Illusion of permanent liquidity

Claudio Borio, Head of Monetary and Economic Unit of the Bank for International Settlements (BIS) stated that loose monetary policies had given an "illusion of permanent liquidity" spurring investors to take risky bets and fuel asset prices. Borio was referring to historically low interest rates in Western developed countries since the 1997 financial crisis as a critical monetary policy tool to deal with recession. BIS has long opposed moves to cut rates and warned that this merely whets the investor appetite for short-term high risk investments, for example the property market thereby potentially creating bubble conditions for a new market crash.
Low interest rates encourage borrowing that was theoretically argued would be invested in medium to long-term productive sectors thereby generating growth as well as employment opportunities that, in turn, would lead to a receding recessionary phase. This has simply not occurred and the West and developed economies continue to suffer from very low growth rates that their central banks cite to justify keeping interest rates low. The reason, Borio argues, was because the market showed an "exceptionally subdued volatility" at levels similar to before the financial crisis, which is a sign of "high risk-taking." He warned that "a common mistake is to take the unusually low volatility and risk spreads as a sign of low risk while in fact they are a sign of high risk." Additionally volatility is not only a direct outcome of interest rates but also other factors like political stability (with the Ukrainian crisis and the Islamic State of Iraq and Syria destabilising markets) as well as natural disasters.
Borio's solutions that he presented at the annual meeting of the BIS were: (i) recognise the problem first and put it on the radar screen, (ii) take a medium as opposed to short-term focus, (iii) policies must be symmetric across boom and bust phases than at present and (iv) be holistic. The key elements that he identified that would be required to achieve such policies would incorporate (a) macro-prudential framework, implying thereby that those institutions that are more likely to take informed decisions with respect to investment must be encouraged, (b) monetary policy that leans against financial booms, and (c) extra-prudent fiscal policies. Or in other words, it has to be an amalgam of prudent fiscal and monetary policies as well as the identification and implementation of prudential policies that would resolve the problem.
Borio's analysis raises some questions about the linkage between interest rates and market reactions, which may not always either be rational or immediate. One major factor that mitigates the impact of low interest rates on volatility in one block of countries is the fact that this does not translate into low volatility in the foreign exchange market until and unless it is backed by low investment risk and measured by the rate of interest of the developing nations as the other bloc of countries.
An example from the Pakistani perspective would be the policy statement repeatedly made by the Federal Finance Minister Ishaq Dar that he is procuring foreign loans from the West at low rates of interest (around 5 percent was cited) to retire the domestic debt that has been procured at a much higher rate of return (around 12 percent) to reduce the country's overall indebtedness. However, this does not take account of the foreign exchange risk involved and unless Dar can transform Pakistan from a high investment risk country due to ongoing law and order problems, dharnas and the continued energy shortages with a rising energy bill that makes it increasingly difficult for the domestic sector to compete in the international marketplace the cost of borrowing from abroad would soon surpass the cost of domestic borrowing.