Increase in the Federal Reserve Rate as the Precipitate of the Next Financial Crisis

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Introduction

We have very limited knowledge of social science and the unexplored areas so vast that

due to necessity, we measure progress by understanding we obtain of certain and pressing issues. Thus, Alan Greenspan, former chairman of the Fed, described the financial crisis of 2007-2009 as a “once in a century tsunami.” This tsunami flattened world wide economic activity, producing the most severe contraction since the Great depression. This made scholars, investor, firms and governments to lose confidence in the ability of central bankers to successfully manage the economy. There may be a lack of general consensus among scholars on many financial issues, but what most if not all agree is that an increase in interest rate by the fed has been a cause of all financial crisis from the great depression of the 1930s to the recent one of 2000s (Ferlito, 2014).

As such, this essay will seek to show theoretically and empirically how the Federal Reserve, by increasing the federal reserve rate, will cause the next global financial crisis.

Why federal reserve rate increase will cause the next financial crisis

Theoretical Analysis

Austrian business cycle theory (ABCT)

This theory argues that business cycles occurs as a result of excessive growth in bank credit resulting from artificially low interest rates set by central banks or fractional reserve banks. Text books economics show that lowering interest rates up to a certain level is a recipe for a disaster. The view ABCT is shared by Fertilito (2017), who argues that the lowering of the interest rate results in increased economic activity. This lead to initiation of projects which would not have been thought viable if the interest rates would not have been influenced by the central banks. Consequently, demand for production materials and labour increases resulting to an increase in prices of consumption goods. As such, Schularick and Taylor (2012), Borio and Drehmann (2009) demonstrates that banking crisis are endogenous and follow prosperous times. If the banks were to stop any more lending the boom would halt. But prices and wages continue to rise when they continue to expand credit (Ferlito,2017). As long as the public thinks that price increase will stop in the near future, inflation and the boom can continue smoothly. As soon as public realises that there is no reason to expect the end of inflation, panic sets in and they buy things, so as not to buy more expensive in the future. By doing so, they get rid of the money which results in product prices increasing disproportionately. When inflation runs out of control, the federal reserve interferes by increasing interest rate and the solving of one problem, inflation, causes a bigger one, a recession and a financial crisis. Additionaly, Ferlito (2014), pinpoints that business endeavours which had been launched thanks to artificially lowered interest rates and which had also been made possible by equally artificial increase of prices, no longer appear profitable. Some business cut back their scale of operation, others close down. When prices collapse; crises and depression follows the boom. Similarly, Colombo (2018), espouses the supposition that after a recession, central banks set interest rates and hold them at low levels so as to create an economic boom. When they do so, they interfere with the organic functioning of the economy which creates distortion and imbalances. Interest rates held by Fed at artificially low levels create “false” signals that encourages the undertaking of economic activities that would not be profitable in a normal interest rate environment. These businesses or investments created by artificial credit conditions are called by the proponents of ABCT as “malinvestments” which according to Colombo (2018), fails the moment interest rates rise to normal levels again. Examples of malinvestments are dot-com companies in the late 1990s and the failed housing developments in the mid 2000s housing bubble. When fail in an economy due an increase in interest rates, a recession or banking financial crises is inevitable.

When national debt has risen as it has done today at record levels, interest rates do not have to rise much to cause a financial crisis.

The chart below shows how recessions and financial crises have occurred after historic rate hikes cycles

Another well known financial crises brought by an increase of interest rate is the Latin America debt crisis of 1980s. The crisis began in the mid-1970s when many of the OPEC countries amassed wealth and banks were willing to led billions of dollars. Other developing countries borrowed large sums of money at low interest rates. These loans that were adjustable rose in the early 1980s when U.S. attempted to reduce inflation by raising interest rate. As a result, raw material prices fell and the countries in the Latin America had even less money to repay their debts. As Shin (2009) and Ham et.al.(2011), points out, the behaviour of banks when times are good sows the seeds for the next financial crisis. 

Some few examples which proves ABCT correct and which further demonstrates that fed reserve rate increase will cause the next financial crisis just as it has caused in the past include;

First, U.S. savings and loans crisis of the 1980s where savings and loans associations failed as the interest rate at which they could borrow rose above the fixed interest rates on the loans they had issued. Second, U.S. housing market bust, when mortgage rates surged as high as 18%  causing housing affordability to sink ,existing home sales fell by 50% from 1978 to 1981, affecting the whole industry including mortgage lenders, real estate agents, construction workers, etc. Third, Automotive industry crisis of the 1980s which was similar to the situation in housing where higher interest rates made automobile financing more expensive. As a result, automobile sales plunged, causing a third of the jobs to be cut. Fourth, tech bubble burst. Higher interest rates helped burst the late 1990s tech bubble that was centered around internet related companies, dot-coms, the telecom industry, etc. Fifth, U.S. housing bubble bust / credit crunch which resulted due to low interest rates after the early 2000s tech bust, causing the formation of a bubble in housing and credit. When interest rose again in the mid-2000s housing prices and mortgage backed securities plunged (Colombo,2018).

As shown by the above examples, an increase in interest rates may be good for banking sector profits but for other business sector, a rate hike reduces their profits. That’s because the cost of capital required to expand increases. Furthermore, an increase in interest rates causes the stock market as a whole to go down. When Fed increases the rate, business and consumers cut on spending which causes earnings to drop resulting in a drop in stock prices and the market tumbles.

Empirical analysis               

Various empirical studies have been carried out that support the assertion that the federal reserve rate increase will cause the next financial crisis.

Firstly, Boissy, Collard and Smets (2016) calibrated their model on post-WW2 U.S.A. data and the financial cycles in fourteen OECD countries (1870-2008) and assess its quantitative properties. They found out that most of the time, bank assets remain below the threshold for banking crises. Additionally their model generate banking crises either following an exogenous large and negative productivity shock around the steady state; or follow an endogenous over-accumulation of assets by the household and excess credit supply by banks. More so, they discovered that the typical crisis is triggered by a moderate negative shock toward the end of an unusual increase in credit. What this means is that low interest rates as we have seen above causes banks to borrow more and therefore leds more to the households and before an increase of the interest rate by the central banks to curb inflation that arises, on the surface economy will appear to be humming along just fine but when you look under the hood things will look very troublesome. A hike in borrowing costs kickstart a cascade of bankruptcies in a financial contagion. Shin (2010), for example, shows the demise of a U.K. bank-Nothern Rock- in 2007 as primarily originating from sudden freeze of the short term lending market.

Secondly, the standpoint above is also supported by Perri and Guadrini (2014), who by studying U.S. and other G7 countries over the period of 1995-2012, concluded that  liquidity shortage can be responsible for the initial collapse in economic activity typical of a financial crisis.

Thirdly, Reinhart and Rogoff (2009,2013), report that banking crisis have historically been followed by declines in output and employment, with output falling from a peak of 9% to trough with the duration of the downturn averaging roughly 2 years. Two years is much more than during ordinary recessions, one reason for it being that financial recessions come along with a credit that amplifies the downturn, as Claessens et.al. (2008,2011) show.

Fourthly, Schularick and Taylor (2012) and Mendoza and Terrones (2012) also provides evidence that banking crisis follow credit booms. For example, a research by Schularick and Taylor (2012), show that in advanced economies high credit growth is a vital predictor of future banking crisis.

Fifthly, an increase in interest rates boost the borrowing cost of the U.S. government resulting in an increase in the national debt. In 2015, a report by the congressional budget office and Dean Baker, who was a director at the centre for economic and policy research in Washington, estimated that the U.S. government may end up paying $ 2.9 trillion moreover the next decade as a result of increases in the interest rates, than it would have if the rates had stayed near zero (Baldwin, 2010).

Suggestions on future resolutions

To avoid federal reserve rate increase causing the next financial crisis, this essay offers two suggestions. First, the fed should not lower interest rates below the “natural” rate. This standpoint is supported by Ferlito (2017) who maintains that the attempts to artificially lower the rate through expansion of credit produces temporary results and that this recovery will always be followed by a deeper decline once interest rates rises to the “natural” levels. Interest rates should be determined by the free play of economic forces. Banks should not remedy the consequences of the shortage of capital or the effects of wrong economic policy by extension of credit. Second, before the fed thinks of hiking interest rates in order to curb inflation, they should think of long term measures like privitisation and deregulation which would make firms more productive and competitive. Such policies would reduce inflationary pressures in the long run.

Conclusion

An explanation for all financial crisis in the past, which is the most worrisome for the future, is that mistakes that were made by well-informed an well intentioned decision makers at the federal reserve, were responsible for all of them. As this essay has tried to show, an increase in federal reserve rate has been one cause and some will say, the main cause of financial crises.

Based on ABCT theory, this essay has demonstrated how cycles of excess capital are followed by cycles of financial crisis. This is as a result of excess capital giving rise to malinvestments which fail the moment interest rates rises. This essay has recommended two solutions to prevent another crisis. First, the fed should not keep interest rates artificially low. Instead free play of economic forces should determine the rates. Second, before the fed increases rates to lower inflation, they should come up with long term measures like privitisation and deregulation that would make firms more productive. If the federal reserve keeps on increasing interest rates, we all have a good reason to feel that the day of reckoning is fast approaching.