Last Wednesday, both the Bank of Japan (BOJ) and the Federal Reserve of the United States (FED) launched statements that in a way surprised the markets but in the end didn’t change much. Right now, most of the developed world’s central banks are implementing the so called Quantitative Easing program, which is basically the use of several strategies to reduce the cost of borrowing in order to fuel economic growth. There are two main tools right now, the first one is keeping the reference rate at which banks can borrow from the monetary authority very low in order to boost borrowing, investment and then growth. The second one is to buy government bonds (although corporate bonds have been bought in some cases) to further reduce the costs of borrowing of the entire economy.
But let’s go back to what happened on last Wednesday, first the BOJ announced a new twitch to their Quantitative Easing program, now they will be targeting the 10 year rate although they will maintain their annual quota of bond purchases. Across the pacific also appeared new phenomena, apparently the members of the Federal Reserve Open Market Committee (FOMC) are not agreeing as much as before on the long term expectations of the economy which could lead to a change of policy in the medium term. However, the message to the markets was clear, low rates are here to stay at least for a little longer and this was appreciated by the investors as the S&P 500 gained 1.75% after a rough week and the Nikkei 225 gained 1.91% after a month full on consecutive losses.
Nonetheless, is Quantitative Easing around the globe achieving what it is supposed to achieve? These efforts are embedded into a (theoretically) bigger policy of demand stimulation according to classical Keynesian economics. Basically, the idea is to sustain the demand of products and services in times of crisis by using government money. Off course this money has to come from somewhere and it cannot be taxation, this would only will deepen the crisis, therefore, it has to come from debt or reserves. The original Keynesian idea is very elegant in this respect, simply hold reserves in good times and when crisis starts use them together with debt if necessary to boost the demand and avoid the negative impacts on employment and productivity. It sounds very reasonable and it mimics what individuals are advised to do. Now, let’s examine the first part of the road map, save during good times, as of 2005 none of the biggest players of the world economy was saving in net terms, they were all borrowing. Yet, the rationale for this is simple, things were going well, borrowing to boost investment or social welfare will be covered with future growth as had been done for the last couple of years. Though, the Great Recession arrived and boosted debt levels (as there were no reserves) to a new high with China being the world’s creditor. Is true that this net debt levels have been improving (except for China, as the said phenomenon is reverting), but in general terms, the debt has only increased.
Ever since the financial crisis, debt has increased faster than GDP in all zones, even China; a special case is Japan which has risen to over 130% of GDP in debt. This increase has been sustained for over 8 years, a period which in accordance with economist should cover a whole economic cycle. Furthermore, the data for the last 11 economic cycles shows that around 15% of the duration of the economic cycle corresponds to contraction and the rest corresponds to expansion. Hence, even being generous and only counting 2009 as the period of contraction, a maximum of 7 years of expansion should follow.
However, many agree that conditions in these economies are far from desirable, even policy makers say that economic welfare is lower than in pre-crisis times. Then, why keep up with Quantitative Easing that is essentially a monetary policy tool? Well an acceptable answer would be that it is helping achieve central banks their main goal: price stability. Even in the case of the FED which has a double mandate, price stability remains a vital concern for the decisions of the board, yet there is no clear evidence that they are taking the course of action that would be best for this goal.
With the exception of Japan, all the regions saw an abrupt increase in inflation after the crisis, a phenomena that can be attributed (at least in part) to the Quantitative Easing. This would be in accordance to classical economic theory, a monetary stimulus will increase investment and accelerate inflation. However, after this initial period inflation has been decreasing albeit the monetary stimulus has continued, reaching pre-crisis levels and even going further down. Meanwhile, Japan was slowly getting out of the deflation that has been present there for the last two decades, and in 2014 even exceeded its 2% inflation target. Therefore, there are two possible conclusions for central banks at this point, either the inflation has reached again it’s natural pace and the stimulus can be retired or it has not achieved the desired behavior even with the stimulus in place. Furthermore, given the strength of the monetary stimulus (even coming to the bizarre territory of negative interest rates), there is little room to call for an even bigger stimulus on the rationale that the given one was not enough.
In any case, there is no evidence for keeping the stimulus, either it worked and price stability has been restored or it has not been useful and other measures are needed. In this point it comes the issue of employment, which is an explicit responsibility of the FED but is also tacitly targeted by the other central banks. With the exception of the Euro area, all regions have achieved pre-crisis unemployment levels or even lower in the case of Japan. However, there have been many criticisms to the unemployment measures as some analyst claim that the reason unemployment has fallen is that some people just stopped looking for a job because they feel is pointless. Leading again to the same dilemma, either the stimulus worked and unemployment is under control, or it has run for 7 years without improving employment opportunities for people.
However, despite all the evidence, policy makers are reluctant to eliminate the stimulus, because they are afraid that this could deepen the crisis even more. The precedent of this was the credit crunch that the FED used in the aftermath of the 1929 financial crisis. Many scholars and practitioners believe, including former FED chair Ben Bernanke, that this actually expanded the crisis to unnecessary levels. Their main point is that the US experienced downturns from 1929 until 1933 and again in 1937-1938, which is mainly attributed to the lack of financing due to the monetary policies of the FED at the time. And now, central bankers are afraid to make the same mistake yet again, and have extended the credit line for the economy to the maximum and essentially written a “blank check” for whatever is needed to borrow.
Still, there is one important issue for policy makers to consider, an issue that is too often overlooked, the long term effects of piling up debt. As a result of the prevailing conditions, the interest rates that governments have been paying for their debt is on rock bottom, yet for many of them especially for long term debt they are not that small (except for Japan). This means that the economic recovery not only has to maintain capital and resist inflation but it has to give the government enough funds to repay the interest on their debt. With a net debt change between 15% and 52% of GDP, even with low yields, the governments face a huge increase in debt service.
A clear example of these phenomena is the fact that in two occasions during his term in office, President Barak Obama’s administration was at risk of defaulting on its bonds due to a legal impediment of issuing more debt. One of these occasion even led to a government shutdown for several days. Albeit this was for internal issues regarding the Obamacare legislation, it shows how the US in particular has not been able to balance its budget between its obligation of social welfare and the cost of debt service.
Therefore, if the increase in debt implies a cost for future generations, there is no evidence that it should be maintained from the monetary policy point of view and the economic welfare has not picked up, why keep up with the Quantitative Easing? Well, the cruel answer is that economists around the globe are clueless about what to do next. According to Keynesian precepts, the course of action was correct and it should by now have restored the economy to balance and we should be expecting the next contraction as it has been 7 years of the crisis. But the reality is that economic welfare has not returned to pre-crisis levels, and this has materialized in the political arena in several points: the movements against austerity in all Europe, the exit from the United Kingdom from the European Union, the US 2016 presidential election and the anti-corruption war of Chinese president Xi Jinping.
Finally, there is a lot at stake in this discussion, and more than monetary policy tools and concerns are on the table. However, monetary authorities should come to realize that the time for their efforts (at least in a traditional sense) is over. Even if Quantitative Easing was the marvel that saved advanced economies from a worse recession or it has not been useful at all, its time should come to an end. New strategies have to be devised in order to cope up with the emerging economic conditions. Even Keynes knew that demand supporting policies were merely a contingent measure that could only fix cyclical variations as they have done successfully in the past decades, yet seven years is not a cyclical variation but a structural change. The next challenge for investors, policy makers and scholars will be to adapt to this new uncommon economic conditions and still manage to deliver value through the existent (or new) mechanisms.Lucas Buenahora firstname.lastname@example.org
Bond: Traded security that is analogous to a loan between the investor and the entity issuing the security. For more info click here.
Gross Domestic Product (GDP): Measure of economic welfare of a country counted as the value of all finished goods produced in a determined time frame. For more info click here.
Rate of Inflation: Rate at which the money loses purchasing power. For more info click here.
Yield: Rate of return or a fixed income security (typically a bond). For more info click here.
Keynesian Theory: Theory devised by John Maynard Keynes after the Great Depression that advocated for the intervention of government to guarantee economic growth by using monetary stimulus and investment to sustain aggregate demand. For more info click here.