central banks intervene heavily in the markets with policies like negative interest rates and bond buying programs like QE. Now, they want to unwind these measures. Will that go well?
Central banks aren’t to blame for low interest rates. This is a case of global real factors that affect investment and savings which have led to these very low interest rates. Also, quantitative easing in the United States is smoke and mirrors. It’s almost meaningless. The first round of quantitative easing where the Federal Reserve was buying car loans and all sorts of private debt was significant because that’s a fiscal transfer. But simply buying treasury bonds is smoke and mirrors because it’s just the Treasury owing money to the Fed. So it’s absolutely an illusion and I don’t think it matters when they change it either.
What do you expect from incoming Fed chief Jerome Powell?
I wouldn’t expect any major changes at the Federal Reserve. Janet Yellen would have done what Jay Powell will try to do. I talked to him many times over the years and even though he’s a lawyer he really has excellent command of economic and regulatory issues. I think he’s a perfectly fine appointment, especially given that there are so many economists already on the board of the Fed. But it’s also a fact that President Trump would like to keep interest rates very low. He doesn’t want anyone to ruin his «beautiful» stock market. So the real question will be, what happens when inflation rises and the Fed feels a lot of pressure to raise rates. Will suddenly President Trump start treating Mr. Powell the way he’s treating Secretary of State Rex Tillerson, constantly undermining him? I think that would be very bad institutionally and I’m very concerned about that risk.
And what about monetary policy in Europe?
The biggest challenge facing the ECB is that quantitative easing in the Eurozone is not the same as in the United States. It’s basically a subsidy from the northern countries to the southern countries. Places like Spain, Portugal and Italy have received massive loans from Germany and France under the table through the ECB. If the ECB changes its quantitative easing, Europe is going to need some vehicle to substitute QE and support these countries, maybe some form of an Eurobond or something. So it’s going to be quite a challenge if quantitative easing stops in the Eurozone.
Also, in many parts of Europe interest rates are still negative. Will that leave permanent damages to the economy?
I think that’s nonsense. There isn’t any particular evidence that negative interest rates are leading to permanent damages or that the risk of a crisis are higher. But eventually, we’re going to have another deep recession or financial crisis. Not tomorrow, not soon I hope, but it’s going to happen. And if countries don’t prepare for it it’s going to be much worse than the last time because interest rates are already near zero, quantitative easing is ineffective and helicopter money is a silly idea. That’s why I think that in the future we will see the major central banks and Treasuries of the world all prepare for having much deeper negative interest rates the next time we have a financial crisis. It’s a much, much more elegant solution than anything that’s been proposed. So I think many countries will prepare for negative interest rates and I would say within the next decade it will be in every central bank’s tool kit.
How will these preparations look like?
Right now, central banks are very limited because if you set interest rates too negative big players will hoard cash. But it’s not very hard to do: Without getting into the weeds, the core of it is that physical currencies are becoming increasingly unimportant in the real economy. Cash is not disappearing, and I only advocate a cash lite society not cashless society. But as cash becomes less important in the legal economy, the different measures that you need to take, ranging from eliminating large bills to potentially taxing deposits into the financial system become very easy to do. You’re also having an effect on tax evasion which is not really affecting normal people. And by the way, for all these ideas, you can exclude small savers with no particular difficulty.
But already today, people can circumvent such measures with cryptocurrencies.
But if we interpret cryptocurrency to be anonymous or nearly anonymous currencies, governments can’t allow that on a large scale. If you look at the history of coinage and paper currency, the private sector invented everything at different times at different places. But the government eventually regulates and appropriates. That’s going to happen here, too. Governments have taken a deliberately hands-off attitude, thinking that the benefits of the innovation outweigh the risks and that the risks are not systemic. But as cryptocurrencies make it easier for tax evasion, crime and corruption to take place around the world, anti-money-laundering laws are going to have to step in and shut them down. That’s coming. There is no doubt about it.
So what’s going to happen with Bitcoin?
Bitcoin is a classic bubble. There are things in the technology that are valuable. But Bitcoin is more likely to be worth $10 than $10’000 in a decade. It’s very likely that it will get regulated and regulations will eventually undercut it. Even in the best-case scenario Bitcoin will probably be like MySpace. Remember that before Facebook? When they were first in but eventually a better competitor came along? When the private currency gets too big then the government has to do something and that’s the case here. You can have blockchain currencies that are not anonymous. That’s a different matter. They will live forever. But those are not the cryptocurrencies where all the speculation is taking place.