The other side of low interest rates and Central Bank sponsored lending policies

Sri Lanka’s interest rate cut against IMF warning

The Central Bank cut its lending rates – the rate at which it eliminates the banking system’s excess liquidity known as REPO rate and the rate at which it pumps money to banks known as Reverse REPO rate – by a mega 0.5% in May 2013. Thus, REPO and Reverse REPO now stand at 7% and 9% respectively.

The purpose of this rate cut was, as the Bank had announced is “to stimulate the domestic economy, particularly in the light of the gradual moderation in headline inflation and subdued demand pressures in the economy,” though the IMF had not viewed it in the same tone in its Article IV Consultation Report of May 2013 pertaining to Sri Lanka.

A decline in the whole savings rate structure

The rate cut by the Central Bank was expected to be followed by similar rate cuts – both in deposit and lending rates – by banks so that borrowers, who the Central Bank thinks are all investors, would be treated to funds at lowered costs. Those borrowers, the Bank had presumed, would put the money they raise from banks in worthwhile investments thereby increasing the production of goods and services and helping the economy to get stimulated.

So, the Central Bank had justified that it had done its duty to push the otherwise sluggish economy forward. To match this stimulating action by the Bank, the Treasury bill and Treasury bond rates too have been lowered, it appears, by a strategy that has carefully selected or rejected the bids submitted by primary dealers at the respective public auctions.

Commercial banks cut deposit rates but not lending rates

Commercial banks, in response to Central Bank’s rate cut, reduced their deposit rates immediately, not by 0.5% as the Bank had done but by about 2-2.5% while not touching the lending rates at all. Hence, only a half of the Central Bank’s goal of affecting the market interest rates has been realised.

This is understandable because commercial banks do not have to pay high interest rates to attract deposits now in view of the fact that the Central Bank had caused all other competing alternative interest rates too to fall in line with the Bank’s action. So, depositors have no choice but to accept whatever the rates that are offered by commercial banks.

But commercial banks and other lending institutions did not have to make similar adjustments in the lending rates, again because they do not have to do so since there is no shortage of prospective borrowers knocking at their doors. Consequently, borrowers whose demand for credit has increased have no choice but to accept whatever the rates charged by banks.

The result has been the widening of the gap between the deposit rates and lending rates of banks which according to the reported information has risen as high as 8 percentage points in certain cases. The super profits made by almost all banks in 2012 and in the first quarter of 2013, albeit at a little lower rate, evidence this development.

Certainly, this was not a development which the Central Bank had expected but not totally unexpected when rates are cut arbitrarily when high inflation expectations are reigning in the economy as had also been warned by IMF earlier in May, 2013.

Pondering to impose lending rate ceilings

Frustrated by commercial banks’ failure to cut lending rates appropriately, the Central Bank is now reported to be considering the imposition of lending rate ceilings on banking institutions. As a start, the Bank is reported to have directed commercial banks to cut the interest charge on unpaid credit card balances after one month of free credit from 28% to 24% and expected banks to follow suit in the case of other lending rates as well (available at: http://www.ft.lk/2013/06/12/cb-orders-cut-in-credit-card-interest-rates/).

Given that the interest rate on credit cards is for encouraging cardholders to pay within the free period of credit and thereby discouraging the default or delaying of payments – a macro-prudential measure of ensuring financial system stability – the announced direction that goes against the Bank’s own financial system stability goal appears to be a strange start of directing banks to lower lending rates for increasing investments.

Are low interest rates investor-friendly?

The first measure by way of cutting interest rates by the Central Bank was considered by analysts and businessmen as an investor-friendly monetary policy. If the Bank imposes a ceiling on lending rates, that will, going by the same euphoria in the market, be considered a super-investor-friendly policy because the Central Bank is now seen as having used its powers to discipline, in the opinion of many, the non-cooperating recalcitrant bankers.

However, the economists’ profession is divided over the success and the final outcome of such government-led lending policies.

Keynesians believe so

Economists who call themselves Keynesians, Neo-Keynesians or New Keynesians consider that policies that will lower interest rates or enhance credit to private sector will do miracles in an economy. They are principally guided by the economic ideology of the 20th century’s most influential British economist John Maynard Keynes who argued in the first part of that century that an economy would fail to produce at its potential level because there is no effective demand for the products that are produced by its installed production capacity.

As a result, businesses start accumulating unsold stocks that compel them to fire workers leading to a massive unemployment, on the one hand, and a decline in income and output, on the other. To cure this deficient effective demand, he suggested that the government can step in and create a new demand by increasing Government expenditure.

The boost in demand so created will first eliminate the unsold stocks and when that new income is passed on to people, they will start demanding more goods and services. Thus, the economy starts getting back to a higher production path and will return to the full employment of resources automatically.

Warning against the uncritical application of Keynesian prescription

Keynes’ prescription was limited to two special cases. First, it was applicable only to a closed economy where there were no international trading activities or international financial transactions. Hence, the entirety of the credit extended was expected to remain within the economy absorbing unsold stocks and then creating new outputs.

Second, it was relevant only to an economy which has been performing well at the full-employment level but has slipped away from that level temporarily into an ‘economic recession’. However, despite these limitations, later economists and politicians found a way to apply it to open economies which are below the potential output level not due to temporary economic recessions but due to structural problems.

The founding Governor of the Central Bank of Sri Lanka, John Exter, warned in 1949 in the report he submitted to the then government on the establishment of a central bank, known as the Exter Report, those who wanted to apply Keynesian policies uncritically to Sri Lanka: He said that though Keynesian policies may work in self-sufficient developed economies meaning that there is no outflow of resources by way of increased imports and, hence, all new expenditure can generate domestic incomes, they will lead to balance of payments difficulties in countries which depend on imports for sustenance (pp 26-7). Sri Lanka was and is still such a country which should not uncritically adopt Keynesian type stimulating policies.

The ignored Austrian economist in the English speaking world

Many years before Keynes, one Austrian economist, Ludwig von Mises, had refuted the claim that low interest rates, money creation and government sponsored expenditure or lending can create wealth. In a path-breaking publication he made in 1912 in German and translated into English only in 1934 under the title ‘The Theory of Money and Credit’, Mises argued that lowering interest rates below the market expecting interest rates arbitrarily by central banks, expenditure programs undertaken by governments to stimulate economies and generous government sponsored bank lending to private sector do not work but bring disasters to the economies concerned.

According to von Mises’ protégé in the USA, Murray Rothbard, who published ‘The Essential von Mises’ in 1973, his voice was not heard in the English speaking world because it was translated into English just before the outbreak of the World War II and by then, Keynes had already reigned as the single most important economist in the Western world.

Hence, though strong and powerful, Mises’s remained only as an unread academic contribution not even worthy of being mentioned in major macroeconomic textbooks. However, a revisit to Mises will show that what he presented in 1912 is equally valid for today.

‘The Wealth Effect’ of new money

Mises put to rest the popular belief that money created and supplied through government action can create wealth and prosperity. The argument by pro-money economists is that when money is in the hands of people they get a feeling that they are richer than before because they can now command a bigger basket of real goods and services for their own welfare. Economists call this ‘the wealth effect’.

Given this feeling, people will start working harder – making new investments and producing goods and services so that they can become still richer. Then, the counter-argument made was that if all the people get the same amount of money, the wealth effect gets diffused and it will not compel people to work harder because there is no improvement of their position when compared to others, say their neighbours.

Connected people to benefit from government expenditure

Mises took a view different to even the counter-arguing economists. He said that when the governments with the support of their central banks increase money in the hands of the people, it is those who are connected to the government that will get the benefit of such new money and not all citizens equally.

That was the nature of the government he saw in Austria and Europe in early 20th century and today’s governments are not different from that style of governance. These people, says Mises, enjoy the new income given to them by the government.

However, later when the prices go up which is a certainty according to Mises, it is those people who have not got any benefit out of the increased expenditure of the government that will suffer from inflation. When viewed from this point, it appears that government stimulus packages and central bank sponsored credit expansions act like pyramid schemes in which the early entrants get the benefit at the cost of the late-joiners.

In an open economy, new money will fly out

Mises has pointed out that the new money created through government expenditure and the central bank sponsored bank lending will lead to increases in consumption by people. To the extent they use imported goods, it will create balance of payments difficulties, an observation made by John Exter about 40 years later and Singapore’s economic visionary Dr Goh Keng Swee further 25 years later.

Even if people use their new income to buy domestic products, due to supply constraints in the immediate turn, there will be a shortage of local goods and it will push the prices up ending in an unexpected inflation. But what will happen if people use that money for investment? It too will not help an economy because the investments are totally biased toward producing capital goods – goods like roads, buildings, power plants, ports and airports etc.

Since those capital goods do not produce consumer goods immediately, it too will put pressure on the prices to increase. The increase in domestic prices either way will put pressure for the exchange rate to weaken further.

Thus, Mises’ prognosis was that the government’s and central banks’ action to stimulate economies through increased budgets or lowered lending rates or central bank sponsored credit expansions to the private sector will not deliver the aimed results but inflation and balance of payments difficulties. In other words, they will create incomes in other countries as it has happened in the case of USA today and in Sri Lanka throughout the post independence period.

The sacrifice of time preference by savers

Then, how will the arbitrarily reduced interest rates affect the desire to make savings? Mises has analysed it in terms of the interest rate theory presented by his own Guru Eugene von Bohm-Bawerk, an influential Austrian economist of the late 19th century.

Bohm-Bawerk found that people demand a payment for their savings or lenders for their lending to compensate them for the sacrifice of ‘time preference’. Time preference is simply the mental desire of people to enjoy a benefit today rather than tomorrow. When people earn, they can use their earnings for consumption in the current period which improves their wellbeing. But if they save and make that money available to another person, they sacrifice their current consumption in favour of consuming later when the borrower repays his loan.

In Bohm-Bawerkian terms, it is simply sacrificing the time preference today for the sake of having it tomorrow. That sacrifice requires a payment and that payment is called the real interest rate. The real interest rate is then the difference between the money interest rate and the expected inflation rate. The emphasis here is on the expected inflation rate because people do not trust the inflation rate numbers released by authorities, however well those numbers have been compiled.

This is because the governments have throughout history had incentives to show a lower inflation than the actual one on account of satisfying their own interests. Good examples are today’s Argentina and Myanmar which have been accused of systematically underreporting the actual inflation in the respective countries.

Central banks cannot alter time preference of people

Mises then argued that people have a notion of an expected real interest rate which he called ‘the natural interest rate’ to compensate them for the sacrifice of time preference. As a rule of thumb, this should be at least equal to the actual economic growth rate since the savers have the expectation that their welfare should improve at least by that rate in real terms.

This is not an unreasonable expectation since the real welfare of people improves on average by the real rate of growth in the economy. If wage earners, profit makers and land owners are compensated by that rate in real terms, why not compensating money providers who make a current sacrifice by cutting their consumption voluntarily?

Savings flows dry out

When central banks arbitrarily reduce market interest rates to stimulate the economies, the actual real rate falls below the natural rate. The result is disastrous for savings because the savers instead of saving will use their resources for current consumption. Since modern economies are import dependent economies, it leads to trade deficits and consequential balance of payments difficulties.

If countries have free capital accounts, such money will fly out of the home economies in search of higher interest rates elsewhere. This is evident from the current wave of investments in Sri Lanka government Treasury bills and bonds by US citizens who get a negative real interest rate back at home.

Thus, the arbitrarily lowered interest rates result in drying-out the long term savings flows requiring the governments to print money continuously to keep the economies going. But the results are disastrous as prognosticated by Mises: Continuous inflation, balance of payments difficulties and exchange rate depreciation. Sensible economic policies require a country to take measures to avoid falling into this pitfall.



 (W.A Wijewardena can be reached at [email protected] )