The low-interest road to ruin

The global financial crisis had many causes, but among the more important of them was that the US Federal Reserve under Alan Greenspan, and his counterparts at central banks in other major advanced economies, kept interest rates too low for too long in the aftermath of the mild recessions that followed the collapse of the internet bubble at the beginning of the present decade.

The mistake was not in cutting official interest rates to what were, at the time, unprecedented lows after the ''tech wreck'' and the terrorist attacks of September 11, 2001. Rather, the mistake was in keeping interest rates at the levels struck in response to those events until as late as November 2003 in Britain, August 2004 in the US and December 2005 in the euro zone - long after the requirement for unusually low interest rates, to counter the risks of recession and deflation, had passed.

Keeping interest rates too low for too long had two important consequences, which came together in such devastating fashion in the global financial crisis.

First, the extended period of inappropriately low interest rates enticed many American households, whose incomes or credit histories would ordinarily have precluded them from becoming home owners, to take out mortgages which they were unable to service once interest rates began returning to more normal levels.

This consequence of abnormally low interest rates was, to be sure, compounded by the way in which subprime mortgages were constructed (artificially low ''honeymoon'' rates and capitalisation of deferred interest payments), but subprime mortgages would never have caught on as they did had the general level of interest rates not been so low for so long.

More generally, the extended period of unusually low interest rates also encouraged those who had previously been able to access mortgage finance to take on more debt than would have been possible otherwise, adding to the upward pressure on house prices from those newly enfranchised in the market.

Second, the extended period of unusually low interest rates encouraged investors to take on more risk in order to obtain rates of return that could no longer be provided by relatively low-risk investments. This prompted a response from the ''supply side'' of the financial services sector in the form of an ever-growing range of increasingly risky investment products to cater to the growing demand for them - products the risk characteristics of which neither their creators nor regulators fully comprehended.

In short, the choices made by central banks in the US and other major advanced economies to keep short-term interest rates too low for too long encouraged both an increased demand for risky investment products and a greater supply of them.

One of the reasons Australia's experience of the financial crisis has been less severe than has that of most other Western countries is that Australia's central bank was one of the few that didn't make the mistake of leaving interest rates too low for too long in the early years of this decade.

In the face of considerable criticism from many quarters, the Reserve Bank under then governor Ian Macfarlane began raising Australian interest rates in May 2002, and lifted them another three times over the following 18 months.

Each of these moves was accompanied by a fair amount of what Macfarlane's successor, Glenn Stevens, has since described as ''open mouth operations'' - that is, a series of quite forthright public statements (for a central banker) that were designed to highlight the risks associated with highly geared property investments.

These measures helped curtail the ''housing bubble'' that had been building in most Australian markets for some time; the ratio of house prices to incomes began declining from that point onwards until 2007.