Monday, July 08, 2013

Debt shuffling puts us in danger

The public policy dysfunction in the Western world since 2008 has not been restricted to persistent budget deficits, escalating public sector debts and anti-growth regulations.

Central banking practices in response to and following the global financial crisis, particularly in the US, Europe and Japan, have featured unconventional and extremely risky monetary policies.

The monetary policy exotica pursued in much of the West have largely come in two forms, under the seemingly innocuous acronyms of ZIRP and QE.

ZIRP, or zero interest rate policy, has been enthusiastically adopted by many central bankers, with short-term interest rates ranging from zero for the Canadian, Japanese and Swiss central banks to 0.5 per cent in the eurozone and Britain.

With official rates affecting the determination of interest rates by financial institutions, and against growth in prices hovering at about 2 per cent across the advanced economies, real interest rates in many large economies are negative.

The second strange monetary policy beast to be set loose has been QE, or quantitative easing, increasing liquidity in the financial sector with the intent to again encourage economic activities in the private sector.

QE entails central banks purchasing assets, chiefly longer-term government bonds and risky mortgage-backed securities, from financial institutions, giving them greater liquidity in exchange.

QE has been portrayed as a process of central banks effectively printing money to buy up financial assets at a rapid rate.

This policy has been adopted most vigorously by central banks in the OECD, especially the US Federal Reserve with its multiple QE forays, but the practice is widespread, with the Bank for International Settlements recently reporting that global central bank assets have doubled to $20 trillion since late 2007.

Economic debate on the likely effects of ZIRP and QE on price inflation has often been cast against the background of Milton Friedman's famous statement that ''inflation is always and everywhere a monetary phenomenon''.  Most critics of the Friedman position point to relatively well-behaved consumer price indexes as evidence of the benign effects of unconventional monetary policies on price levels.

But prices for certain assets, commodities and equities have rocketed in recent years, which to some extent may be influenced by the desire of investors to seek greater returns than those from financial deposits affected by ultra-low interest rates.

It is notable that the recent announcement by Federal Reserve chairman Ben Bernanke of his intention to wind back the QE policy led to a two-day freefall in the share markets.

Despite central banks flushing the financial sector with additional cash, lenders have been reluctant to lend, and borrowers to borrow, in slow-growing economies.  Nonetheless, the fear among some economists remains that once widespread confidence returns, excess reserves will be unleashed, sparking new rounds of price inflation eventually affecting consumers.

The effects of unconventional monetary policies on the real economy should not be ignored, since the ZIRP and QE experiments may unwittingly sow the seeds of the economic downturns to come.

Artificially low interest rates discourage the savings needed to fuel future investment, and induce price inflation as credit creation outstrips the growth in productive output.  In addition, artificially low rates make long-term investments relatively more attractive than short term investments, with the risk of fomenting an unsustainable capital boom.

Whether intentionally or not, unconventional monetary policies have raised questions about central bank independence, particularly during periods when the relationship between fiscal and monetary policy authorities turns from arm's length to knuckle length.

There can be little doubt a major beneficiary of the ZIRP and QE policies has been the overspending and heavily indebted Western governments, since the central banks have assumed a mass of cheaper government securities onto their heftier balance sheets.

Governments have dragged their heels on fiscal consolidation and deregulation as the central bankers continue to bail out unsustainable fiscal positions.

It will be interesting to see if or how central bankers resist the political complaints about the rising interest costs of public debt as interest rates eventually rise, as they must.

The Reserve Bank of Australia has sidestepped the worst of the monetary policy misadventure afflicting the rest of the Western world, although recent interest rate reductions are of concern from the perspective of avoiding overly low rates.

Australia is not immune from the global economic threats of future price rises, the erosion in global savings, and the growing drag of excessive public expenditure and indebtedness.

No comments: