Current Issues in Economic Integration

Can Asia Inspire the 'West'?

M. Bruna Zolin, Bernadette Andreosso-O'Callaghan

• Publisher: Routledge
• Year: 2016
• Print ISBN:
  9780754679561
• eBook ISBN:
  9781317155492
• Topic: Economics
• Subtopic: Business General
• Index: Economics

The current economic crisis has called into question the long term viability of the decoupling between multinational firms and the banking system. It has also cast serious doubts on the US dollar-centred monetary system, and invited reassessment of the long term viability of US-China economic relations based on a US current account deficit absorbed by Chinese financial institutions. It is also an opportunity to analyse the rise in property prices, particularly in fast-growing economies. Long term food security is also an issue, bringing to the fore the multinational firms from emerging economies (such as China and India) and calling into question the response strategies of multinational firms from the West and Japan. This book engages these key issues within the broad theme of integration, to give an up-to-date consideration of the subject, opening debate on the future stimulating role that Asia could play vis-à-vis the West, particularly the European Union.

PART I
Current Macroeconomic Issues

Chapter 1
Real Interest Rates and the Crisis: Where are the Rates Heading?

Dino Martellato

Introduction

A large part of the strongly expansive fiscal and monetary policies implemented during 2008 and 2009 (in the USA, China and Japan) or merely called for (as was the case of the European Economic Recovery Plan) was based on the idea that the world real economy was experiencing a correction in the trend of sustained growth of the past two decades. If this were really so, the unprecedented stimulation would make the correction brief and growth return to the pre-crisis trend. The price to be paid for reducing the impact of the disaster created by the excessive growth of private debt is the rise in public debt, but it is hoped that a return to the high growth regime of old will pay for it. Yet the odds of a quick return to high growth with low inflation – the ‘goldilocks scenario’ – that the world economy experienced before the crisis are, at best, uncertain as the past experience was characterized by the increase of large imbalances between advanced and emerging economies and sectors. All these imbalances are going to change since the rate of savings is increasing in the private sector in advanced countries, but decreasing in the public sector almost everywhere. A debate is also in progress about the likelihood of deflation and inflation. One possibility is deflation; some countries – such as Germany – while still stuck in recession, are already experiencing a fall in prices. The other is inflation – not a remote possibility since central banks have delivered a global and unprecedented monetary expansion which may lead to an inflation surge even though employment is far from being full. Commodity prices, the cost of credit and other costs can increase on their own even if central banks start absorbing the existing excess liquidity. There are obvious big differences among the different scenarios envisaged so far. The great moderation, or ‘goldilocks economy’ scenario requires low real interest rates,1 but this condition can hardly be considered as certain. In increasingly indebted economies, deflation would be extremely negative for everybody. In the inflation scenario, only some economic agents would pay for it, and exchange rates would be unstable.2 Central banks are trying to inflate out of the current crisis assuming they will be able to stem inflation in due course. This poses the obvious problem of the banks’ credibility. Will they have the necessary credibility when required? If not, they must regain it and, thus, they will be forced to raise real interest rates significantly and possibly for a long time. What if real interest rates surge? After the long descent that took place after the inflation of the 1970s and 1980s, we should not be surprised to see inflation return in an environment characterized by rising real interest rates. Deflation would lift real interest rates and deflate all asset values, i.e. collaterals. This would prolong and certainly worsen the problems in the housing market and the banking sector. At first sight, the odds of a surge in real interest rates are thus quite high. Indeed, if debt is poised to rise everywhere, savings must do the same. Should not the savings rate and the real interest rate increase as well? If so, the chances of a quick return to a high growth regime depend on a turnaround in the housing market. This requires an end to the fall in real estate prices, sufficient availability of credit, low interest rates, and the will of consumers to use that credit to buy new homes. It seems, therefore, quite interesting to consider real interest rates since the possibilities of a sustainable recovery critically depend on the level of perceived real interest rates. Without a resurgence in the internal markets and particularly in the housing market, growth in exports would not be sufficient to avoid the economies of the world limping along for years. Japan, for instance, was not able to compensate the stagnation in its internal demand with the growth in its foreign exports. Section 1 of the chapter focuses on real interest rates in the USA, Europe and Asia, whereas Section 2 considers the prediction that can be obtained from economic theory by focusing on real factors (Section 2.1), monetary factors (Section 2.2) and business cycle aspects (Section 2.3). In Section 3, the peculiarities of the Chinese interest rate and the connections between the Chinese and the US interest rates are considered. Finally, Section 4 provides some conclusions.

2. Real Interest Rates in the USA, Europe and Asia

Real interest rates – defined as the difference between the benchmark 10-year Treasury bond yield and the US Consumer Price Index (CPI) inflation rate – fluctuated throughout the period January 1983–January 2009, which suggested a prolonged downward trend (Figure 1.1). The same is true for all European countries and notably for the 10-y German bund, i.e. the benchmark rate in the euro area. Figure 1.2 displays the average yield of the 10-year European government benchmark bonds computed by the European Central Bank (ECB) with a changing composition. In the case of the USA, the whole period can be divided into three separate sub-periods. During the first, a descending trend can easily be detected from July 1984, when the rate was close to 10 percent, to December 1990, when it was almost 2 percent (average 5.6 percent). The second sub-period was one of stability with an average rate of 3.7 percent with dampened short-run oscillations. During the third sub-period the benchmark interest rate headed down again and on average was 1.8 percent. The average for the whole period was 3.6 percent, but on the basis of the averages of the 10-year benchmark interest rate in three separate sub-periods the USA had a blissful 24-year period as the government and an increasing number of debtors paid less and less in real terms for the use of the savings of others.

As for the Euro area, Figure 1.2 shows high volatility in the years that followed German reunification and the crisis in the European Monetary System (EMS), but after the start of the first phase of the euro, real yields across Europe started a clear downward trend. The trend ended with a double dip in January 2006 and in July 2008. The final jump clearly resembles that in the USA. Indeed, the euro area and the USA share the double dip and final jump. This is not the only similarity since the average real interest rate computed in the euro area over the period 1991–2009 is 3.6 percent and coincides with that found in the USA in the 1963–2009 period, although not with that in the 1991–2009 period (2.7 percent in the USA).

One strand of thought claims that aggregate demand and supply are brought into balance by the interest rate. The other strand of thought was started by Keynes, who observed that periods of prosperity and periods of recession (and even depression) alternate and who built a theory according to which it is the level of economic activity that keeps in balance the flows of savings and investment. According to Keynes, the rate of interest is the return that individuals get by holding their wealth in the form of bonds instead of liquidity. The progressive reduction in the average real interest rate both in the USA and the EU can therefore be explained in two different ways, which, as we shall see below, are only partially different from that warranted in China. On the one hand, it may be argued that people were keen to hold bonds – particularly 10-y government securities – at an increasingly lower price, or that the current 10-y real interest rate followed a declining normal real interest rate. Earnings yields, i.e. the returns observed in the stock market, have been consistently higher than bond returns, thus implying a premium of stocks over bonds. On the other hand, savings were surging worldwide because of sustained global income growth and this allowed mainstream economists to argue that the equilibrium in the loanable funds market was reached at an increasingly lower natural interest rate. In both cases, therefore, a reduction has taken place in the equilibrium level of the real interest rate, i.e. the rate that has played a key role in contemporary monetary policy ever since the adoption of inflation targeting. This policy is based in one way or another on some interest-rule and some idea of the equilibrium or neutral real interest rate. The equilibrium rate can be conceived as the rate compatible with macroeconomic equilibrium in the sense that if the economy settled at it for some time, output would constantly match the potential, and inflation would be low and stable. Central banks, therefore, have merely managed short-term rates to follow a supposedly declining equilibrium level. The equilibrium level is not directly observable and can only be estimated and central banks perhaps discover this step by step in doing their job. Recent research on the joint estimation of the level of the natural real rate of interest3 and the level of the output gap for the USA (Lauback-Williams 2003) and for the Euro area (Garnier-Wilhelmsen 2005) point to the common conclusion that the natural rate has declined gradually over the past forty years. In the case of the euro area, the decline was from 4 percent to 2 percent. One hypothesis is that the large availability of savings, particularly in the emerging economies, was the enhancing factor behind the rate fall.

Figure 1.1 Real interest rates US 1983–2009
10-year US Treasury bond yield CPI-deflated

Source: Federal Reserve Bank.

Figure 1.2 Real interest rates Euro area 1991–2009
10-year Government benchmark bond (changing composition) yield HICP-deflated

Source: European Central Bank.

Another possibility is that of a deviation from the equilibrium rate of interest (i.e. the rate at which some form of macroeconomic equilibrium is assured) and of a slow reversion pace. The downward trend of interest rates over the last twenty years could accordingly indicate that the economy has taken a detour from the equilibrium rate and that it is poised to revert to it sooner or later. Following Wicksellian monetary theory, one could argue that banks and capital markets (i.e. global finance) were able to make the volume of bank loans independent from the flow of national savings thus accommodating the increasing demand for loans at ever lower rates. If rates had increased, rather than decreased, particularly in deficit countries, the gap between market rates and the equilibrium real rate of interest would have reverted to the equilibrium level. Yet this hypothesis is not convincing since inflation was subdued everywhere until the surge in commodity prices started to fuel the rise in consumer prices in 2006.4

The benchmark real interest rate fell below zero in July 2006 and then returned to a regime of high volatility just before the onset of the crisis in 2007. The crisis represented a break in the old trend and should give an indication of its future direction. Figure 1.3 shows that the US real interest rate plunged below zero in 2005. Then it rose again, only to fall below zero just two years later, and then dipped even lower just before the worst weeks of the crisis. After November 2008, the rate rocketed up again. Figure 1.4 highlights a similar story for Germany’s 10-y bund real yield. The only difference is the much smaller range of variance. While in the US case the yield basically goes from -1 to 3 percent, in the case of Germany the yield hovers in the 1 percent–3 percent interval. The profile, however, is rather similar. The yield increased slowly from October 2005 to June 2007, i.e. until the outbreak of the crisis. The crisis brought about a sharp fall in the real interest rate to 1 percent and then a slow recovery until November 2008 and then a steady increase just above the 3 percent line.

Figure 1.3 Real interest rates in US 2005(IX)–2009(IV)
10-year US Treasury bond yield CPI-deflated

Source: Federal Reserve.

Figure 1.4 Real interest rate Germany 2005(X)–2009 (IV)
10-year bund yield CPI-deflated

Sources: Bundesbank and Statistiches Bundesamt.

Both cases show that the crisis, in particular from the turning-point in September 2008, marked a change of direction in interest rates. Will the surge continue in the future? What can we predict about real interest rates on the basis of theory? What will be the impact of the surge? Before addressing the theory, let’s briefly consider what happened in China, which is obviously an important reference for what pertains to emerging Asian economies. Available data offer a short track because the People’s Bank of China (PBC) was the only bank in charge and the money and bond markets were non-existent until recently (Fan and Johansson 2009). Since there is constant excess demand for bills and bonds, one could argue that yields are low also because of this. The government does not need to finance its expenses, but the PBC needs to sterilize the liquidity created by the commercial surplus. Official interest rates, and particularly the 1-year rate, seem to be the most important benchmark instruments in the hands of the PBC for controlling yields in the bond market (Fan and Johansson 2009). A distinct feature of the Chinese experience is the short track. The PBC is in charge of managing the renminbi, in order to favor growth and control inflation. This difficult task is achieved with a parsimonious use of the official rates. After the Asian crisis in 1998, the PBC lowered the official rates quite sharply from around 6 percent in 1998 to about 2 percent in 2004. Then it returned to higher rat...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• List of Figures
• List of Tables
• List of Abbreviations
• List of Contributors
• Acknowledgements
• Introduction
• PART I CURRENT MACROECONOMIC ISSUES
• PART II FIRM AND INDUSTRY LEVEL ISSUES
• Index