Zombie Lending

Stephen S. Roach writes in Project Syndicate,

It remains to be seen whether the Fed will resist the temptation of negative interest rates. But most major central banks are clinging to the false belief that there is no difference between the efficacy of the conventional tactics of monetary policy – driven by adjustments in policy rates above the zero bound – and unconventional tools such as quantitative easing and negative interest rates.

Therein lies the problem. In the era of conventional monetary policy, transmission channels were largely confined to borrowing costs and their associated impacts on credit-sensitive sectors of real economies, such as homebuilding, motor vehicles, and business capital spending.

As those sectors rose and fell in response to shifts in benchmark interest rates, repercussions throughout the system (so-called multiplier effects) were often reinforced by real and psychological gains in asset markets (wealth effects). That was then. In the brave new era of unconventional monetary policy, the transmission channel runs mainly through wealth effects from asset markets.

Two serious complications have arisen from this approach. The first is that central banks have ignored the risks of financial instability. Drawing false comfort from low inflation, overly accommodative monetary policies have led to massive bubbles in asset and credit markets, resulting in major distortions in real economies. When the bubbles burst and pushed unbalanced economies into balance-sheet recessions, inflation-targeting central banks were already low on ammunition – taking them quickly into the murky realm of zero policy rates and the liquidity injections of quantitative easing.

Second, politicians, drawing false comfort from frothy asset markets, were less inclined to opt for fiscal stimulus – effectively closing off the only realistic escape route from a liquidity trap. Lacking fiscal stimulus, central bankers keep upping the ante by injecting more liquidity into bubble-prone financial markets – failing to recognize that they are doing nothing more than “pushing on a string” as they did in the 1930s.

The shift to negative interest rates is all the more problematic. Given persistent sluggish aggregate demand worldwide, a new set of risks is introduced by penalizing banks for not making new loans. This is the functional equivalent of promoting another surge of “zombie lending” – the uneconomic loans made to insolvent Japanese borrowers in the 1990s. Central banking, having lost its way, is in crisis. Can the world economy be far behind?

It is when metaphors and oft-quoted terms come out of the woodwork, like ‘pushing on a string’, ‘zombie lending’ – and I must have seen several references to ‘Alice in Wonderland’- it is then that we know we are all worried.

There is a difference between being worried whether you can climb the last bit of the mountain, and being worried when you are lost in a tropical jungle and have no clue which way to go. With the former, at least you know the direction, but with the latter, you might go around in circles and end up where you begin.

If negative rates are held for a prolonged period, who should be worried? Everyone, from bondholders to money market funds, life insurers to commercial banks. The risks are plenty, from banks engaging in excessive and risky lending to asset bubbles to a looming pension crisis.

What I haven’t seen though, is the discussion of inter-temporal risks, as well as intergenerational risks. Stabilising the situation today can mean sowing the seeds of future economic turbulence, while the balance of benefits from interest rates policy between the old and young generations needs to remain fair.




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