The Federal Reserve Board’s decision to implement a rise in interest rates this month is widely expected. However, this is only the second time in 8 years that this has occurred, the first 0.25% in December of 2015 and, as seems likely, 0.25% one year later. This is hardly tight monetary policy; 50 basis points in 8 years is largely symbolic, although, having said this, the January 2015 hike did cause quite a kerfuffle in the markets.
The Fed’s monetary incontinence has been replicated by central banks around the world in their attempts to deal with the bust of 2008, and the sluggish growth since that time. Monetary policy (to be distinguished from fiscal policy) has been used to counter deflationary trends and act as a prop to stave off complete economic/financial collapse. The policies involve several guidelines which include control of interest rates, bank reserve ratios, and Quantitative Easing (QE). The theory and practice of QE is not new. Once called Open Market Operations it involves the Central Bank – in this instance the US Federal Reserve Board, or, the ‘Fed’ – buying US Treasury Bills (government debt instruments) from various investors. From there the new money finds its way – it is hoped – into the American banking and credit system and further on to new investors. The policy is designed to increase liquidity putting more money into circulation and thus boosting aggregate demand; this in turn is supposed to increase growth and lead to a lowering of unemployment. So much for the theory.
In practice, however, things haven’t quite worked out as planned. Prior to QE, the Fed engaged in an aggressive policy of lowering short-term nominal interest rates; still the policy. These now stand at 0.25%, and in the UK, at 0.5%. This did not, however, have the desired outcome; so, enter QE. The first round (QE1) saw an injection into the US economy of US$1.75 trillion. This led to a recovery (of sorts) which started in the first quarter of 2009 and reached the giddy heights of 6% GDP growth in January of 2010. Since then, however, diminishing returns have set in and growth has declined significantly since those heady times: averaging an annual GDP growth rate from 2008-2015 of 1.3%. These anemic figures are not what a ‘recovery’ should look like.
The last QE injection – QE3 – took place in 2012, and the programme was officially closed in 2014. During this period the Fed expanded its balance sheet of ‘assets’ (should those toxic debts purchased as part of the Troubled Asset Programme TARP be regarded as ‘assets’ one wonders?) from $870 billion in 2008 to $4.5 trillion by 2014. And the effect on unemployment? Per the headline figures US unemployment fell from 9.9% in 2009 to a present low of 4.9%., However, to make any significant impact on unemployment a growth rate of more than 3% would have been required. Moreover, the figures for the labour participation rate have fallen concurrently with unemployment from 66.2% in 2007 to 62.8% now. We are asked to believe that both employment and unemployment fell at the same time as each other. Swallowing this piece of nonsense would take some Jesuitical reasoning, or Orwellian double-think! Thus, this unprecedented peace-time rise in liquidity, notwithstanding, all that has been achieved is, at best, a jobless recovery or growth recession, the emergence of asset price bubbles in property, stocks and bonds, and a huge increase in US government debts and unfunded liabilities to unpayable levels.
One of the reasons for the failure of orthodox monetary policy has been the inability on the part of the monetary authorities to recognise that in depression conditions (i.e., the current situation) as opposed to bog-standard post WW2 recessions; making more money available will not in itself lead to increased consumer spending and businesses investment; this is because of the high levels of both personal and household debt, as well as excess capacity in industry. Thus, despite the Central Banks’ attempts, both in the US and UK, to kick-start the economy by injecting further liquidity, such liquidity is simply piling up in the vaults of retail banks simply because consumers are paying down their debts, rather than spending, and businesses are putting investment decisions on hold due to market uncertainty and the existence of spare capacity in their businesses. Similarly, the retail banks, having had their fingers burnt when their mortgage derivatives turned overnight into toxic debt, are more interested in rebuilding their balance sheets than lending. Such lending that does take place – particularly mortgage lending – is now subject to very strict lending criteria. Increasing the money supply in this situation, is, as Keynes once said, like pushing on a piece of string. This is what is referred to in the economics jargon as the “liquidity trap” a situation where no amount of loose monetary policy has any impact on the level of demand in the economy. Retail banks are simply hoarding and profit seeking, mobile capital, is looking at more profitable climes abroad or speculation. This brings us to the second point.
Although the evidence for liquidity injections into the economy designed to bring about increased rates of growth and a fall unemployment were, to say the least, tenuous, this hasn’t stopped the monetary authorities from pursuing this strategy. Ah, if only wealth could be created ex nihilo, a bit like the big bang theory, something out of nothing. However, given that there are always opportunity costs in the world of economics, this policy has a very dangerous downside. Other things being equal, such a policy will almost certainly bring about a rise in the general level of inflation. Fortunately, this did not happen since these liquidity injections did not find their way into the real economy and money aggregates – M4 – contracted during the QE period. The monies were simply hoarded or used for speculative asset purchases. That would be bad enough in itself. But we should remember that the US$ is the global reserve currency and most central banks around the world hold most (60%) of their foreign reserves in US$s. This being the case US$ inflation would become global inflation. Additionally, given that excess dollars on global markets will lead to a devaluation of that currency, this will mean that all other currencies will be effectively re-valued which will give the US a competitive trade advantage. Now who is the currency manipulator?
Moreover, the surplus dollars with no investment outlets in the US will seek out investment opportunities which give the greatest return. These optimal investment opportunities will be found in the emerging economies of the BRICs. Brazil, Russia, India and particularly China with its massive infrastructure projects in central Asia and beyond, a 21st century Silk Road. But the influx of hot monies into these economies will drive up local currencies as well as equity and property markets causing multiple asset bubbles which would eventually burst as the hot money, after profit taking, promptly departs. This could be a re-run of the 1997/8 Asian crisis where hot money inflows inflicted severe damage on the then emerging economies of Thailand, South Korea, the Philippines and Indonesia.
As far as the rest of the world was concerned the US has declared a currency war on them. Now, retaliatory measures – control of capital inflows, competitive devaluations – are beginning to take shape. Non-Anglosphere nations increasing resent the extraordinary power enjoyed by the US through the position of the $ as the global reserve currency, central to international finance, trade and payments. This is to be expected in straitened economic times, notwithstanding all the pious platitudes about the need to avoid protectionism.
For their part the Americans argued that its huge deficits on current account have been caused by China pegging its currency to the US$ and thus trading with an undervalued currency. This seemingly reasonable argument would stand up if the fact that the USA runs a trade deficit with nearly all its trade partners is conveniently ignored. In this respect the UK is very similar. If a nation chooses to de-industrialise, allows its industry to be hollowed-out, allows foreign takeovers of its manufacturing base, allows its domestic industries to offshore (invest productive manufacturing abroad) and generally is content to see its export earning companies wither, as its economy becomes increasingly dependent on house price bubbles, financial services and the construction industry, while at the same time allowing an ultra-loose monetary policy, whereby banks offered limitless credit, which then resulted in increasing import penetration, then it can hardly complain about trade imbalances.
Being of a rather cynical disposition I would contend that the Fed’s policy is one of a deliberate attempt to initiate inflation (or debt monetization in the economics jargon). Not so much QE as Weimar MK2 to erode the mountains of debt which have piled up around the world. Inflation is, after all, just devaluation by the back door. In this way governments are rescued from their fiduciary commitments whilst savers, creditors, wage-earners, pensioners are shafted. Of course, this can never be openly admitted but this is nonetheless the policy which is being implemented. Better hope the bond markets don’t get a whiff of what is going on or they will certainly dump any inflated currencies thereby pushing up long-term interest rates. Then the world will go the way of Ireland and Greece. However, the attempt to stoke up inflationary pressures from central banks around the world is coming up against the immovable object of global deflation as prices fall due to lack of demand and excess capacity. This being the case a stalemate exists as the tectonic plates of inflation and deflation push against each other.
Little wonder the rest of the world regards US monetary policy as the beginning of an open trade and currency war. China, for example, with its massive holdings of US dollar denominated assets (US Treasury Bills) estimated at US$ 2.5 trillion, will take a huge hit as the value of these debt instruments is eroded. An induced inflation will also hit ordinary Americans as they see the value of their earnings and savings deteriorate. What inflation will do is pump up asset prices to unrealistic levels – this, it is hoped, will result in a “feel-good” factor which will encourage people to go out and spend. So there could be a short lived inflationary boom as stock markets go into euphoria mode as the inflation artificially lifts their asset values. Of course, it will be no more successful than the last ‘boom-cum-bubble’ Worse in fact since several nations are now in fact insolvent.
So, in policy terms we are back to square one: a policy debt-fueled, asset-price inflation. The very policy which got the world into this mess in the first place. These people are like the Bourbons: Forgotten nothing, learnt nothing.
In the coming period, it seems almost inevitable that globalization will no longer be able to survive in its present form. The forces of protectionism will become (have become) irresistible as each nation will endeavour to protect its interests as it sees them. Of course, the forces of globalization will push back. But this crisis has been brewing since the breakdown of the Bretton Woods dollar-gold based trading system and is now in an advanced stage.