INTEREST RATES: Time to raise rates

A new Great Depression has been avoided. Gargantuan efforts from governments and monetary authorities have limited the damage of the credit crunch to a bad recession. But the world's political and business leaders should not relax as they chat at the World Economic Forum in Davos conference this week. They should build a consensus for higher interest rates.

There are too many signs of financial excess for anyone to be comfortable. Chinese real estate, commodity prices and credit spreads are all worrying. Bankers are once again making fortunes. And why not? When the bubble popped, the leverage that propelled asset prices upward hardly declined. It was just shifted from the private sector to governments.

If asset prices keep rising, they can fall suddenly. A renewed recession or a sudden loss of confidence in some doubtful currency or country could restart the downward spiral of losses and reduced lending.

Investment and commercial banks would call on the government for help. The official cavalry would certainly try to come to the rescue. But the saviours are almost out of ammunition.

(prepared by Edward Hadas/Reuters/National Post)
Policy interest rates cannot be reduced further. Government deficits and total debts are already reaching high levels. Since few governments would have the capacity to oblige by adding substantially to their deficits, a new crisis would call for new measures. Governments and their central banks might resort to the ultimate weapon in the official arsenal--money printing.

In theory, money can solve many problems. Some cash can be pumped into banks as equity. If consumers and companies are flooded with funds, then prices and wages should start to rise. That inflation would reduce the real value of current debts. It should also increase governments' tax take, perhaps faster than higher interest rates would increase the burden of debt.

But money printing is risky. The first problem is that the cash might just get hoarded rather than being spent -- as Japan has discovered in the past two decades. But historically a more common problem is that once inflation gets started, it is hard to stop. What was supposed to be a little healing inflation tends to end in tears.

But if the authorities were reluctant to turn on the printing presses in response to a second burst bubble, their options would be very limited. The world would be staring at widespread defaults on corporate and government debts.

If politicians, bankers and industrialists were wise, they would agree to do whatever is necessary to keep a new bubble away. Most economists agree on what needs to be done. Over the next few years, the supply of bubble-fuelling debt should be cut back. That means tougher financial regulation, more balanced global trade and a return to balanced government budgets.

But even if everyone agreed on that agenda, it will take several years to make the necessary changes. The one move that can be made right away is to bring the era of near-zero policy rates to an end.

Of course, there are good arguments to keep extreme monetary stimulus going. Growth in the world economy, with the exception of a few countries such as China, is tepid. Banks need the support and many borrowers, including governments, would find higher rates hard to bear. Jacking up policy interest rates might trigger a double-dip recession.

But consider the alternative: A new popped financial bubble could easily end in monetary chaos -- uncontrolled inflation or unexpected sovereign defaults. It would be hard to avoid a deep depression.

Tighter monetary policy around the world might slow down the recovery. But higher borrowing costs would make future bubbles less likely to arrive and smaller if they come. And having raised rates, central banks will at least have the scope to cut them again when the next bubbles burst.