Satyajit Das Presents a Global Economy Health Check
Mr. Global Economy gets a metaphorical physical and psychological examination. Here are the results.
Having reduced interest rates to zero, central banks are giving Mr. Economy the modern monetarist prescription, changing the quantity of money available. Under quantitative easing, they buy government bonds, thus injecting money into the banking system to lower borrowing costs and increase the supply of money to stimulate demand and inflation. Central banks believe that they can keep rates low and print money to finance government debt purchases indefinitely.
But greater government spending, lower rates, and increased supply of money may not boost economic activity. Crippled by existing high levels of debt, low house prices, uncertain employment prospects, and stagnant income, households are reducing, not increasing, borrowing. For companies, the absence of demand and, in some cases, excess capacity means that low interest rates are unlikely to encourage borrowing and investment.
Loose monetary policies may not also create the hoped for inflation that is needed to lower real debt levels. Banking problems and the lack of demand for credit means that the essential transmission mechanism is broken. Banks are not using the reserves created and money provided to increase lending. The reduction in the velocity of money or the rate of circulation has offset the effect of increased money flows. The low velocity of money, the lack of demand, and excess productive capacity in many industries means the inflation outlook in the near term remains subdued.
The treatments being used have serious side effects. Low rates involve a transfer of wealth from investors to borrowers, with the lower coupon payment acting as a disguised reduction of the principal amount of the loan. They provide an artificial subsidy to financial institutions, allowing them to borrow cheaply and then invest in higher yielding safe assets such as governments bonds.
Low rates discourage savings, creating a disincentive for capital accumulation. They encourage mispricing of risk and feed asset bubbles, such as that for income (high dividend paying shares and high yield low grade debt) as well as speculative demand for commodities and alternative investments.
Low policy interest rates have created massive unfunded pension liabilities for governments and companies. In the US, S&P 1500 companies have aggregate pension deficits of US$543 billion, an increase $59 billion in the first half of 2012.
In the long run, economies become dependent on low rates as high debt levels cannot be sustained at higher borrowing costs.
Internationally, low interest rates distort currency values and also encourage volatile and destabilizing short term capital flows as investors search for higher yields. Attempts by nations to increase their competitive position by weakening their currency also threaten tit-for-tat currency wars, trade restrictions and barriers to investment flows.
The faith-healing cures provide symptomatic relief, but do not address fundamental problems such as the high debt levels, lack of demand, declining employment, lack of income growth, or the problems of the banking system. It is not clear how if at all any of the cures being pursued can create real ongoing growth and wealth to restore Mr. Economy's health.
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