Satyajit Das: Economies may be sick, but will the cure be worse than the illness?

Midweek View: Governments can no more control money than a gardener can control a hosepipe by grabbing the water
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The Independent Online

Politicians, central bankers and policy advisers share a belief that policy actions will ultimately boost demand and create sufficient inflation to bring the global economy's elevated debt levels under control and restore growth. The debate is about the "right" policy and political ideology.

The Keynesian cure entails government spending financed by taxation or borrowing to restore Mr Economy's health. There is no evidence it can arrest long-term declines in growth. Government spending boosts activity temporarily, but may create excess capacity in the absence of underlying demand. As tax revenues have fallen due to slower economic activity, governments have already borrowed to finance large budget deficits.

Government ability to borrow to finance spending is increasingly limited, without innovative monetary techniques. In recent years, the US Federal Reserve has purchased around 60-70 per cent of all US government debt issued. The European Central Bank now finances governments indirectly by lending to banks to purchase sovereign bonds.

The limits of governments' ability to borrow and spend are highlighted by the European debt crisis. Investors are increasingly concerned about public finances, reluctant to finance nations with high levels of debt or demanding high interest rates.

Having reduced interest rates to zero, central banks are changing the quantity of money available. They believe that they can keep rates low and print money to finance government debt purchases indefinitely.

But greater government spending, lower rates and increased supply of money may not boost economic activity. Crippled by high levels of debt, low house prices, uncertain employment prospects and stagnant income, households are reducing borrowing. For companies, the absence of demand means low interest rates are unlikely to encourage borrowing and investment.

Loose monetary policies may not create the hoped-for inflation, needed to lower real debt levels. Banking problems and lack of demand for credit mean the essential transmission mechanism is broken. Banks are not using the reserves created and money provided to increase lending. The reduction in the velocity of money or the rate of circulation has offset the increased money flows. The low velocity of money, the lack of demand and excess productive capacity in many industries means the inflation outlook in the near term remains subdued.

These policies also have serious side-effects. Low rates transfer wealth from investors to borrowers, with the lower coupon payment a disguised reduction of the loan. They provide an artificial subsidy to financial institutions, letting them borrow cheaply and then invest in higher-yielding safe assets.

Low rates discourage savings. They encourage mispricing of risk and feed asset bubbles, as well as speculative demand for commodities and alternative investments. Low interest rates have created massive unfunded pension liabilities.

In the long run, economies become dependent on low rates as high debt levels cannot be sustained at higher borrowing costs.Internationally, low interest rates distort currency values and encourage short-term capital flows as investors seek higher yields. Attempts by nations to increase their competitive position by weakening their currency also threaten tit-for-tat currency wars and trade restrictions.

The policy prescriptions provide symptomatic relief but do not address fundamental problems — high debt, lack of demand, declining employment, lack of income growth, the banking system.

Economic relationships are poorly understood and unstable. Does money supply influence nominal income or does nominal income affect velocity and the demand for and thereby the supply of money? The ability of governments and central banks to influence economic activity is overstated. As the economist Wynn Godley put it: "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".

Doing nothing is politically and socially impossible, but the treatments may do more harm than good. As French playwright Moliere noted: "More men die of their remedies than of their illnesses".

Satyajit Das is a former banker and author of 'Extreme Money' and 'Traders Guns & Money'