Stephen King: The magicians of monetarism have very few tricks left up their sleeves
Developed economies are ending up with economic permafrost, where attempts to kick-start growth bump into economic reality
Monday 29 August 2011
Somehow, investors have got it into their heads that the world is run by magicians always capable of pulling rabbits out of hats. Last week was a case in point. Ben Bernanke, the chairman of the US Federal Reserve, gave a speech at Jackson Hole, Wyoming, at the annual shindig of central bankers, academics and assorted policy wonks. Would he wave his magic wand? Did he have a few tricks up his sleeve? Would the world's economic problems come to an abrupt end?
As it turned out, Mr Bernanke promised little, announcing only that there would be an extra day set aside at the next scheduled meeting of the Federal Open Market Committee (FOMC) in September to discuss further policy options. Big deal. Still, it was enough to get investors excited again. A two-day meeting? What could be going on in the Federal Reserve monetary laboratory? Was there financial alchemy at work? Had the FOMC hired Harry Potter to help conjure up some new economic spells?
We already have a pretty good idea of what is left in the monetary locker. The Federal Reserve could decide to buy bonds at longer-dated maturities that tend to have a more direct influence on the cost of borrowing for households and companies, thus widening the Fed's direct influence over the broader economy. It could buy up a range of less liquid assets such as property or equities (subject to a change in the law). It could choose to buy not just domestic IOUs but also foreign IOUs in a bid to steer the dollar down to a lower level (although what Congress would make of a Federal Reserve hell-bent on building up holdings of Greek or Portuguese government debt is anybody's guess).
It could even decide to print more money and give the newly-created notes to the government to allow a "monetised" tax cut, turning the Fed chairman into "Helicopter Ben" (a policy which sounds great in theory but, as the experiences of Weimar, post-war Hungary and, more recently, Zimbabwe suggest, may not be quite so clever in practice).
And ... well, that's about it. In the world of monetary economics, we're getting to the end of the line. Investors hope and pray for a bit of central-bank alchemy because they know that, otherwise, life could become jolly uncomfortable. Yet this view is remarkably myopic. It's true that, following the Fed's decision to adopt a further round of quantitative easing last year – so-called QE2 – markets rallied and, for a while, investors made hay. But, aside from a short-run shift in the ownership of assets (if yields on risk-free assets are pushed down to artificially low levels, riskier assets become relatively more attractive), it's a lot more difficult to argue that there has been any kind of follow-through in terms of economic recovery. Indeed, consensus growth forecasts have tumbled this year, reflecting both disappointing outcomes and mounting recessionary fears. Markets have, as a result, sold off.
Even worse, unconventional policies have led to unexpected effects which may simply mean that central bankers are nothing like as powerful or influential as they'd sometimes like to think. In his Jackson Hole speech, Mr Bernanke talked about the "temporary" effect of the run-up in commodity prices earlier in the year as if this was something completely unrelated to the monetary policies pursued by the Federal Reserve and other developed-world central banks. Yet, arguably, rising commodity prices were both a result of excessive monetary stimulus and a cause of the more recent slowdown in economic activity.
The effects of the Fed's monetary decisions spread far and wide. Other nations loosely tie their currencies to the US dollar reflecting both its role as the world's reserve currency and the Fed's reputation – mostly earned following the tough monetary medicine dispensed by Paul Volcker in the 1980s – as a guardian of price stability. Many of those nations, however, are not going through the financial traumas which have beset the US. American households may be frantically deleveraging and Washington may have got itself tied up in fiscal knots, but other countries have responded to low US interest rates and unconventional monetary policies with considerably more vigour. Most of these nations are to be found in the emerging world. Emerging nations are, by definition, at a different stage of economic development compared with the US and much of Europe. Their growth tends to be a lot more commodity-intensive. Any monetary action which puts a bit of rocket fuel into emerging-market growth engines is likely to lead to higher demand for commodities. Raw materials prices then rise and the rest of us find our fuel and food bills heading higher.
This process explains some apparent oddities regarding the economic situation in the US, the UK and other developed nations. The level of economic activity is remarkably depressed. The accompanying table shows that, among the G7 nations, only Canada currently enjoys a level of gross domestic product (GDP) above the early-2008 pre-crisis peak. All other nations have lower GDP, in some cases considerably so. Things look even worse if actual levels of activity today are compared with expected levels as gauged by consensus forecasts made in 2008 before the financial crisis. GDP is at least 5 per cent lower than expected and, in some cases, more than 10 per cent lower.
Given the scale of the financial crisis, none of this may seem particularly surprising. What is odd, however, is the persistence of inflation. Economists tend to think about inflationary pressures in relation to the amount of spare capacity in an economy, as measured by the so-called "output gap". Given the contraction in activity in recent years, inflation has proved to be remarkably sticky. Yet it's difficult to come up with any obvious "domestic" explanation for this stickiness. Money supply growth is incredibly weak and wage growth is non-existent. The usual suspects are very well behaved.
Instead, inflation is elevated because commodity prices have been rising. And those increases have simultaneously squeezed spending power in the Western world. If prices rise but wages don't follow, people are genuinely worse off. And, with excessive levels of debt, they're not going to borrow any more to offset the hit to real incomes. Instead, we end up with economic "permafrost", a world in which attempts to kick-start economic growth raise hopes but ultimately bump into a chilly economic reality.
Central bankers, then, are sometimes more like magicians than we'd ever like to believe. They are great at providing us with entertaining illusions but, when things go badly wrong, those illusions are revealed for what they really are: we are deceived for a short while into believing that economic recovery is underway but, eventually, we realise that much of what we've seen is no more than smoke and mirrors.
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