Glass-Steagall can solve the monetary policy trap

In a 16 April article for the Sydney Morning Herald, headlined “The world is caught in a debt-trap built by central bankers”, respected business journalist Stephen Bartholomeusz reviewed a Bank for International Settlements (BIS) research paper by the head of its Monetary and Economic Department, Claudio Borio. The technical paper expressed concern that the ultra-low interest rate environment fostered by central banks is suppressing economic growth. As low interest rates continue, however, what does grow are financial bubbles, which ultimately burst, leaving piles of debt with little real growth to show for it.

Bartholomeusz reported that the deliberate central bank policy of low interest rates encouraged higher risk-taking and speculative gain. “That has led”, he said, “to a massive increase in leverage—debt to income and assets—at every level of the financial system.”

There has been a debate, he continued, about whether central banks should “lean against the wind” of the policies that lead to asset bubbles by tightening monetary policy; but the BIS instead revealed that “monetary policy is the wind” encouraging those bubbles (emphasis added). There are other dangers. A “debt trap” can form, said the BIS report, making it hard to raise interest rates without damaging the economy—a strata of companies having emerged that can only exist at low rates.

With the developed world “already caught in the debt trap”, the BIS report falls short, Bartholomeusz concluded: “[W]hile the BIS paper helps explain how the developed world arrived in the fragile, over-leveraged, low-growth and unproductive environment we’re still experiencing, and why the central banks are now bound within a straitjacket they designed”, he explained, “it doesn’t provide any pathways for an escape.”

Easy money

The debate over easy monetary policy, including low to negative interest rates, bank bailouts and quantitative easing, is not new, but has intensified in recent years. Monetary policy is designed to allow central banks to influence the output of the nation, its employment levels and the prices of its goods by adjusting the supply of money and the interest rates at which it is lent. After a decade of extremely low interest rates, however, some pundits are warning that monetary policy is dead, and governments are considering more extreme varieties of pump priming from “helicopter money” (direct injections of money to the population) to “Modern Monetary Theory” (governments printing money to fund deficits, bond payments, et cetera).

On 5 July 2018 the BIS issued a warning from its Committee on the Global Financial System, currently headed by Reserve Bank of Australia (RBA) Chairman Philip Lowe, warning that an extended period of low interest rates can adversely impact financial stability. “[P]rolonged low rates could still involve material risks to financial stability”, said the BIS, and not only from the “snapback” reaction once low rates are raised. A “low-for-long” interest rate scenario can affect profitability and strength of financial firms, and a snapback could have a major impact on bank solvency and create liquidity issues, altering the “balance of vulnerabilities”, according to Lowe, under whose leadership the RBA dropped Australia’s rates to record lows for the longest period in its history.

In 2017 the RBA had issued a report, co-written by Claudio Borio, titled “Is monetary policy less effective when interest rates are persistently low?” Despite an unprecedented period of almost-zero rates in advanced economies, economic recovery has been “lacklustre”, said the report, speaking of the decreasing effectiveness of monetary policy.

Lowe co-wrote a BIS Working Paper in July 2002 with Claudio Borio, titled “Asset prices, financial and monetary stability: exploring the nexus”, which raised the worldwide disagreement over whether monetary policy should be used to crimp asset-price bubbles. But already in 1997, as head of economic research for the RBA, Lowe had answered in the negative in a paper titled “Asset-price Bubbles and Monetary Policy”, co-written with then-RBA researcher Christopher Kent, now assistant governor. They recommended that if the RBA thinks a bubble might “collapse under its own weight”, it should not raise interest rates, but keep them on hold or even lower them further. In other words, let the bubble grow—as has happened with Australia’s property market.

Despite the awareness of the perils that monetary easing has delivered, in December 2018 Deputy RBA governor Guy Debelle foreshadowed further interest rate cuts and added, “Quantitative easing is a policy option in Australia, should it be required”.

One way central bankers might attempt to get out of the trap they have built for themselves—to “fully restore monetary policy space with negative interest rates” in a low interest rate environment—has been proposed by the International Monetary Fund. In August 2018 the IMF suggested negative interest rates could be normalised by overcoming one of the biggest issues with them, namely, that charging people to deposit their money prompts them to withdraw it from the banking system, negating the effect of the increased liquidity. The proposal would establish a mechanism to cause cash to depreciate over time by “decoupling” it from electronic money, taking away the incentive to withdraw deposits. Economist John Adams exposed this move towards a cashless society in a 26 February post on his website adamseconomics.com, titled “The New Global Push for Negative Nominal Interest Rates”. In the event of a bubble bursting, Adams wrote, “a 3-6 per cent interest rate cut is typically required in order to neutralise the deflationary forces that typically result”; this is the capacity they are seeking to restore.

In the meantime, the US Federal Reserve, European Central Bank and Bank of Japan have all returned to variations of QE and/or have stopped raising rates. Former US Treasury Secretary Lawrence Summers has urged the Fed to lower interest rates, possibly as low as zero. “Planning for greater Treasury-Fed cooperation in the event that we have another zero lower bound episode is something that I think should be part of the Fed’s contingency planning”, Summers said. Recent advocates for deep negative rates include former IMF chief economist Olivier Blanchard 2010, New York Federal Reserve Governor John Williams, and Harvard economist/ historian Kenneth Rogoff, among others.

The IMF, Bank of England, former US Federal Reserve Chair Janet Yellen and the Organisation for Economic Cooperation and Development (OECD) have all warned about the dangerously bloated corporate debt bubble, which was fed by decade-long low interest rates. Negative interest rates would fuel the bubble on a nuclear scale, by paying speculators to borrow rather than charging them. Not only is there some US$13 trillion in global corporate debt already, but much of it is highly leveraged and much is bundled up into speculative gambling instruments called Collateralised Loan Obligations (CLOs), a close cousin of the Collateralised Debt Obligations (CDOs) that triggered the collapse of the financial system in 2008. CLOs (securities using leveraged corporate debt as collateral) stand at some US$700 billion, roughly the same volume as CDOs prior to the global financial crash, with default rates also comparable—still relatively low at this stage. The market for Credit Default Swaps (CDSs), which are contracts the banks use to insure themselves in case the heavily indebted companies they are lending to go under, is US$10 trillion. Recent cases of hedge funds engineering defaults or missed payments to get a payout have drawn attention to the risky nature of such derivatives.

Recoupling money and economy

Given this state of affairs, it is small wonder more attention is being paid to the only historically efficient mechanism which prevented banking from having any entanglement with such a speculative powder keg—Glass-Steagall bank separation. In a 17 April article for RealInvestmentAdvice.com titled “The economic cost of repealing Glass-Steagall”, author Michael Lebowitz referred to the Depression-era law as a form of economic tax. “Regulation”, he wrote, “is a form of interventionism representing a direct or indirect tax on the economy.” The Glass-Steagall Act of 1933 is an example of such, which is “well worth its cost”, having protected both the banks and the population from economic depression. “Many factors have weighed heavily on the economy in recent years, and in our opinion, the repeal of Glass-Steagall is one of them”, Lebowitz wrote. “Its repeal in 1999 provides a clear breakpoint in the history of financial institutions and the activities this regulation once restricted.”

Glass-Steagall combatted “over-reaching bank activities that led to financial instabilities” by separating traditional banking activity from trading and investment practices, stated the article. After its repeal in 1999, “profits in the financial industry soared almost immediately”. But economic profits did not follow suit, although they had been promised by the financial industry which claimed the repeal would benefit the entire economy through “bankers’ ability to provide more capital and liquidity to spur economic activity”.

As Lebowitz’s graphs show, GDP growth in the last 16 years has been some 2.5 per cent less than that of the pre-repeal era; and this doesn’t take into account the cost to the public of the mammoth bailouts and money pumping following the first major collapse since the implementation of Glass-Steagall, in 2008.

“[T]he repeal of Glass-Steagall was a windfall to the financial industry”, Lebowitz concluded. “Before GlassSteagall was abolished, financial institutions accounted for 20 per cent of total corporate profits. Over the last 18 years, that amount has doubled to 40 per cent. We remind you that banks do not innovate; their profits represent a missed opportunity for someone else to innovate.

“When banks take a bigger share of the economic pie, labour, investment activity, corporations and shareholders suffer. The removal of Glass-Steagall has resulted in a large shift of capital from those that consume and innovate to the financial intermediaries or the economic bookies.”

As such, the repeal of banking separation has widened the “wealth imbalance”, whereby the bank executives have been the main beneficiaries, while the working class—the other 99 per cent—“were not only left behind but … subsidised the policies fuelling the wealth of the top 1 per cent”.

Which brings us back to the monetarists wondering why their easy-money era has not led to growth. If you want to grow the economy, the money actually has to go into the economy, not just into banks! The restoration of Glass-Steagall laws will give us the power once again to reconnect finance to the productive sector. Speculation would be safely domiciled at arms length from commercial banking functions vital to the health of the real economy. Culling the flow of finance into speculation and restoring the lifeblood back to productive industry would, in conjunction with national credit to build transformative infrastructure projects, stimulate the economy in a way that monetarists can only dream about.