As the economic contagion of the global financial crisis was spreading from country to country in 2007, it was frequently noted that the mainstream economics profession seemed to be just as much in the dark about the true causes of the crisis as were the general public. In place of anything incisive and theoretically grounded, most people were forced to make do with vague hand-waving and metaphors to explain the crash, with one particularly well-worn bromide sticking out in my own memory as almost the defining phrase of the crisis: “When America sneezes, the whole world gets sick.”
However applicable that apophthegm may have been to the 2007/8 crisis, it was certainly the phrase which came to mind recently when news broke that, following the U.S. Federal Reserve’s dovish turn last month, central banks across the developing world have followed suit by shifting back toward lower interest rates.
An aggregate of interest rate moves across 37 developing economies showed that, over the course of February, the number of central banks in that group which had cut interest rates was greater by three than the number which had raised interest rates. This compares with a net rate rise in January, with one more central bank having raised rates than cut them in that group. Indeed, this aggregate of 37 developing economies had not shown any net fall in interest rates throughout the previous nine months leading up to the end of January 2019, with interest rate hikes having either equaled or exceeded interest rate cuts for the duration of that period.
An Easy-Money Trend
The trend began on 1st February — just two days after Fed chairman Jerome Powell announced that “the case for raising rates has weakened” — when Azerbaijan’s central bank cut its refinancing rate by 50 basis points, bringing it down to 9.25%. This move was followed shortly afterwards by the Reserve Bank of India, which unexpectedly cut its key interest rate by 25 basis points on February 6th. One of the biggest interest rate cuts of the month followed on the 14th, with a surprise move by the Egyptian central bank, which cut its deposit rate to 15.75%, and its lending rate to 16.75%, a decline of 1% in both cases. Then on February 20th, the Bank of Jamaica cut its key rate by 25 basis points, down to 1.5%. Two days later, the Central Bank of Paraguay made a similar 25 basis point cut to its policy rate, bringing it down to 5%. And rounding out the month, the National Bank of the Kyrgyz Republic cut its own policy rate to 4.50%, down from 4.75%, on February 26th.
What has prompted this widespread shift toward looser monetary policy in the developing world? While the rationales may differ from country to country in some of their specific details, one prevailing theme has appeared time and again throughout the various justifications for these shifts toward lower rates: fear of deflation.
After having strengthened consistently throughout most of 2018, the US dollar first stumbled and then noticeably fell between mid-December and mid-January, and has largely been flatlining since. As the equal and opposite reaction to this weakening of the dollar over the past few months, the currencies of many of these developing economies have correspondingly strengthened in terms of dollars. This has threatened to drop certain measures of inflation in those countries below their central banks’ inflation targets, which, in the mind of the mainstream economist, brings with it the threat of unemployment and economic slowdown. Couple this with the various uncertainties and potential shocks currently manifesting on the global economic stage, such as the Chinese economic slowdown and the uncertainty surrounding Brexit, and you have a situation in which cutting interest rates would seem to be, to the mainstream economist, the textbook response. After all, what harm could possibly come from central bank inflationism and artificially low interest rates?
The Price of Low Interest Rates
The advocates of Austrian Economics may find themselves increasingly occupied with the task of answering that question, over the coming months. After having maintained near-zero interest rates for most of the past decade, the past two years have seen the world’s central banks gradually start the process of normalizing rates again in response to the sluggish recovery. However, as the Austrian Business Cycle Theory of Ludwig von Mises demonstrates, that period of unsustainably low interest rates will not have been without costs. Such low interest rates will have induced investors into risky, long-term projects, which will no longer maintain the illusion of profitability once rates rise back to their natural, long-term levels. The relative upswing in the global economy over the past few years will be put under increasing pressure by the rising cost of borrowing, pressure which it will likely not be able to withstand, given the unsound foundation of unsustainably low interest rates on which that upswing has been built.
Examining the movement of interest rates over the previous two business cycles in, for example, the United States, seems to reveal a familiar pattern. As the economy was recovering from the previous bust and entering the next boom, the Fed took this as its cue to raise interest rates back up to non-crisis levels. Just as the Austrian Business Cycle Theory would lead us to expect however, these rising rates shook the foundations of the unsustainable booms created by the previous periods of lower interest rates, causing the economy to stutter. The Fed then reacted to this weakening of the boom by first halting and then reversing its interest rate rises, with the recessions of 2001 and 2008 both having followed shortly after such reversals. With central banks around the world currently signalling a likely softening of their previous plans for rate hikes, it may well be that we have begun entering into the final stages of of this familiar cycle once again.
George Pickering is a 2018 Mises Institute Research Fellow and a student of economic history at the London School of Economics.
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