How deregulation left central banks with few weapons

DAVID JAMES writes on how financial deregulation has left central banks and authorities with few levers at their disposal to tackle rising inflation and debt.

Photo by Marcus Reubenstein on Unsplash.

Since the global financial crisis of 2008, Western financial markets have experienced steadily falling interest rates. Three years ago, they were close to zero.

In 2020 the US benchmark interest rate, the 10-year treasury fell to 0.5 per cent, which meant that, after factoring in inflation, it was effectively nothing. The pattern was similar in Australia; the 10-year government bond yield fell to 0.8 per cent.

Negligible interest rates might seem like a good way of managing short-term crises in the economy – and there was a great deal of concern in 2020 about the effect of the pandemic lockdowns – but any short-term gains come with a cost.

The centrepiece of capitalist systems, to state the obvious, is the cost of capital – mainly, the interest rate on debt. There is also an implied cost of capital on equity, but this is more notional, whereas interest payments are far from notional.

Take away the cost of capital and the central organising principle of the system goes away, leading to extreme distortions.

These have been mainly evident in the ballooning of debt – which was cheap because of the low interest rates – in most Western economies and China.

The picture is grim. According to the International Monetary Fund, in 2022 total world debt was 237 per cent of global GDP, or economy. In 2021, total US private and public debt was US$88 trillion, or 377 per cent of GDP. 

China’s debt is of similar proportions, and the country is printing money to keep its banking system and ailing property market afloat. China’s internal money supply, the renminbi, is more than twice its GDP.

Australia’s debt problem is mainly evident in soaring property prices – a two-decades-long distortion of the price of a critical asset class. 

Australia’s public debt is comparatively low; in 2021, it was 58 per cent of GDP, which was only 60 per cent of the world average. But private debt, more than half of it household debt, is over 200 per cent of GDP.

Eventually, the period of negligible interest rates had to end, and the emergence of consumer price inflation turned the wheel. 

The US and Australian 10-year treasury yields are now about four per cent and likely to rise further. The cost of capital has returned with a vengeance.

Because of the huge build of debt, it is very likely that economic stresses across the world economy will be severe. Either the debt payments will be served, sharply depressing economic activity, or there will be debt write-downs, which will put banking systems under pressure and most likely make credit harder to get. That, too, will depress economic activity.

China, whose banking system is state-owned, perhaps has the option of large-scale cancellation of debt, but that is not possible with the West’s private banking systems. Debt write-offs of about five per cent are enough to wipe out most private banks.

The situation raises some core issues about the management of capitalist economies. It is common to hear from private self-interested financiers that problems arose because the system runs on ‘fiat money’ created by central banks. 

Those same financiers then hysterically attack the central banks, especially the US Federal Reserve, as incompetent.

This is the opposite of the truth, although it is fair to say that central banks have made a mistake in letting interest rates fall so low. 

Because of the ‘deregulation’ of financial systems in the 1980s – a nonsense idea because money is rules – central banks lost all control over the quantity of money in the system. 

Some basic money, such as cash, remains a function of government fiat – such as the government rules on what a bank note has to have – but most of the money is created by private players, especially bank credit. Neither the governments nor central banks had any control over it. 

In Australia, it was the banks’ aggressive lending that set off severe asset inflation in the form of a housing bubble. 

Unlike consumer price inflation, which is easily recorded, asset inflation is hard for central banks to measure, so they do not respond to it. Accordingly, the Reserve Bank did nothing about the property bubble.

Because of financial deregulation, central banks have been left with only one weapon at their disposal – the base interest rate. It did not take long to see how limited that tool is.

Three decades ago, the Japanese central bank played out many of the current problems that we are witnessing now. In the 1980s, the country was awash with ludicrous levels of debt not dissimilar to the debt now.

The bubble was pricked early in 1990. The Bank of Japan tried to stimulate the economy by reducing interest rates to negligible levels. It also invented quantitative easing (QE) – the technique of money printing that central banks, including the Reserve Bank, have been using in the last three years to buy back government bonds.

It did not work. No matter how low the Japanese interest rate went – at times it was actually negative – the Japanese consumers and Japanese corporations did not want to borrow any more. The economy has been moribund for over 30 years.

For most of this century, Western central banks, especially the US Federal Reserve, have been implicitly trying to avoid Japan’s fate. But they are now in a situation that resembles it. The lesson seems to be that once authorities give up control of the monetary system – that is, once they relinquish ‘fiats’ – their ability to control events is much more limited.

Instead of trying to manage short-term crises by manipulating interest rates, the more common sense option might be to set a consistent cost of capital – say between 5 and 7 per cent – to avoid distortions and maintain the basic financial discipline on which the system depends.

But it is unlikely that central banks will stop trying to fight with one arm tied behind their backs. And it is a certainty that financiers will continue to blame them for doing so, rather than looking at themselves.

David James has been a financial journalist for 28 years. He was a senior writer and columnist at BRW for 25 years, a senior journalist at AAA Banking magazine, an editor and writer for stockbroker JB Were & Sons and a journalist at The Melbourne Herald. He has a PhD in English Literature from Monash University and now works as a freelance journalist and editor.

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