The link between interest rates and financial instability is asymmetric information

Mike Konczal, Nick Rowe, and Brad DeLong are deeply disturbed by FOMC members who are concerned that low interest rates feed financial instability. Mike Konczal concludes his analysis of the arguments in favor of raising interest rates:

It’s hard not to read the financial stability arguments as saying “look, we can’t trust the financial sector to accomplish its most basic goals.” If true, that’s a very significant problem that should cause everyone a lot of concern. It should make us ask why we even have a financial system if we can’t expect it to function, or function only by put the entire economy at risk.

Well, precisely. What did the crises of 2007-08 mean if not that our financial structure is fundamentally flawed.

Theoretically raising interest rates can have two effects (and a range of combinations between them that I won’t address). In the absence of asymmetric information, raising interest rates allows fewer projects to be funded (that is, fewer projects have positive expected returns given the higher cost of borrowing) and this reduces economic activity and employment. (I think this story is consistent with Nick Rowe’s view of monetary policy as acting through spending, though he would include a multiplier effect.)  In the presence of asymmetric information, however, we can have a very different outcome due to adverse selection.  An increase in interest rates can result in an increase in the number of projects funded, as “bad” borrowers prefer to get money that there is a high probability that they won’t be able to pay back now and incur the likely costs of default later. Of course, in a world with perfect information the lenders wouldn’t participate in this scheme, so we need an environment where lenders are misinformed. Theoretically, when lenders realize how bad loan origination methods are, the whole market can collapse. This is the “lemons” problem.

It is also arguably what happened in 2008. From mid-2004 to mid-2006, interest rates were rising – and the origination of adjustable rate mortgages – where the initial rate is very sensitive to short term interest rates was rising. (see here page 17)  Not coincidentally, the issuance of private-label MBS was also increasing over this time.

In 2008, the market recognized it’s origination failures and was at the edge of collapse just as the theory predicts, but the Fed prevented the collapse by lowering interest rates and making it easy to roll over many of the negative-present-value projects that had been funded, giving banks the opportunity to terminate them over time, instead of experiencing an immediate huge hit to their balance sheets. (Through a variety of mostly off-balance sheet guarantees, the banking sector had significant exposure to the private label mortgage markets.)

It is far from clear that that our banks retain the underwriting skills necessary to distinguish between positive and negative present value loans. (They may have switched to automated systems and now have a deficiency of underwriting experience.)  The other crucial question is whether the banks have taken advantage of this prolonged period of low interest rates to bury their dead bodies, or whether they remain hidden under the carpet. (This is clearly related to the idea that bankers are “gambling for job tenure” or “reaching for yield.”) The test of this will be what happens when we raise interest rates.

In some sense, one of the major problems with prolonged zero-interest rates is that they are very effective at hiding deep-seated problems in our financial system and, thus, are very likely to be interfering with the process of financial reform, and with the basic economic principle that failing businesses and projects should be allowed to fail.

In my view the appropriate policy response in this situation is to slowly raise interest rates, while simultaneously engaging in aggressive fiscal expansion, targeted towards the individuals who will be most adversely affected by the increase in interest rates. Given that the unconstrained optimal policy is politically impossible, I am willing to assume that the Federal Reserve’s current policy is a constrained optimum (especially given that I know the Fed has studied the problem much more carefully than I have).  In any event, critics of the Federal Reserve should probably include discussions of asymmetric information in their analyses.

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