photo: Nicolas Raymond
While the central bank and government policies have stabilised conditions, they have not restored growth or created sufficient inflation to address the world’s debt problems. As Helmuth von Moltke, a 19th century head of the Prussian army, observed: “No battle plan ever survives first contact with the enemy”.
Given that the bulk of recent growth was driven by debt fuelled consumption and investment, slower credit growth has predictably affected the level of economic activity. Slower population growth, lack of new markets with most nations integrated into the global trading system, slower rates of innovation, slower productivity improvement, an aging population in developed nations, declines in science education, the effect of climate change and decreasing return on investment in energy and food combined with the overhang of debt will limit growth for some time.
There is also little evidence of inflation, although asset prices have increased sharply in response to low interest rates.
From a policy perspective, inflation would assist in reducing debt levels by increasing nominal growth rates above the nominal interest rate. It would decrease purchasing power reducing the value of debt. Where the debt is held by foreign investors, it would reduce the value through depreciation of the currency. Inflation may also induce more consumption, as people accelerate purchases, anticipating higher prices in the future.
Policy makers fear deflation. General tax revenues would stagnate or even fall. Asset price falls would also reduce tax revenues. There would be an appreciation in the real value of debt. The high level of borrowing would be increasingly difficult to service, with serious consequences for the banking system.
The premise is that expanding money supply will create inflation as the monetary claims on real goods and services increases causing higher prices. In practice, the process is complex, with additional conditions needed to create inflation.
Central banks control the monetary base, a narrow measure of money supply made up of currency plus the reserves that commercial banks hold with the central bank. The relationship between the monetary base, credit creation, nominal income and economic activity is unstable. While the money supply has increased, the velocity of money has slowed.
The liquidity supplied is being held by banks as excess reserves with the central banks. Banks have not increased lending reflecting a lack of demand for credit and unwillingness to lend because of capital or other constraints. Reductions in permitted banking leverage, onerous liquidity controls and restrictions on risk transfer processes, such securitisation and derivatives, also affect the circulation of funds. The reduced velocity of money offsets the effect of increased money flows.
Inflation also requires an imbalance between demand and supply. Most developed economies have a significant “output gap” ranging from 2% to 8% (the amount by which the economy’s potential to produce goods exceeds total demand), though the extent is uncertain due to drops in participation in the labour force which may have reduced capacity. The gap reflects lower demand but also excess capacity. In many industries, such as automobiles, national and political considerations have meant maintenance of uneconomic operations. This translates into a lack of pricing power and low price inflation.
Economist Wynn Godley may have been correct when he observed that: “Governments can no more control stocks of either bank money or cash than a gardener can control the direction of a hosepipe by grabbing at the water jet”.
While ineffective in achieving its targeted outcomes, current policies have toxic by-products.
Expansionary fiscal policies have left many countries with large levels of sovereign debt. While there is debate about the sustainable level of government borrowing, there is agreement that high debt levels may adversely affect growth.
High levels of government debt also reduce flexibility and increase the risk of financial distress. The rapid build-up of government debt following the events of 2007/ 2008 now restricts the ability of many governments to respond to new crises.
ZIRP and QE distort normal economic activity.
Low interest rates reduce the income of retirees living off their savings, decreasing demand. Low rates perversely reduce consumption and increase savings as lower returns force people to set aside larger amounts for future needs.
Low rates artificially lower the cost of capital, favouring the substitution of labour for capital goods in the production process. Reduced employment which results in reduced income and consumption ultimately decreases economic activity.
CitiGroup equity strategist Robert Buckland argues that low rates and QE actually reduce employment and economic activity, rather than increasing them. These policies encourage a shift from bonds into equities. But as investors are looking for income rather than capital growth from shares, they force companies to increase dividends and undertake share buybacks.
To meet these pressures, companies boost cash flow and earnings by shedding workers and reducing investment to cut costs. This increases unemployment and reduces consumption, but increases equity prices. Low rates increase unfunded liabilities of defined benefits pension funds. These shortfalls ultimately retard growth as sponsors must divert earnings to meet these future liabilities.
Low rates ‘zombie-fy’ the economy. Low rates allow weak businesses to survive, directing cash flow to cover interest on loans which can never be repaid but which banks cannot afford to write off. This ties up capital and reduces lending to productive enterprises, especially SMEs which account for a large portion of economic activity and employment. Firms do not dispose of or restructure underproductive investments. The creative destruction and re-allocation of resources necessary to restore the economy’s growth potential does not occur.
Low rates distort investment, encouraging excessive risk taking in search of higher returns. Risk premiums have fallen sharply to uneconomic levels in equities, dividend paying stocks, corporate debt, high yield bonds, structured securities and other risky assets.
The rush to re-risk has reduced general lending standards. Practices that contributed to the global financial crisis, such as reduced lending standards have re-emerged, driven by investors seeking additional return. Covenant lite loans, with low protection for lenders, are driving a resurgence of private equity activity. Borrowing to pay dividends to investors in private equity transactions has also risen. Even sub-prime loans and securitisations, in automobiles and commercial real estate, have re-commenced. These risks are compounded by the continued high levels of leverage in financial institution.
Many stock markets in developed countries, led by the US, recovered to their pre-crisis levels. The celebrations ignored the basis of the recovery, which was the excess liquidity that had been injected into the global economy by central banks.
The low rates, mispricing of risk and excessive debt levels that were the causes of the crisis are now considered the ‘solution’. It is reminiscent of the observation of Viennese critic Karl Krause about psychiatry: “the disease which masquerades as the cure”.
© 2016 Satyajit Das