Central Banks: Doing more harm than good?

Central banks are working overtime to kick start the global economy but monetary policy is being relied on to do too much and may just be creating more problems.

With the global economy in a slump and monetary policy not gaining much traction, it seems natural for there to be doubts about the ability of central banks to manage fluctuations in the economy.  But it is not just an issue of whether monetary policy is working or not, but the questions extend further to whether the actions of central banks have intensified the swings in the business cycle.  Your Neighbourhood Economist has started to wrestle with his own concerns as even more creative monetary policies seem to be having little effect but the finger for blame should not be pointed at central banks.

The standard format of monetary policy revolves around the setting of interest rates.  The desired effect of any policy intended to lower the interest rates is to spur investment by making borrowing cheaper.  This basic policy format was deemed to be sufficient to deal with previous recessions over the past few decades and helped to build up a sense of infallibility that bolstered the reputation of central bankers such as Alan Greenspan.  But the extent of damage to the economy resulting from previous recessions, such as following the plunge in tech stocks in 2000 and 2001, was superficial in comparison to the global financial crisis.  As such, tinkering with the interest rates was enough to get the economy moving again in the past but interest rates close to zero have had little impact this time around.

The critical functions of finance having stalled in the aftermath of the current crisis with banks holding back from lending due to heavy losses in the finance sector coupled with new restrictions on their activities.  It is typical for recessions resulting from a banking bust to be longer and deeper so central banks have delved into a range of unconventional policies such as quantitative easing to kick start the economy.  The money supply has swelled up as central banks have been printing bundles of cash and providing banks with cash to splash out on lending.  Yet, the larger money supply has not fed through to make any substantial effect on the economy.  The surplus money sloshing around has been flowing into the non-productive parts of the economy such as asset prices rather than into businesses which produce assets and liabilities. 

It is this excess money that can jump around the global economy and cause unnecessary volatility.  Central banks act in a way to maintain this surplus cash in the global financial system due to a bias in their policies regarding periods of strong and weak economic growth.  Interest rates are slashed with further measures rushed out when the economy is on the slide but central banks are less aggressive in resetting interest rates to appropriate levels when growth takes off.  Furthermore, the perceived receptiveness of the economy to oversight by the central banks during only mild fluctuations in the economy has increased the faith in monetary policy to shield the economy from shocks.  So, when the economy is booming, the prices of real estate and share prices soar due to the excessive confidence of investors and households who think that the good times will last.  Spending by household increases while debt rises and savings drop off as people think themselves to have more money in these assets despite some of the rise in wealth being transient. 

Banks also act to extenuate the inflation of asset prices by increasing lending to further fuel this boom in property and the stock market while clamping down on new loans when things turn bad.   The finance sector was even more of a culprit in the build-up to the current banking bust due to new innovations when banks thought they could offload lending risks to other parties.  However, this just resulted in an underestimation of risk which blew up in many bankers’ faces during the crisis.  Support from governments and central banks for the finance sector adds to the reasons why banks would want to make bigger bets when economic growth is perky. 

Too much has been expected of monetary policy and this is having adverse effects on the economy.  Central banks have been given oversight of the long-term health of the economy while politicians can pander to the preferences of voters (see More Power to Economists for reasons why this is the case).  The absence of better management of government finances over the past decade has resulted in only limited options in terms of fiscal policy.  Increases in government spending would have been a more appropriate response to the current slowdown in economic growth as cash would have been fed into the real economy rather than just sitting in the vaults of banks as has been the case with the current monetary policy. 

As such, central banks have over extended themselves trying to kick start the economy.  There may be follow on effects from this as the huge quantities of money currently being printed by central banks are likely to exacerbate the trend of excess liquidity in the global financial system as it will be hard to mop up the extra cash once the economy starts moving again.  There are many villains in the tale of the missing economic growth – central banks may be seen as one of them but it is only because monetary policy is being called on to save the day when all else has failed.

Walking a Tight Line

Europe is being caught between convincing investors that all is well while trying to stop the improving outlook from feeding through to a strong currency.

All of the fires that had been keeping politicians busy over the past few years seem to have been put out – the Eurozone is no longer on the verge of collapsing, politicians have come up with a short-term comprise to deal with increasing government debt, and the outlook for the global economy looks likely to improve in 2013.  So with disasters averted, the focus is turning to generating growth in stagnating economies.  With domestic markets still sluggish, exports have been targeted as a route back to economic recovery and a weak currency is a crucial advantage.  But what seems easy in theory is tricky in practice.

This shift has been most pronounced in Europe.  The worst seems to be over with investors having been snapping up bonds from previously shunned countries such as Spain and Italy over the past few months.  But the long slog of getting the economies in Europe moving again still lies ahead (refer to Both Good News and Bad News for Europe for more on these two trends).  Exports have been targeted as a source of growth by tapping into perkier demand in emerging markets.  A weaker currency is an easy shortcut into foreign markets but such a policy is of little use (and could work to the determent of all) if other countries follow suit.  Hence, the rise of concerns about “currency wars” as the policy of central banks printing cash to prop up weak economies has also had the added benefit of lowering the value of currencies (for more on this, refer to Currency Wars).  Currencies will tend to fluctuate depending on economic forecasts with weak growth linked to a low interest rate which puts off investors from holding cash in that currency. 

The new government in Japan has been quick to push its central bank into pumping out more cash.  On the other hand, Europe has been hamstrung by fears about inflation from the overly cautious Germans as well as brighter prospects for its economy now that the dark clouds of the Eurozone crisis seem to have passed.  So the improving situations in Europe along with its less aggressive monetary policy could saddle the Eurozone with a strong euro which could scupper the recovery.  The euro had held up reasonably well despite the turmoil as the currency remained necessary for trading with the large single market in Europe.  The perceived turnaround with regard to the fate of the euro has resulted in investors rushing in to buy bonds of Spain, Italy, and the like due to their higher interest rates. 

A further problem is the different competing view on what would be a suitable policy with regard to the euro.  On one side of the argument, the French president Francois Hollande has called for a managed exchange rate with a target for the exchange rate set by the European Central Bank.  France is averse to market reforms which would improve competitiveness so a weaker euro is an easier option.  Jens Weidmann who is the head of the Central Bank in Germany sits at the other end of the spectrum and argues against a weak euro as this will increase inflation (due to imports becoming more expensive).  The Germans have also been among those most vocally critical of the Japanese government influence over its central bank and its aims to reduce the value of the yen. 

Squeezed between the two powers (France and Germany) in Europe is Mario Draghi, the president of the head of the European Central Bank, who takes a more nuanced stance.  It is Draghi who has done the most to stabilize the situation in the Eurozone (see Whatever it takes) and has tried to instil confidence in the fate of Europe while stopping the euro getting stronger as a result.   Draghi came out with a statement earlier this month that it was not the role of the European Central Bank to dictate the value of the euro.  However, strengthening of the euro and any resulting inflation would require action.  This would involve interest rates being nudged up from their current low levels and the growth prospects in Europe would suffer as a result – hence stopping a possible rise in the euro in its tracks.

If Your Neighbourhood Economist was to bet money on the outcome of this tussle, it would bet on Draghi.  The ability of the European Central Bank to act without being restricted by what voters might think gives a reason for investors to listen to what Draghi has to say.  The policy of the European Central Bank to do “whatever it takes” has helped to save the Eurozone despite no action having been taken as yet and this shows how an intention to act by itself can influence the market forces.  It may take more than words and a splash of extra cash to keep Europe on track but the situation could be significantly worse considering the competing opinions in Europe.

Disappearance of the “Strong Dollar”

The demise of this phrase from the lexicon of politicians in the United States says a lot about the changing landscape of the global economy.

It is easy to notice when a new term pops up but harder to spot when a phrase falls out of use.  Adherence to the principle of a “strong dollar” was a cornerstone of government policy in the United States for generations but it is not something that is referred to by politicians anymore.  Your Neighbourhood Economist would argue that this change in thinking by politicians about the US dollar that has mostly gone unnoticed is part of a wider picture of the changing global position of the United States.

It may seem strange at a time when countries are vying with each other to weaken their currencies (for more, see Currency Wars), but not so long ago, politicians in the United States would pledge their support for the notion of a strong dollar.  But the origin of the strong dollar was from a previous era when the United States was the dominant global trading power.  Trade flows in the thirty years following the Second World War typically followed a certain pattern – rich, developed countries such as the United States would import agricultural products and raw materials for manufacturing while importing manufactured goods back to the poorer, less developed countries. 

Manufacturing at this time was limited to a small group of privileged countries that benefitted from economies of scale stemming from their large and wealthy domestic markets.  Most other countries were limited to importing materials which ended up being plentiful and cheap due to the large number of other countries having nothing else to offer in terms of trading.  So the United States was in an advantageous position of being one of a few that supplied crucial manufacturing products but having a wide choice of trading partners in other goods.  Its dominance was extenuated with many other manufacturing countries being decimated following the War. 

This central role of the United States in the global economy also extended to its currency and the US dollar was used in trading between different countries and as a means for any country to store its wealth.  The widespread popularity of the US dollar increased its value which put the United States in an even better position.  A strong currency helped businesses in the United States by making imports cheaper but was only helpful in so far that there was minimal competition regarding exports.  

While the United States remained on top for a few decades after World War II, it inevitably faced numerous challenges.  The oil embargos in the 1970s were a shock to the system but it was the rise of Japan as a manufacturing rival that signalled that the good times were coming to an end.  Companies in the United States had grown flabby and slow due to a lack of competition.  Focused and ambitious Japanese firms easily outperformed their US rivals in areas such as cars and consumer electronics.  The revival of business in the United States was facilitated in part due to an agreement in 1985 to revalue the Japanese yen at a higher value. 

However, the new competition from Japan was just a sign of things to come as other countries in Asia such as South Korea and Taiwan followed in the footsteps of Japan culminating in the re-emergence of the sleeping dragon, China.  The global economy was in the process of becoming increasingly interlinked due to lower costs for transport and communication and the resulting surge in imports into the United States devastated some local manufacturing industries.  Surviving businesses in the United States lobbied for support from the government through protectionist measures.  Yet, politicians maintained their belief in the benefits of a strong dollar with reiterations of this policy being repeated as recently as during the Bush Junior administration.

The United States government policy regarding its currency eventually caught up with the realities of the repositioning of the United States in the global pecking order.  Nowadays, the only mention relating to the US dollar by politicians is belligerent moaning about the perceived injustices stemming from a belief that China is manipulating its currency.  This is part of an increasing vocal backlash looking to stem the flood of goods from overseas and reflects the difficulties that businesses in the United States are having as globalization increases the number of rivals.  Slower economic growth and an increasingly high debt burden means that exporting is becoming more important as the United States economy has to work harder to generate growth.  This is one of the many challenges that are likely to lie ahead as the United States scrambles to hold onto its global crown.

Lessons to be learnt?

Will things be different the next time around?
 

Booms and busts are an inevitable but undesirable element of a capitalist economy.  The current slump in the global economy is a harsh reminder of what can happen after the good times end.  Recessions following financial crises are particularly severe as a loss in confidence in the banking system leads to the wheels of finance seizing up.  The current stagnation in the global economy and the resulting economic suffering would suggest the potential for the collective will to push to apply the lessons that have been learnt in the aftermath of the financial crisis.  However, what is plausible in theory may prove difficult to implement in practice when the economy is growing again and the recession seems far off.   

Favourable circumstances enable a quicker pace of economic growth and help to spur on investment in a range of new technological and business fields.  Yet amongst this, inefficient and nonviable companies will also prosper and increased competition for resources will push up prices for labour and materials which acts as a brake on growth.  The slowdown as part of the business cycle is necessary as it helps to weed out the weaker companies and free up resources for the stronger businesses. 

There seems to be links between the boom time and the recessions that follow – the excesses which are generated amid rapid economic expansions have to be purged before the economy can begin to grow again.  The length and pace of the economic growth can be interrelated to the scale of the problems that are created during the good times and these have to be dealt with before growth can resume.  Excessive lending both fuelled the surge in growth and also has hampered the economic recovery with both households and government weighed down by too much debt.  More restrained growth could in theory result in more temperate slowdowns.

Therefore, it would be preferable for the governments and central banks (who control fiscal and monetary policy) to be more aggressive in moderating periods of expansion so as to limit the extent to which problems can build up.  Your Neighbourhood Economist would argue that the Eurozone crisis, high unemployment, and weak growth is too much of a price to pay for the previous lending binge and that governments and central banks need to be more alert to excesses which amass during rapid economic growth.  An assortment of measures such as higher interest rates, lower government spending, and specific policies to lower borrowing need to be considered as the economy approaches the top of the business cycle.

Yet, politicians would loathe being the ones to turn off the party music and put an end to the economic good times by popping the balloons.  Voters could instead be easily persuaded to vote for a party who would permit a higher level of growth.  There is also the possibility of hubris – it was Gordon Brown, the chancellor of the government in the UK, who infamously claimed that his government had put an end to boom and bust.  Even the conservative types in central banks want to court controversy by limiting economic expansions.  Even Alan Greenspan who was revered during his stint as the head of the Federal Reserve in the United States believed that it was not the role of the central bank to pop a bubble but only to deal with the consequences afterwards.

The argument for moderating growth over the business cycle is easy to make when the economy is in the doldrums but the timing and policies required will be more difficult to judge and find support for when the economy is roaring.  This problem is made even trickier by what seems to be a form of collective amnesia that takes hold during the good times.  Rather than remembering back to the previous boom and bust, even the most brilliant of minds tend to get caught up in the euphoria.  There is also typically a story to back up why this time is different –whether it be the potential of the internet during the surge in popularity in tech stocks or the steady hand of central banks and new financial wizardry in the lead up to the current bust.  

So it remains to be seen whether the leaders across the globe will apply the lessons from the past five years and whether voters will enable them to do so.  History suggests not.  But perhaps an even more depressing thought is that, even if there is sufficient commitment to apply the lessons, high levels of debt in developed countries and better prospects for investment elsewhere may mean that a level of growth where the policies above are required may not be reached for a long time (if ever). 

The danger of positive thinking

With global stock markets in the midst of a major mood swing at the beginning of 2013, a new found optimism brings its own perils.

It is as if the market as a whole decided to focus on the positives as its New Year’s resolution.  Global stock markets have taken off in January 2013 as investors have shrugged off the worries that had weighed down on stock prices in 2012.  But while chronic pessimism has plagued markets over the past few years, the opposite has been the case in the New Year as stock prices have rebounded to levels which are tough to justify amid weak growth in the global economy.  So even though too much negativity has wreaked havoc in the markets, unfounded optimism can bring its own problems.

The prices of shares had been due for a rebound.  Investors had been on a knife edge with the potential for disaster seemingly around every corner as leaders in Europe dithered during the Eurozone crisis, politicians stepped up to the edge of the fiscal cliff in the United States, and the economy in China slowing during changes at the top of the Communist Party.  But along with Mayan predictions of the end of the world, all major catastrophes were averted in 2012 and this prompted a change of heart after investors returned from their holidays. 

Bonds are the typical haven for investors in times of woe and the past few years followed this pattern with investors having snapped up the bonds of prudent countries that have manageable debt levels even though interest rates have been below two percent.  Yet, bond prices have risen so high that further gains are not likely, but there were few other attractive investments at the time. And, as 2012 drew to a close, investors aching for higher returns had already shifted from the safer government bonds into the bonds of previously shunned countries such as Spain and Italy as well as corporate bonds. 

The new signs of life in the stock market tempted many into believing that the time was right to take on more risk and cash in their bonds to place a bet that improvements in the global economy would pick up pace in 2013.  This scenario has prompted talk of a “great rotation” as a swing in sentiment prompts investors into moving money from bonds in stocks.  The continued printing of money by central banks to shore up ailing economies has also helped to buoy the spirits of investors.  This all suggests an abundance of cash which will be heading into the stock market.  Yet, although it makes for a nice story to help prop up share prices, it may just turn out to be a fairy tale.

One of the main sticking points is that, while share prices have rebounded, the outlook for the global economy is still grim.  Higher share prices need to be backed up by companies generating larger profits and this cannot happen until the global economy has regained more vigour.  While an economic armageddon has seemingly been avoided in 2012, growth in the global economy will remain sluggish as high levels of government debt in many countries are trimmed back over years of austerity (for more details about Europe in this context, see Both Good and Bad News for Europe).  

Despite the holes in the story of the “great rotation”, many investors have been keen to believe in a new beginning.  Even the temptation of dubious scenarios can draw buyers back to the market due to concerns about being left behind if the market rebounds.  Investors also buy on expectations of what will happen in the future rather than based on the here and now so a dramatic improvement in economic growth in the following 12 months could prove that now is the right time to buy.  But with many having suffered heavy losses as share prices plummeted during the global financial crisis, a false dawn will do little to reassure investors that it is safe to return to the market.  An overly inflated stock market will also create a conundrum for central bankers and may prompt them to tighten up monetary policy while the economic recovery is still tenuous.  So here’s hoping that investors wake up from the pipe dream of soaring share prices before it turns into a nightmare.  

What’s up with inflation?

Inflation has been given a bad name but redemption may be at hand as high levels of debt mean developed economies could benefit from more inflation.

Inflation has been treated with the same disdain as smelly socks – an unfortunate factor of life that is tolerable at low levels but too much may be the sign of something more serious.  This stems from periods in history when inflation has wreaked havoc such as when hyperinflation in the 1930s in Germany resulted in prices skyrocketing to levels so high that Germans would go grocery shopping with a wheelbarrow full of cash.  Inflation eats away at the value of savings with higher prices meaning that the same amount of money can no longer buy as much.  But the flip side of this is that inflation also reduces the value of debt.  With the high level of debt among the most pressing concerns in many developed economies, inflation no longer seem so bad and there has been a shift in views that will affect anyone with savings or debt which is almost everyone.

The first signs of a change came from the Federal Reserve which has two goals as the central bank of the United States, low inflation and full employment.  A focus on clamping down on inflation had resulted in employment being less of a concern for the Federal Reserve, but as central banks everywhere have been asked to help out with sluggish economic growth, the Federal Reserve is paying closer attention to the job market in the United States.  In December, the Federal Reserve announced that it would keep interest rates close to zero until unemployment had fallen from its current level of 7.75% to 6.5% or until inflation was forecast to top 2.5% which is higher than the target rate of inflation of 2%.  A key role of any central bank is to signal its intentions so as to manage expectations for inflation and the Federal Reserve has shown that it will be more tolerant of inflation if that helps to lower unemployment.

More creative ideas on monetary policy are coming from the newly appointed governor of the Bank of England, Mark Carney.  Carney achieved almost rock star status after a successful spell (due to skill or good fortune) as the governor of Canada’s central bank and his ideas are raising eyebrows.  Carney put forward the idea that central banks should target nominal GDP instead of inflation.  Typical GDP figures are quoted with the effects of inflation taken out but nominal GDP includes both growth in the economy and rising prices.  This would enable central banks to accept more inflation when the economic growth is slow by setting interest rates to be lower (or monetary policy to be looser) than would otherwise be the case.  While this new policy may be a bit too radial for the conservative world of central bankers, it is a part of Carney’s belief that monetary policy can have more of a role in lifting the economy out of the current stagnation and that there are unconventional policies which could be implemented instead of monetary policy simply aiming for a certain level of inflation.

More inflation will also help governments with high levels of debt.  If prices rise at a faster rate, this will increase the size of the economy in nominal terms and the amount of debt will shrink relative to the economy making it easier to pay off.  And it is not only governments with lots of debt but many households who purchased property during the housing boom are struggling with large mortgages and they too should get some cheer from higher inflation for the same reason.  Inflation will also been a boost to businesses that will have more scope to raise prices and will be tempted to borrow more for investment if interest rates are lower than inflation (also referred to as negative real interest rates).  But inflation has always been the enemy of frugal types (including Your Neighbourhood Economists) who have put money away and savers will be the big losers.  While it is unfair to penalise the responsible, the burden of debt on governments and on the economy as a whole in developed countries is currently so great that calls for more tolerance of inflation should be heeded.  Inflation need not be so bad after all.