Unprecedented monetary easing: no free lunch
Chairman SAIFM & Economist at Third Circle Asset Management
he active policy responses by fiscal and monetary authorities around the globe have been hailed as the reason why the 2008 credit crunch has (as yet) not dumped the global economy into a severe and prolonged depression similar to what transpired in the 1930s.
Indeed, the relatively mild recessions that took hold during 2009/2010 in most developed and some developing economies, were counteracted by massive net counter-cyclical government spending (in most instances mainly because tax revenue declined substantially) and extremely accommodative monetary policies.
We had seen – especially in the USA – unprecedented levels of monetary easing, most notably in the form of ultra-low interest rates and quantitative easing (QE) – an euphemism for printing huge quantities of dollars.
In all fairness, the way in which the US government have been conducting QE, has been aimed at avoiding possible inflationary consequences of straightforward money creation. They have instead used the newly created dollars (some $1,2 trillion since 2008) to buy financial assets from the banking sector.
In mid-September 2012, the Fed announced a virtually open-ended QE3 focused on mortgage-backed securities (MBS) purchases and extended its conditional commitment to leave its policy rate at near-zero through to mid-2015. The Fed also stressed that future policy action will depend on how economic conditions develop, particularly as far as the unemployment rate is concerned. The $40bn of MBS purchases per month that the Fed announced, would not include further Treasury securities purchases – at least not yet. But the Fed pledged to continue these MBS purchases until it judges that the outlook for the labour market has improved "substantially".
The QE actions have kept the banks liquid, allowing them to continue lending and propped up their reserves. But bond-issuing and debt accumulation have also reached dizzying highs, with the US federal debt now at $15,7 trillion, or nearly 70% of GDP, and set to rise to 140% of GDP by 2037 unless major changes are effected.
Most analysts and observers would agree that continuously running large fiscal deficits and increasing national debt levels will sooner or later become a major problem – especially for future generations who will have to foot the bill for unchecked spending. The strategy to buy back their own bonds by the US government, has given rise to very low – at times even negative – bond yields in the USA. Currently, this is working in favour of the government since the interest cost is low. But if the low bond yields (and associated higher bond prices) are indicative of a new asset bubble, this could mean that bond yields can only rise in future – creating problems in terms of debt financing and incentivising governments to inflate their economies, thereby reducing the real value of the debt.
But what about the very easy monetary policies – are there also short-term benefits that will have to be weighed against long-term unintended consequences?
Economic theory teaches us that very low rates of interest can often be associated with a liquidity trap situation, where actions to create more money (inter alia by injecting cash into the banking system), fail to stimulate demand in the economy. Under such conditions, consumers and businesses prefer to hoard cash. This may even give rise to deflation which could harm economic growth even more.
Until now, the US economy and even more so the economies of other developed countries, have not shown the hoped for response in terms of economic growth recovery owing to accommodative monetary policies. Although concerns surrounding the fiscal sustainability of some Euro members and the lingering possibility of a break-up in the eurozone have clearly contributed to the low levels of investor and consumer confidence, the very low levels of interest rates and liquidity injections have arguably not had the desired effect. But at least a collapse of the global economy and the financial system has thus far been avoided.
In their recently released annual report, the Bank for International Settlements (BIS) noted that decisive action by central banks during the global financial crisis, was probably crucial in preventing a repeat of the experiences of the Great Depression. However, they also noted that while there is widespread agreement that aggressive monetary easing in the core advanced economies was important to prevent a financial meltdown, the benefits of prolonged easy monetary conditions are more controversial.
Unintended consequences resulting from highly accommodative monetary policies, have been analysed in a recent report from the Federal Reserve Bank of Dallas. Such consequences could, inter alia, include the following:
Easing may have the opposite effect of what is intended
Conventional wisdom would have it that lower interest rates will encourage households to save less but borrow and consume more. This will also encourage companies to expand and invest more. In both instances spending is brought forward from the future, because the discount rate has been reduced.
But a consideration that applies to both household and company spending is the message given by ultra-easy monetary policy: it smacks of desperation. If this notion starts to prevail amongst investors and consumers, it could actually depress confidence and the desire to spend.
The assumption that companies will increase capital formation under low interest rate conditions, can further be challenged for other reasons. Corporate entities are well aware that highly accommodative policies are resulting from an environment of ever growing uncertainty about a number of important issues, such as future domestic demand and uncertainty about job prospects. Companies could easily extrapolate such uncertainties regarding future foreign demand to low economic growth prospects, uncertainty surrounding exchange rates and protectionism, and uncertainty as to how the burden of fiscal restraint and possible sovereign debt reduction might affect the corporate sector – especially as far as the future tax burden is concerned.
Inflation might rise
Although the probability of higher inflation appears to be limited in developed economies because of excess capacity, sharply higher inflation in emerging market economies is perhaps a more distinct possibility. Many emerging market economies appear to be operating at or near full capacity, and their monetary conditions are generally also very loose. In addition, their potential growth rates now seem to be slowing after previous sharp increases. Any import price shocks, such as those relating to fuel or food, could lead to inflation accelerating unexpectedly. This could affect the developed economies as well.
Misallocation of real resources could occur
It may very well be that demand side stimulus could succeed in reviving and supporting the economy in the near term, but such stimulus might come with a longer term price. The Austrian School of economists (notably Hayek and Von Mises) argued that real sector investments, financed by credit created in the banking system rather than being financed from genuine savings, would indeed spur spending, but that this would also create misallocations of real resources (so-called “mal-investments”). Since the true cost of real sector investments and the return thereon are distorted by artificially cheap money, such supply-side misallocations would eventually culminate in an economic crisis.
Some examples of mal-investments could include a rapid expansion of the housing stock and other construction activity; massive increases in infrastructure investment; and massive expansions in export capacity. None of these can be regarded as “bad”, but evidence suggest that unfettered real sector expansions usually drive down profits (leading to bankruptcies) since resource and material scarcities are created, while societal benefits are often over-estimated.
Financial sector may be adversely affected
Low returns on fixed income assets create difficulties for life insurance companies and pension funds. Serious problems, stemming from negative profit margins associated with a low interest rate environment, contributed to a number of life insurance company failures in Japan in the late 1990s and early 2000s. Nowadays insurance companies and pension funds have partly insulated themselves from these effects, either by hedging interest rate risk, or by moving towards unit-linked insurance products or defined contribution schemes. However, these measures eventually shift risks onto households and other financial institutions.
Monetary easing may over time also undermine banks’ profitability. The level of short-term interest rates and the slope of the yield curve are both positively associated with banks’ net interest income. During 2008 to 2010, the negative effects associated with the reduction in short-term policy rates were more than offset by the steepening in the slope of the yield curve. However, in an environment – such as is prevailing now – of protracted low interest rates characterised by both low short-term and long-term interest rates and consequently flattened yield curves, could ultimately lead to an erosion of banks’ interest income.
Effects on central banks
Firstly do the actions undertaken by central banks pose a threat to their independence in their pursuit of price stability? As central banks have progressively been purchasing (or accepting as collateral) assets of lower quality, they have exposed themselves to losses. If governments were to deem it necessary to recapitalise their central banks, this would be both embarrassing and another potential source of influence of the government over central banks’ activities.
Secondly, have the actions of central banks primarily been motivated by concerns about financial stability? In future, it will be difficult – even impossible – to suggest that monetary policy can be uniquely focused on near term price stability.
Thirdly, by purchasing government debt on a large scale, central banks have opened themselves up to criticism that they are cooperating in the process of fiscal profligacy.
Effects on the distribution of income and wealth
Income inequality has risen sharply in almost every country in the world in recent years. While arguments can easily be made for some degree of inequality to foster growth, there is a sense almost everywhere that recent trends have gone too far. It has also been suggested that greater inequality can lead to a concentration of political power in the hands of those who wish to use it for their own purposes, possibly calling into question the legitimacy of the whole democratic process. Further, by raising perceptions of unfairness, the trust that underpins all transactions in a market system can be eroded.
It may be argued that those that have the means to get access to cheap capital, may be more inclined, willing and able to take advantage of financial market swings to enhance their wealth. At the same time low growth rates and financial instability reduce employment levels and aggravate poverty for those who are unable to secure credit facilities, and are uneducated and hence unable to enhance their wealth through financial markets participation.
Given the global incidence thereof, rising income inequality is most likely deeply rooted in technological change and globalisation, both of which threaten the less well educated. Nevertheless, it is also worth asking whether, to some degree, this might be another unintended consequence of very accommodative monetary policies: the share of wages, output, and value added in the primary and secondary sectors have been declining in many countries, whereas the shares of these magnitudes for the financial services sector have generally been rising.
In South Africa, during past few decades, there had also been some significant changes in the above ratios as can be seen from the following tables:
For now, monetary and fiscal authorities still have to contend with a variety of crises: credit crises; exchange rate crises; confidence crises; growth and employment crises. Up to now, ultra-accommodative monetary policies have been successful in preventing a total collapse of the global economy or the financial system. But unintended consequences of such easy monetary policies could still emerge in years to come and will potentially present policymakers with a range of difficulties and problems to overcome.
Bank for International Settlements (BIS) Annual Report 2011/2012; 24 June 2012
White, W.R.; Ultra Easy Monetary Policy and the Law of Unintended Consequences; Federal Reserve Bank of Dallas - Globalization and Monetary Policy Institute; Working Paper No. 126; August 2012