Caught in a Trap

Stock prices moved sharply higher during the summer months, as investors speculated that further central bank action might just return the economies of the industrialised world to a more familiar growth-setting in the not too distant future.  The world’s leading monetary policymakers from the Bank of England, the Bank of Japan, the European Central Bank, and the US Federal Reserve, duly delivered on cue, but the notion that the latest round of unconventional measures will do anything more than maintain economic growth not too far below trend, is misguided and virtually certain to disappoint.

Investors continue to cling to their misguided beliefs, even though almost four years of ultra-accommodative monetary policies have already failed to deliver anything like a typical economic recovery in the developed world, and the lacklustre activity in the US has prompted the Federal Reserve to commit to a near-zero interest rate policy through mid-2015 – nearly a full seven years after the global financial crisis reached its climax during the latter months of 2008.

Real economic activity remains below its pre-recession peak throughout most of the developed world despite the extraordinary monetary stimulus provided in recent years, and the reason is clear.  Monetary policy loses its potency in the face of a deep and protracted deleveraging; it can do little but soften the blow, and buy time until balance sheets have been repaired, such that credit expansion can proceed anew.

Milton Friedman, the Nobel Prize-winning monetary economist, warned the American Economic Association, in his 1968 Presidential address, not to expect too much of monetary policy.  Investors need to wake-up and appreciate that the late-economist’s words of caution are particularly true of the developed world today, where most economies are caught in a liquidity trap.

A liquidity trap occurs when the implosion of a joint asset and credit bubble severely harms private sector balance sheets, and leads to a pronounced and prolonged deleveraging that renders conventional monetary policy ineffective.  To quote the late American President, Dwight D. Eisenhower, “Pull the string and it will follow you everywhere. Push it, and it will go nowhere at all.”

Central banks may reduce policy rates to zero, attempt to engineer higher inflation expectations that lead to negative real rates, and manipulate asset prices through quantitative easing measures, but the impact on growth will remain muted, so long as the private sector’s borrowing capacity remains impaired.

The inability to stimulate domestic demand may prompt the monetary authority to resort to the last policy tool – the exchange rate – and attempt to engineer a currency depreciation that prompts a sufficient increase in exports vis-à-vis imports that offsets the weakness in domestic demand arising from the desired increase in private-sector savings relative to investment.  However, a competitive devaluation’s ability to replace demand lost to deleveraging depends not only upon the size of an economy’s exports and imports relative to GDP, but also upon the strength of import demand among its trading partners.

The economic reality suggests that the export sector is not sufficiently large across the majority of industrialised countries to make a meaningful difference, while the dependence of many economies upon the consumer means that higher import costs could depress domestic demand even further.  More importantly, most of the developed world is caught in a liquidity trap, which means that ‘beggar-thy-neighbour’ policies are simply not an option.

With no more tools in the central banker’s toolbox, governments have little option but to run large fiscal deficits and fill the demand gap – even though public-sector debt ratios have already climbed to levels that have been shown empirically to retard growth.  In this regard, central banks need to compromise their hard-won independence by allowing monetary policy to become subservient to fiscal policy in an effort to get the industrialised world growing again.

Financial markets have become used to the tactics employed by the most credible central banks in their efforts to dictate fiscal policy and defeat the inflation demon through the 1980s and 1990s.  Indeed, former Fed Chairman, Paul Volcker, forced President Ronald Reagan’s hand by setting real interest rates above the economy’s real growth rate, which put the fiscal position on an unsustainable path.  The battle was won by the central banker, which underlined the Federal Reserve’s independence as we know it today.

Investors need to appreciate however, that changed circumstances call for different rules.  In the presence of a liquidity trap and the resulting deflation risk, central banks need to set interest rates well below the economy’s growth rate in order to keep public-sector debt ratios in check, while governments exploit the favourable borrowing costs and engage in well-planned fiscal stimulus.

Investors continue to look to central banks for solutions to the developed world’s economic travails, but most of the developed world is caught in a liquidity trap, which has rendered monetary policy ineffective.  Premature fiscal austerity will only prolong the economic misery.


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