Central bankers need to follow Hoenig's lead on 'hard choices'

Actually, the monkeys are right. Three bananas in the morning are better than two in the morning, because there is a time preference of consumption now versus consumption later. The two choices are not the same because there is a value attached to time, which is the interest rate. The interest rate is the price to compensate for delayed consumption, because in the afternoon the monkey risks not getting the third banana, so it prefers to consume one more in the morning. The two choices are identical when the interest rate is zero, because there is no reward for consuming now or later.

This is exactly the dilemma the world faces under quantitative easing, which is another word for printing money.

There are two reasons why advanced countries may want interest rates to be near zero. The first is that after a crisis, zero interest rates mean that the central banks do not fear higher inflation. The second is that zero interest rates subsidize the borrower, especially since the advanced economies are all highly in debt.

But zero interest rates have huge distortive effects on resource allocation. If the advanced countries are growing at 2-3 percent per annum, the real interest rate should be around 2-3 percent per annum, because the savers should be compensated for the growth in the economy, otherwise their capital is being eroded in value.

With interest rates at zero, markets also have difficulty pricing risks. The gross interest rate or dividend should always price in an element of risk that the borrower may default or inflation may rise.

By printing too much money and keeping interest rates very low, central bankers in advanced economies are hoping to reflate their economies. Japan has tried this for decades without any success.

Actually, my diagnosis of the Japanese debt deflation is that there are two mutually reinforcing reasons of demographics of an aging population and lower income from low interest rates. As the population ages, the economy must slow.

Lowering interest rates causes the aging population to save more, rather than consume, because their income from their savings is declining. This creates a vicious circle. In the short run, the low interest rates create a bond bubble (since the price of the bond is the inverse of the bond yield).

When the government runs higher and higher fiscal deficits, it can only do so by lower and lower interest rates. This is exactly what has happened in Japan, when the domestic fiscal debt has reached 200 percent of GDP and if interest rates rise to global levels, the government would have an impossible fiscal crisis and the bond market would implode. Europe and the U.S. are running large fiscal deficits with fiscal debt averaging 100 percent of GDP and rising.

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