WE BORROW TOO MUCH FROM THE FUTURE AT OUR PERIL / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

We borrow too much from the future at our peril

Peter Fisher

Central banks seem concerned about liquidity, but it is not the issue

©Bloomberg

Janet Yellen, chair of the US federal reserve, center, talks to Mario Draghi, president of the European Central Bank

 

Why are central bankers so concerned with liquidity? Is this sympathy for the plight of the hard-working bond trader? It is more likely they wonder if the lofty asset prices they have engineered with quantitative easing can be sustained.

By liquidity we mean our ability to sell an asset without material loss. In this sense, individual transactions can be liquid and some of us can find liquidity for some of our assets some of the time. But we cannot all withdraw our deposits from the bank the same day nor sell all our bonds and stocks at the same time.

 

In financial markets when we rush for the exits the doors get smaller. The system rests on a liquidity illusion. Keynes derided the idea that liquidity was a virtue, calling it an antisocial fetish that “forgets that there is no such thing as liquidity of investment for the community as a whole”.

 

Although central banks were invented to backstop our liquidity illusion, today’s central bankers are somewhat embarrassed by their origin as liquidity providers and lenders of last resort. Not satisfied with merely stabilising the value of money, they have committed themselves to ensuring good macroeconomic outcomes.

 

This commitment is today expressed by the powerful idea that if the supply of labour and other resources exceeds the demand then interest rates must be too high. The only acknowledged constraints to this imperative are inflation and financial stability concerns.

But from whence do low interest rates conjure additional demand?

By lowering interest rates we can weaken our exchange rate and take demand from our trading partners. We can also take demand from the future by inducing more borrowing against future income and also by a “wealth effect” when lowering interest rates makes future cash flows appear more valuable. So we can steal demand from foreigners, induce people to borrow more than they otherwise would, or make rich people appear richer. That’s it.

Foreigners can defend themselves but the future is defenceless. It is at risk if we borrow too little and also if we borrow too much. Thought of in this way, we can integrate financial stability concerns and monetary policy objectives.

A virtue of finance capitalism is that we can convert our future income into current investment and consumption while creating savings vehicles for others. If we borrow too little from the future we risk underperforming our economic potential.

We all recognise the risk that we might borrow too much if, by increasing indebtedness, we bring too much demand from the future into the present and create inflationary pressures. But there are other risks.

We might “over-invest” and borrow too much investment from the future, creating too much output compared with demand, contributing to deflationary forces. We might borrow too much compared with our future income and constrain our propensity to consume, weakening future demand.

We might incur debt greater than our ability to repay and undermine the value of financial assets.

Borrowing from the future via a wealth effect is a trick that can work but once which must push us closer to uncertainty about the sustainable level of asset prices and, thus, to the risk of financial instability.

A pernicious consequence of borrowing too much results if we borrow beyond our probable income against the collateral of unsustainably elevated asset prices. This creates a balance sheet mismatch that can lead to a debt deflation and, hence, to conditions of chronically weak demand.

The inter-temporal trade-off of borrowing from the future might make us better off both now and in the future but there is no guarantee. Those who ignore the risk of a negative trade-off put financial stability and macroeconomic outcomes in jeopardy.

Central banks have pumped up financial conditions in the hope of creating a good equilibrium between the supply and demand for resources. It is unlikely they have simultaneously engineered an enduring equilibrium in asset prices. Liquidity is not the issue.

 

 

Peter Fisher teaches at the Tuck School of Business at Dartmouth; he previously served as under secretary of the US Treasury for domestic finance and head of fixed income at BlackRock