Tuesday, 25 September 2012

Another dose of medicine but will it help…

Vital signs suggest that the global economy in 2012 is not healthy.  Europe is the main cause of concern as politicians argue about the right course of action with regard to the sovereign debt crisis.  But problems in other major economies such as the United States and China are also adding to the ailments of the global economy.  This deteriorating outlook for the global economy has also sapped the willingness of many firms who operate on a global level to spend and invest.  The typical economic prescription in cases where a lack of optimism dents spending by firms and consumers is Keynesian – the government is to step in and increase spending to cover the drop in demand from elsewhere.

But governments in many countries such as the United States have their hands tied due to large amounts of government debt which limits further spending.  Central banks have also tried the textbook response to a weak economy by cutting interest rates to close to zero.  But this has had little effect as business will not borrow even at low interest rates if the prospects for the economy are dim. 

So central banks have been pushed to try less conventional medicine.  The new prescription is referred to as quantitative easing and involves the central banks printing money and using this to buy bonds issued by their government or by businesses.  This acts to further lower interest rates on the bonds and the lower return for investors in bonds prompts some of them to move their money to other investments such as shares which acts as a shot in the arm for the stock market.

Growing concerns that the global economy is on its sick bed have jolted the central banks in the United States, Europe, and Japan into ordering a further dose of medicine.  The European Central Bank released plans to buy as many bonds of indebted countries as necessary to help out the sick patients of Europe after its pledge to do “whatever it takes” to support the euro (more on this in a future posting).  The Federal Reserve in the United States followed suited and announced it would buy an unlimited amount of bonds until unemployment began to come down.  The Bank of Japan also jumped on the bandwagon with its own plans to buy up bonds.
This new consensus among central banks has not pleased everyone.  There are concerns over the new roles for central banks who have traditionally been bastions against inflation.  Inflation is seen as a negative influence as it reduces the value of money which hurts savers.  Central banks have killed off inflation by increasing interest rates but this has been possible due to the targeting of inflation by central banks.  But attempts by central banks to revive flagging demand through quantitative easing also could result in the resurrection of inflation.  As quantitative easing also involves central banks creating money for nothing, it also acts to drive down the value of the currency (as will be described in a future posting) and this is controversial as a weaker currency boosts exports at the expense of other countries. 

Even if the quantitative easing by central banks is seen as a necessary evil, there are further fears about whether the policies themselves are having the desired effect.  Because quantitative easing involves buying bonds in the hope of influencing investment decisions of other buyers of assets for investment, the effects are not clear and the continuation or even worsening of economic problems suggests that the policies are not a cure-all.  This is reinforced by the fact that, for example, this will be the third round of quantitative easing in the United States (hence the abbreviation “QE3” in the newspapers). 

In effect, there are few differences from when Your Neighbourhood Economist first started this blog in November 2011 (So what is going on…???).  The problems that central banks are grappling with are beyond the scope of the current understanding and available tools.  It remains to be seen if the unlimited resources now being tapped by the central banks will in fact be enough to resuscitate the major economies.  There is not much else that can be done.  Even Your Neighbourhood Economist does not know what to expect in twelve months’ time.

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