Download The perils of extended expansionary monetary policy: What did we

The perils of extended expansionary monetary policy:
What did we learn?
by
Richard Preschern*
and
Friedrich Schneider**
February 2016 *Richard Preschern Co-­‐Founder & Chief Risk Officer, FX Vision AG, Poststrasse 24, 6301 Zug, Switzerland http://www.fxvision.ch [email protected] phone: +41 (0)78 620 25 50 **Prof. Dr. Friedrich Schneider Department of Economics, Johannes Kepler University, Altenberger Strasse 69, A-­‐4040 Linz -­‐ Auhof, Austria www.econ.jku.at [email protected] phone: +43/732 2468-­‐7340 1
The perils of extended expansionary monetary policy: What did we learn? 1. Introduction Eight years have passed since the great recession of 2008 started with the downfall of Bear Stearns. As a response to the global financial shock, central banks initiated their zero interest rate policy(Fig.1) also known as ZIRP. Furthermore, large expansionary monetary programs titled as “Quantitative Easing” were implemented to reignite economic growth. As intended, the world economy was saved and nurtured back to stability if not slow growth. In addition to monetary policy, expansionary fiscal policy was initially employed in a Keynesian manner in order to create economic activity on the demand side. It is safe to say that quick policy response to the crisis was successful. Fig.1: Effective Federal Funds Rate 2006-­‐2016 Source: Federal Reserve Bank of St. Louis, 2016 *1
However, as the world enters 2016 we find ourselves in a markedly fragile yet altogether different state of global stability once again. China’s economy is clearly slowing, emerging markets are reeling from the significant fall in commodity prices and the western world is at best described as stable in America but at worst, frail as can be observed in France. In fact, global and western economic powerhouse, the United States of America, is by objective measures nowhere near a healthy economy today. For example, both federal and student debt have exploded since the last recession(Fig.2). 2
Fig.2: Total US-­‐ Federal Public Debt, Total US-­‐ Federal student loans Source: Federal Reserve Bank of St. Louis, 2016 *2
In addition, rising debt has been accompanied by significantly falling family incomes and a worrying jump in federal “food stamp” assistance(Fig.3). Fig.3: US real median household income, total supplemental nutrition assistance program Federal Reserve Bank of St. Louis, 2016 *3 3
From the viewpoint of an active financial market participant we find that the current monetary and fiscal policies’ effectiveness has waned if not become counterproductive to grow the global economy. Financial markets appear out of sync with the economy and hint at massive “adjustments” in the not too distant future as we will outline in this piece. Our focus here is to point out the current perils of extending QE and ZIRP beyond the immediate recession at the end of the past decade. In chapter 2, we will try to highlight how loose monetary policy, primarily directed at governments and financial institutions in conjunction with fiscal austerity in its current form in large parts of Europe lead to deflation rather than inflation. Chapter 3 is a focus on the composition of GDP assessment as well as policy effect on overall GDP growth. In chapter 4, we evaluate and challenge the idea that rising interest rates are coupled with falling (asset) prices. Then, in chapter 5 we explore the necessity to combine fiscal and monetary policy effectively before outlining actual fiscal policy suggestions in chapter 6. Thereafter, in chapter 7, we take a closer look at current monetary policy including policy recommendations. In chapter 8, we outline a fiscal and monetary policy combination that, in our view, will be conducive to real economic growth reflected by healthy financial markets. Finally, chapter 9 is a summary statement regarding the status quo of fiscal and monetary policy and followed by a personal assessment of and for the future envisioned. 2. Deflation/ Monetary Velocity: What happened? One of the stated goals of expansionary monetary policy is to avoid deflation and target a certain inflation rate. It is accepted and applied economic theory that low interest rates as well as quantitative easing are effective tools to create a benevolent increase in prices. In reality, we currently find ourselves in a disinflationary, if not deflationary situation in the industrialized world. One of the primary reasons for this undesirable situation is monetary velocity. As you can see below(Fig.4), monetary velocity in the western world is currently at record lows, meaning that expansionary monetary policy has not led to increased economic activity which in turn would raise inflation to the level desired by central banks. 4
Fig.4: Monetary velocity of M2 US$ Money Stock, total M2 US$ money stock Federal Reserve Bank of St. Louis, 2016 *4 In our view, the main reason for this conundrum lies in the fact that the primary beneficiaries of QE happen to be governments and financial institutions with troubled balance sheets rather than those entities that create growth in the real economy through added productivity, e.g. entrepreneurs, small business, research, educational facilities/stimulus etc. It is unrealistic to assume that conventional government spending beyond infrastructure is capable of increasing overall growth of an economy in the long run. Furthermore, one cannot expect financial institutions to take on capital risk at near zero rates especially when their balance sheets are still heavily exposed to considerable credit risks and are in process of being repaired. It would be utterly imprudent to lend at, say 3% p.a., to a young entrepreneur in order to start a new business, thus little to no credit is available for small and new businesses at any rate. Consequentially, job creation is painfully low and we observe youth unemployment in Europe anywhere from 10-­‐60% which not only results in lasting adverse economic effects but social ones as well. On the flip side, many credit worthy potential investors are unwilling to borrow at any rate due to high taxation as well as regulatory burdens in a stagnant economy that may not be fertile ground for growth. 3. GDP composition and growth: A closer look. Did we have enough growth? One main reason quantitative easing and zero interest rate policy were implemented in recent years was to encourage GDP growth. Lending at low rates should spur investment. Expanded government projects were created with the intention to raise employment in the public sector and improve 5
infrastructure, thus result in higher consumption and productivity. Finally, expansionary monetary policy ought to cause a depreciated domestic currency, thereby increasing the trade surplus, NX. In economics, we find the common equation used for calculating GDP as: GDP = C + I + G + NX. While in theory all inputs of the model are accounted for, in reality we find several issues with using monetary policy to increase GDP besides the problem of the current recipients/beneficiaries of policy as previously explained. G, or government spending is certainly increased through QE and ZIRP, however, it is also accounted for twice in the equation, therefore overstating GDP as reported. In effect, when government spends new funds received from the central bank in order to hire government employees, this money spent is accounted for in G but also in C or I as the new employee will either consume or save/invest his salary. As a result, we constantly see stagnant or slowly increasing GDP figures(Fig.5) while in reality GDP growth is certainly lower if not negative. In addition, ZIRP leads to zero return on savings, which in turn lowers consumption and investment while jeopardizing the viability of numerous pension funds globally. Finally, we would like to add a comment regarding NX, the trade balance. Lowering a domestic currency in the short run clearly increases an economy’s competitiveness but if all countries follow the same path, this policy cannot achieve its desired effect as a race to the bottom, i.e. currency war ensues. Fig.5: Real GDP in Europe Source: European Economic Snapshot, 2015 *5 6
4. Asset prices, Quantitative Easing and Zero Interest Rate Policy: Where are we in terms of valuation? What does history suggest the future holds? It is commonly expected that low interest rates and monetary stimulus lead to high asset prices which are important for an economy in order to create economic activity, confidence and wealth. In this respect, QE and ZIRP have arguably functioned as intended at the height of the great recession to stabilize financial markets. However, the extended artificial support given by global central banks beyond the immediate crisis has now led to a situation where all major asset classes have objectively reached historic highs at the same time. This situation, as you can see below(Fig.6), has in the past without exception led to gigantic asset price corrections if not collapses in the following decade, thus massive (asset) deflation. Fig.6: Current and historic major asset valuation Source: Deutsche Bank, Business Insider *6 Given the fact that interest rates are already at or close to zero and that stimulus via new debt has reached historic proportions it is evident that we need to look at more efficient ways to combine fiscal and monetary policy in order to lessen the negative effects of the next recession which will inadvertently occur sometime in the future. Please refer to the graph below(Fig.7) and you will find that economic expansions were accompanied by inflationary periods and rising interest rates while falling interest rates were associated with deflation and recessions. Therefore, the assumption that rising interest rates are negative for asset prices is simply unfounded. In fact, the last stages of growth in the economic cycle are typically marked by rising rates as can be seen in the white areas in the graph before the grey recessions. At some point in every financial cycle however, rates rise to the point where they eventually hurt economic growth. Therefore, it is essential to raise rates in a fashion that is prudent and ensures acceptance by the real economy. 7
Before we go into our basic ideas on how to improve global economic policy we would like to point out that recessions have occurred every 4 to 9 years in the past as you can see below. Assuming financial cycles to continue occurring in the future, it is highly probable that we will find ourselves in the next contraction before the end of this decade. How can we be prepared monetarily for such an event if interest rates are near zero? How can governments respond fiscally given record public debt levels? Fig.7: US$ inflation rate and historic recessions Source: Wellenreiter Invest, 2015 *7
5. The importance of optimized fiscal and monetary policy coordination Previously, we have focused on the existing misconceptions and inefficiencies of prevalent economic thinking regarding both fiscal and monetary policy. Before we outline improvements in general applied policy to achieve the undisputed goal of economic growth we would like to focus our attention on the interdependence of fiscal and monetary policy as well as the need to coordinate the two efficiently. First of all it is essential to understand that fiscal and monetary policy should not be viewed separately. While the official independence of central banks to conduct policy has its merits, failure to coordinate fiscal and monetary policy can become extremely counterproductive. For example, most of Europe currently pursues aggressive monetary policy while at same time enforcing fiscal austerity. In effect, massive amounts of money are made available by the ECB but can barely reach the profit/tax producing segment of the economy. Today, fiscal authorities generally demand increasing taxes and reduced government spending which practically undermines the intended effects of expansionary monetary policy. As a result, the private sector must operate within limited 8
means in a sluggish economy in which it is unwilling and/or unable to borrow, invest and create jobs, thus a stale economic environment and job market persist. Unfortunately, combining expansionary monetary policy with tight fiscal policy has, to a large degree, offset the, if individually regarded, well intended and benevolent policies of providing ample credit(monetary) while minimizing the public budget deficit(fiscal). Therefore, finding the optimal combination of both fiscal and monetary policy is tricky but indispensable for helping the overall economy achieve growth. Second, it is necessary to define and understand the characteristics and limitations of monetary and fiscal policy. In general the central bank is the first institution to act when overall economic conditions change or reach turning points. This is sensible action as the flow of credit is the fuel of modern economy and expanding or restricting it immediately affects the underlying economy and its exchange rate. Therefore, monetary policy’s major advantage lies in the speed in which it can influence economic activity to counter sudden, adverse economic developments. Fiscal policy on the other hand should be viewed as a tool to alter the fundamental structure of an economy that is crucial for increased sustainable, productive activity. However, while the effects of fiscal policy can be decisive, any adjustment of fiscal nature tends to be slow to enact and implement. As a result, fiscal policy usually displays lagging results and, if misguided or ill-­‐combined with monetary policy, may lead to unintended neutral or negative consequences economically. For example, the political process to agree upon, implement and enact a general change in the income tax rates takes considerable time politically. Seeing the new tax regimen affect the real economy then requires even more patience as economic participants’ behavior slowly adjusts. Clearly, both fiscal and monetary policies have their merits and limitations. It is of the utmost importance to understand and streamline policies in order to be both effective and beneficial to the economy at large. 6. Fiscal Policy suggestions to improve the global economy and lessen the effect of the next recession Now, it is time to outline combined policy ideas that will be beneficial to growing the economy in its current state. In particular they are: Fiscal policy Let us revisit the equation for GDP where the components’ order is rearranged for arguments sake. Clearly, real GDP growth is the desired goal of modern society and the basis for prosperity. Again, GDP = C + G + NX + I Fiscal policy can target any and all components of this equation and let us look at each one in detail. Consumption is evidently a short-­‐term way to contribute to an economy. Buying a TV for example may bring temporary pleasure to the owner and income to the seller but will lead to little if any increased productivity, arguably not today and certainly not in the future. As a result, targeting consumption growth, for instance via lower VAT, may benefit the economy little if the general population lacks well-­‐paying jobs, thus discretionary income. Such income must first be generated 9
through private sector profits to ensure that consumption today does not replace future private spending via debt financing of consumption or worse, lead to future debt default. Government spending and effective economic infrastructure are without a doubt essential to attract and grow productivity in an economy. However, depending on public governance, government spending is generally less efficient than private investment in raising productivity, the key to economic growth. Most importantly, government is financed by taxes which are factually derived from a share of the profits the private sector creates. Therefore, competing with the private sector for QE funds and financing also lowers the potential tax base and constricts the economy unnecessarily. Consequentially, increased government spending beyond helping the private sector produce profits/tax revenue is highly counterproductive to the health of the overall economy. NX, the trade balance is largely a function of an economy’s exchange rate in combination with the competitiveness of its products and services in the global markets. Fiscal policy can mostly be employed via trade restrictions. However, history has shown that imposing barriers to trade typically lowers an economy’s competitiveness and leads to political tensions or trade wars internationally. Obviously, effects of this nature are not in the long-­‐term interest of organically growing a healthy global economy. Therefore, fiscal policy should not be employed to target the trade balance. Savings and Investments are the key to innovation and increased productivity. Any money that is not consumed or taxed within an economy is either saved or invested, i.e. it is employed to yield a future return in excess of principal. In a perfect world, investment is fiscally supported so that the private sector can innovate, expand, produce and yield profits which are the foundation for income, both privately(jobs) and publicy(taxes). It is our solid conviction that we must pursue a fiscal policy that encourages the private sector to increase the productivity of the economy. In particular, corporate, capital gain as well as income tax rates should be lowered. Tax incentives must be extended to encourage new business formation as well as attract existing foreign businesses, intellectual property and talent. By providing the fiscal incentives to invest and innovate we will be able to create employment and experience meaningful, sustainable growth. For example, building an applied culture of progressive entrepreneurialism via venture capital and private equity as practiced in places like Silicon Valley would immediately benefit Europe in terms of employment and increased productivity. Surely, many start-­‐ups fail but the economic benefits of those that perform far outweighs the loss of those ideas that don’t progress, all while providing employment and precious experience to young entrepreneurs. The positive long term effects of creating an innovative “venture capital sector” on GDP will come from the creation of new companies that morph into global industry leaders. Keep in mind that Microsoft, Apple, Facebook, Google, Tesla, Amazon etc. all started out as innovative ideas that have become productive giants in the global economy. And yes, they are all American success stories. Today, these industry leaders employ millions of people, pay taxes and improve the global standard of living. Considering the high standards of European education it is rather puzzling how European governments idly stand by and watch the brain drain to innovative global regions such as Silicon Valley. Please see below how(Fig.8) far Europe lags behind America in start-­‐up investments. 10
Fig.8: Venture capital investment by region Source: Ernst & Young, World Economic Forum, 2015 *8
In summary, regarding current fiscal policy, it appears to us that taxes, i.e. disincentives to investment, in large parts of the western world are being increased while employment, especially youth employment, has stalled. Raising taxes leads to less consumption and investment as can be seen in low velocity and disinflation/deflation. Lowering taxes, especially in the productive areas of the economy, would certainly increase incentives to engage in capital investment and consequentially, economic activity. The latter issue regarding employment should be addressed via fiscal support(benign taxes, subsidies) to those economic components that encourage employment and growth in the long run, e.g. schools/research, new technology/start-­‐ups, infrastructure improvements to attract and nurture intellectual as well as physical capital. Finally, it is necessary to keep in mind that all government funds, directly or indirectly received through monetary policy mechanism, are funds that could be employed in the private sector. 11
Efficient, responsible and lean government spending of such monies must be ensured to provide support to the private sector. In the end, the private sector creates the jobs and income via profits that are the basis of prosperity for the entire economy including government. 7. Monetary policy: What should be done today? Essentially, we would recommend a similar path as currently chosen by the Fed’s Mrs. Yellen: a cautious yet steady normalization of monetary policy. Due to its immediate effects on the wider economy monetary policy should be used primarily as a tool to quickly counteract unfavorable economic trends and financial market panics. Therefore, it is of the utmost importance to let interest rates return to a level where central banks are able to effectively counteract potential financial shocks to the global and/or domestic economy. Furthermore, raising interest rates will increase consumption, savings and investment via savers while helping pension funds meet their obligations. Considering the amount of baby boomers facing retirement it appears likely that the current trajectory of zero to low interest rates will lead to a general pension fund crisis in the coming decade. In addition, central banks should consider providing incentives for commercial banks to lend into the productive private sector by adjusting the excess reserve rates on bank deposits held at the central bank. There is no valid economic reason why excess reserves should be parked at the central bank when there is a clear need to expand the private sector and consequentially the economy. Furthermore, while it would be unrealistic to assume that any central bank is omnipotent in resolving economic crises, we must reequip our policy makers with potential financial and economic shock absorbers such as ZIRP and, for extreme crisis, QE. Therefore, room to cut rates and employ QE must be created before the next recession. In addition, addressing the issues of the past, namely too much debt, with a policy of increasing debt endlessly is by any means absolutely irrational and will merely increase the scale of the next crisis immeasurably, possibly rendering the ensuing situation unmanageable for both monetary and fiscal authorities. Please see the global debt growth below(Fig.9) and ask yourself if this is healthy and sustainable. 12
Fig.9: Total global credit-­‐market debt Source: Michael Roscoe, 2015 *9 Finally, lowering a domestic economy’s exchange rate via ZIRP or QE can only provide temporary relief to the export sector as the exchange rate will eventually adjust to where the FX market decides it should be. Worse, artificially lowering an exchange rate will lead to global tension if not retaliation by other countries that may adopt a similar policy. Therefore, monetary policy cannot and should not be confused with fiscal policy. In the short run it is the central bank’s responsibility to provide sufficient liquidity to the economy at the optimal price(interest rate). Government is responsible for providing the fundamental physical and legal structure in which the economic constituents can operate, thrive, innovate and attract productivity. Following a well-­‐coordinated set of policy measures, both fiscal and monetary, are the key to present and future economic growth, peace and stability. 8. Summary and final note In summary, we find the numerous, commonly established misconceptions regarding deflation/velocity, GDP growth and current economic policy with its effects on asset prices to be extremely dangerous to the overall health of the global economy. It appears to us that if we are to remain on the current policy track, both fiscally and monetarily, we will be utterly powerless to counter the negative economic forces the next recession will bring along. Considering the magnitude of the “great recession” eight years ago and the scale of today’s global debt levels it is evident that policy improvement and cooperation is highly urgent and essential to avoid a major currency and/or debt crisis. 13
Our hope for this paper is to be interpreted as a constructive, brief analysis of current monetary and fiscal policy from the combined viewpoints of a financial market participant and an academic scholar. We identified several severe flaws in our official thinking and generally applied policy with the aim to contribute to a better present and future approach economically. However, while we are clearly concerned about the future, experience has shown that mankind has proven to be reluctant to change but in the end adapts for the better. May our policy decision makers cooperate and have the wisdom to help us avoid many of the obvious and not so obvious yet inevitable bumps along the path of human evolution. 14
References *1-­‐4: Economic research, Federal Reserve Bank of St. Louis, USA, 2016 https://research.stlouisfed.org/fred2/ *5: European Economic Snapshot: Europe Grows Apart by Thomas Coley, Ben Griffy, and Peter Rupert, USA, 2015. http://europeansnapshot.com/2015/09/08/europe-­‐grows-­‐apart/ *6: Deutsche Bank, Business Insider: DEUTSCHE BANK: We examined 200 years of data and concluded stocks, bonds, and housing are at 'peak valuation' by Greg McKenna, Australia, 2015 http://www.businessinsider.com/deutsche-­‐bank-­‐stocks-­‐bonds-­‐housing-­‐near-­‐peak-­‐valuation-­‐2015-­‐
9?IR=T *7: Wellenreiter-­‐Invest: Wellenreiter-­‐Invest Studie, Ausblick 2016 by Rethfeld Robert, Alexander Hirsekorn, Germany, 2015 https://www.wellenreiterinvest.de/boerseninformationen/jahresausblicke *8: Ernst & Young, World Economic Forum: Which countries have the most venture capital investments? by Peter Vanham, World Economic Forum, 2015 http://www.weforum.org/agenda/2015/07/which-­‐countries-­‐have-­‐the-­‐most-­‐venture-­‐capital-­‐
investments/ *9: What does $200 trillion of debt really mean for the global economy? by Roscoe, Michael, 2015 http://positivemoney.org/2015/02/200-­‐trillion-­‐debt/ 15