The risks and dangers for the global economy are like hidden reefs for a ship – invisible but deadly. It is quite possible, for example, that expansionary US monetary policy can cause an asset boom in China so large that its collapse would bring the Chinese economy down with it – and thus throw the world including the US into deep depression. This could happen while US retail prices held absolutely steady. There would be no pressure on the Fed to raise rates, and no justification for doing so from a short-term US perspective.
After the crash would come the recriminations. The US – and the IMF, to judge from its recent stance – would complain that China should have raised its exchange rate to ward off the inflow of funds. But raising the RMB exchange rate could itself have thrown China into depression, and be unacceptable politically. There is nothing in the current international monetary system to guard against a global meltdown by this route – except reports, like the one the IMF issued today (comment here) and speeches such as that made by Jaime Caruana of the BIS.
At present financial markets are trading on the central banks. Markets know that central banks want to keep interest rates at ultra low levels – and believe they are able to ensure they do. If the central banks remove support, and let rates rise, then asset prices will fall. Fear of the consequences of that makes central banks and governments fear to move. That fear is itself a symptom of a monetary neurosis. Thus nobody knows what the equilibrium interest rate is. The benchmark for all financial asset prices everywhere – the long term US T-bond rate – is unreliable. That itself distorts markets and impedes the efficient allocation of global resources.
In the first year or two after the outbreak of the crisis, in 2008-10, central banks had plenty of challenges but they had what seemed to most observers a reasonable strategy; throw everything into the fight to prevent the recession becoming a deep slump, refloat the financial system, clean up banks, and encourage de-leveraging. There were expected to be difficulties – notably in reducing debt levels. Defaults were anticipated; and already there were fierce internecine wars between austerians and expansionists. To prevent a recurrence in future of the crisis, central bankers looked to better regulation, plus the new toolkit of macro-prudential policies. Meanwhile, private sector market participants were expected to have learnt yet again the virtues of prudence, proper checks of credit worthiness of counterparties, and so on.
What has actually unfolded has been so far from these expectations as to count as a catastrophe. It is catastrophic because – despite signs of improvement here and there – few believe we have found a way out of the trap. Mervyn King said in 2011 that none of the underlying causes of the crisis has been removed.. There is no reason to think he has changed his mind since. Worse, we are no nearer finding a solution
Too many “experts” have their sights fixed on the wrong targets. The eurozone’s problems are used too often as a hand-me-down excuse, especially in the UK, where it feeds into the new wave of “withdrawal fever”. In fact, the British financial crisis was largely home grown. Of course it was part of a global crisis – and the eurozone’s travails have not helped – but London was the epicentre. The madness of investment banking, the deceit and criminality of too many people in the markets, the AIG scandal, the downfall of RBS, the build up of huge holdings of US subprime mortgages and derivative products by UK banks were nothing to do with its membership of the EU and yet they made the UK economy one of the hardest hit by the crisis.
Central banks have now become vast liquidity sinks. They know not what to do with their trillions of new assets and liabilities. People regard them as money-making machines. With their $7 trillion of asset purchases and forward guidance they hold interest rates at ridiculously low levels. They grossly underestimate the adverse effects of their policies in destabilising their own economies and the global economy.
Their inflation targeting frameworks have been shot to pieces. Who believes, for example, they can rely on their calculations of the output gap? Clearly, in retrospect, output was way above a sustainable long term level pre crisis. But it was convenient to focus on measures that showed output to be well below potential. Some progress has been made in the US – not in Europe – towards cleaning up bank balance sheets, but mainly because so much of the toxic assets ended up effectively nationalised through the US government sponsored enterprises (Fannie Mae and Freddie Mac). Dodd-Frank has not changed the banking landscape radically. The wrong measure of bank solvency and liquidity – Basel measures – are still trumpeted as achievements when in fact they take us further away from a solution, as former FDIC head William Isaac, among others, constantly remind us.
But there are even more serious implications of long periods of artificially low interest rates. They undermine the capitalist system. It is often said that the failure of economies to recover from the crisis has been due to the continued malfunctioning of the banking system. This is not allocating credit and resources as it should do. But worse than that is the systematic exploitation of savers by reckless borrowers, including governments and big banks propped up with state money (see excellent article by Jonathan Davis in City A.M. ) Yet all the big banks continue to benefit from a government guarantee and implicit subsidy.
Meanwhile, real investment is held back by businessmen’s and investors rational fears of yet another financial crash when they will need plenty of cash. With market analysts saying that the Fed will keep rates at near zero until 2016, even if unemployment falls – the Fed is in effect expected to adopt an employment target while intolerable strains build up in the financial system. Knowing that an earthquake could trigger another scary financial tsunami at any moment, is it any surprise that around the globe corporations are sitting on trillions of cash?
So governments get their budget deficits financed courtesy of central banks, central banks’ balance sheets replace markets, too-big-fail-bankers get their bonuses financed by state subsidies, corporations hoard cash, while workers, consumers and savers are screwed. Thank you very much.
Governments, bankers and central bankers put us into the money trap. Desperate to get out of it, their excessively loose monetary policies are eroding the springs of growth. Please stop.
Or is it time to break up too-important-to-fail central banks? See this amusing item by Alex Pollock
For more on all this, see my Opinion article on CentralBanking.com – Watch What Central Bankers Do Not What they Say – here