Monetary policy needs tightening

January 25, 2010

A new Great Depression has been avoided. Gargantuan efforts from governments and monetary authorities have limited the damage of the credit crunch to a bad recession. But the world’s political and business leaders can’t spend too much time on the ski slopes at the World Economic Forum in Davos, Switzerland this week. It’s time for them to build a consensus for higher interest rates

There are too many signs of financial excess for anyone to be relaxing much. Chinese real estate, commodity prices and credit spreads are all worrying. Wall Street is overflowing with excess again. Bankers are making fortunes despite best efforts to rein in bonuses. And why not? When the bubble popped, all the borrowing that propelled asset prices to new highs hardly declined. It was just shifted from the private sector to governments.

If asset prices keep rising, they can just as easily fall suddenly. A renewed recession or a sudden loss of confidence in some doubtful currency or country could restart the downward spiral of losses and reduced lending.

Investment and commercial banks around the world would call on the government for help. The official cavalry would certainly try to ride to the rescue again. But with all the bazookas that have already been fired, the saviors are almost out of ammunition.

Policy interest rates cannot be reduced further. Government deficits and total debts are already reaching high levels. Since few governments would have the capacity to oblige by adding substantially to their deficits, a new crisis would call for new measures. Governments and their central banks might resort to the ultimate weapon in the official arsenal — money printing.

In theory, money can solve many problems. Some cash can be pumped into banks as equity capital. If consumers and companies are flooded with funds, then prices and wages should start to rise. That inflation would reduce the real value of current debts. It should also increase governments’ tax take, perhaps faster than higher interest rates would increase the burden of debt.

Money printing is risky. The first problem is that the cash might just get hoarded rather than being spent. Japan has learned this lesson the hard way over the past two decades. But historically a more common problem is that once inflation gets started, it can be hard to stop. What was supposed to be a little healing inflation tends to end in tears.

And if the authorities were reluctant to turn on the printing presses in response to a second burst bubble, their options would be very limited. The world would be staring at widespread defaults on corporate and government debts.

The smarter option for politicians, bankers and industrialists is to agree to do whatever is necessary to keep a new bubble from developing. Most economists agree on what needs to be done. Over the next few years, they say the supply of bubble-fuelling debt should be cut back. That means tougher financial regulation, more balanced global trade and a return to balanced government budgets.

Even if everyone were to agree on that complex agenda, it would take several years to make the necessary changes. The one move that can be made right away is to bring the era of near-zero policy rates to an end.

Of course, there are good arguments to keep extreme monetary stimulus going. Growth in the world economy, with the exception of a few countries such as China, is tepid. Banks need the support and many borrowers, including governments, would find higher rates hard to bear. Jacking up policy interest rates might trigger a double-dip recession.

But consider the alternative. A new popped financial bubble could easily end in monetary chaos — uncontrolled inflation or unexpected sovereign defaults. It would be hard to avoid a deep depression.

It’s true that tighter monetary policy around the world might slow down the recovery. But higher borrowing costs would make future bubbles less likely to arrive and smaller if they come. And having raised rates, central banks would at least have the scope to cut them again when the next bubbles burst.


We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see

truly amazing thing, this human nature. don’t leave it alone for too long. might rear up and bite itself in the ass.
so, how much does a trader at one of the banks need to lose before he turns a profit for the company. suppose it pays to work right next door to the exchange. kind of like being a lawyer right next door to the courthouse. all i want to do is make a decent living, not engage in self-destructive excess.

Posted by highmountainhot | Report as abusive

You are correct in many of the points you present. The point you miss the mark on is more government regulations.

A once great man said “Government is not the solution to the problem, it is the problem”.

Our current day financial mess actually began in 1971 with a change in monetary policy by President Nixon, recommended by then under-secretary of the Treasury economist Paul Volcker. This policy change brought about the collapse of the Bretton Woods system signed by the allies in July 1944, also know as the gold standard.

I find it ironic that Paul Volcker on whose advice our financial system is in the mess it is today, is the same person called on to fix the mess he helped to create.

How does he propose to fix the problem, more government interference. Seems to me he is the last person to seek advice on any money matters.

Posted by MSGret1 | Report as abusive

paul volcker is the statement,” absolute power corrupts absolutely”. the old guy has been living in a vacuum being fed radical leftist rhetoric by his supposed masters. his buddy(dead guy) ronald is probably turning in his grave.pretty to see who’s bought in to this new crap. as usual, inverse proportional relationships will develop and apply. probably in a most unsavory forces have a life of their own, and will find a way to overcome all bull—- that obama,inc. is throwing up in an effort to save their own hides. gotta love obama’s latest observation about himself. he’d rather be a great one-term president than a mediocre 2-termer. well hooray for him. 3 more years of his greatness is truly more than we can afford.
another little funny, now that we’ve more wealth than gold and everything can possibly represent, where do we go from here?

Posted by highmountainhot | Report as abusive