Quantitative Easing – Getting less from more

The European Central Bank has been late to try quantitative easing and may find that additional euros cannot buy much relief

We all have the tendency to rely on the tried and true tricks we have found helpful in the past even when their usefulness has faded.  This also seems true of central banks who have come to rely on quantitative easing even though its effects show signs of fading.  Even the initial boost provided by the first attempts at quantitative easing was limited and the situation has deteriorated amid its continued application.  As the last major central bank to give it a go, the European Central Bank will not get much return from any extra cash. 

Why more is not always more

Economist should know that repeating the same policies does not always work considering a well-used idea in economic theory known as diminishing returns.  This concept refers to the way in which more of the same often comes with fewer additional benefits.  Economists use this to describe why the second plate of ice cream does not taste as good as the first or why one more cook in a crowded kitchen doesn’t necessarily improve the food. 

Printing more money, which is the basis for quantitative easing, sounds like a sure-fire way to generate economic growth but any economy can only handle so much money.  The world is already awash with cash even before central banks started with quantitative easing.  This means that every additional dollar, euro, or pound printed as part of quantitative easing is being added to an already substantial pile of cash.  With money already being hoarded by many companies and governments not wanting to spend more cash, there is not much use for any more.

No need for more

With the meagre effects of quantitative easing on the wane, it was the earlier versions that would have generated the most bang for each additional buck.  It was the Federal Reserve and the Bank of England that tried out the first rounds of quantitative easing – the goal was to push investors away from government bonds to more risky investments such as corporate bonds or stocks.  The hope was that this would help provide companies with easier access to cash and to perk up investors by boosting share prices. 

Not all of the extra dollars and pounds would have stayed local but also headed overseas to find places to earn more money.  This meant that the effects of quantitative easing would have been felt far beyond the countries where the cash was originally coming from.  It has been helpful in places such as Portugal and Spain with overseas investors buying bonds issued by the Portuguese and Spanish governments as worries about Europe eased.

With the effects of quantitative easing having already spilled across international borders, there is not much more to be gained from even more cash.  As such, the additional euros coming out of the European Central Bank following the recent launch of quantitative easing in Europe may not amount to much.  Any further action may also be limited as the saga over whether or not to implement quantitative easing has highlighted how the European Central Bank only has limited room for manoeuvre when running in opposition to Germany.  Now, more than ever, it is time to try something new.

Monetary Policy – where has the magic gone?

The European Central Bank tries to cast another spell to save the Eurozone but its magic has been stolen

Monetary policy is like magic – you have to use tricks to get people into believing what you want them to believe.  Both magicians and central banks apply various devices to convince their audience that they can pull off amazing feats.  A bit of showmanship can be crucial in creating an aura of the fantastical when your powers are actually rather limited.  Central banks have pulled this off in the past but quantitative easing by the European Central Bank is more likely to show that it does not have any rabbits left to pull out of the hat.

Trying to work magic

Your Neighbourhood Economist likes to look back fondly to an era when central banks had the financial market enthralled with their mastery of all things economic.  This admiration was won the hard way in the 1980s by bringing double-digit inflation back to more manageable levels and ushering in an era where the booms and busts seemed to have past.  But central banks have been taken down a notch by their inability to revive the economy after the global financial crisis. 

Slashing of interest rates has not worked as high levels of debt meant that no one wanted to borrow. Upping the ante, central banks tried pumping money into the financial system through quantitative easing.  The effect on the actual economy due to quantitative easing also looks to be limited at a time when there is already a lot of spare cash in the financial system.  Financial markets were buoyed by quantitative easing but a side effect has been the potential for heightened volatility in the financial markets. 

With few other options seen as viable, quantitative easing has gone from an unconventional measure to the mainstay policy for central banks despite questions over its usefulness.  The European Central Bank has been slow to try its hand at quantitative easing even though the Eurozone economy was struggling more than most.  This was because Germany (who had initially done well despite its neighbours being in crisis) was firmly against the central bank in Europe printing cash to buy government bonds.  It was only after a further considerable deterioration in the prospects for the Eurozone (as well as that of Germany itself) that the European Central Bank to override this opposition.  

No more magic left

The European Central Bank has been put at a disadvantage considering that the other big central banks have already tried to work their magic through quantitative easing.  Investors are becoming harder to impress having already seen central banks pull off similar tricks.  To maintain the wow factor, quantitative easing has needed to get bigger and bigger.  The central bank in Japan pledged to double the money supply within two years but had to offer up even more cash when its initial plans proved to be lacking. 

The European Central Bank cannot compete on scale as it has to perform magic with one hand behind its back due to the political constraints within the Eurozone.  Any extra boost using the element of surprise was also dented by the protracted process as the European Central Bank and Germany squabbled publicly over quantitative easing in the months before the policy was launched. 

The fractious politics in Europe has sapped power from the central bank who had previously been the main shining light in saving the Eurozone.  Political squabbles have highlighted the limited power at the disposal of the European Central Bank.  It is like a magician who is being sabotaged by their own assistant – it will take more than magic to escape this spell.

Getting more from Monetary Policy

Japan has made lots of mistakes and it is time that Europe learnt from them

We can all learn from watching others make mistakes and the experiences of Japan continue to provide valuable lessons.  Japan has stumbled into another recession following a hike in taxes to fix the government’s finances.  The other key policy doing the rounds in Japan, using expansive monetary policy to put an end to deflation, also seems to be flagging.  It is Europe that has most to learn from the unfortunate trials and tribulations in Japan since many of the same problems are shared by both.  What should Europe do to avoid making the same mistakes and decades of stagnation?

Following in the same footsteps

Japan has been hit first with many of the same problems that are increasingly expected to plague Europe and other Western countries.  For starters, new-borns in Japan are increasingly outnumbered by pensioners which have pushed the population into decline in recent years with an aversion to immigration further accentuating this trend.  This translates to fewer workers to provide the taxes needed for the rising costs involved with taking care of old people.  The situation is made worse by government debt which is already more than double GDP due to years of inefficient government spending.

Japanese consumer prices have been falling for years as a reflection of the weak demand.  There are few opportunities to profit from in Japan due to the falling population and even Japanese firms are looking elsewhere to invest.  Weak global demand means that even one of Japan’s strengths, exporting, offers only limited respite even with a weaker yen due to its loose monetary policy.  All of this means that the Japanese economy itself is like a tottery pensioner - even a small rise of sales tax from 5% to 8% was enough to push Japan back into recession.  This does not bode well for Europe where the economy is sputtering along due to many of the same problems while the governments there are also trying to get a grip on their finances.

Trying different directions

Having been stuck with these problems for longer, policy makers in Japan are increasingly more aggressive in coming up with solutions.  The current prime minister, Shinzo Abe, launched a raft of new measures dominated by a massive expansion of the money supply to target falling prices.  This new aggressive approach to monetary policy was facilitated by the government installing a new governor to the Bank of Japan who was willing to give up its independence and toe the line.

This is the complete opposite to the situation in Europe.  The head of the European Central Bank is eager to do more with monetary policy but is prevented from doing so by the German government.  German politicians want to reforms to come first due to an expectation that their neighbours will not implement the necessary policies. Whereas, in Japan, the aim was to use the loose monetary policy to help build momentum that will allow the government to implement reforms. 

Yet, the Abe government has been disappointing in its reform efforts (as Your Neighbourhood Economist predicted) and this will bolster the stance taken by Germany.  With the Bank of Japan finding it tough to generate sufficient inflation despite a rapidly expanding money supply through quantitative easing, many will question about the reasons behind using a similar policy in Europe.  Central banks are struggling to have much influence in a world that is already awash with surplus cash.  

Time for Plan C

It seems like the key lesson from Japan is that monetary policy cannot do much by itself.  Japan still languishes despite the best efforts of the central bank as the Abe government shirks the much needed measures to free up the economy.  Yet, bullying countries in Europe to reform by withholding the full extent of monetary policy is not helpful either.  A grand bargain marrying reforms with looser monetary policy, as was supposed to be the case in Japan, seems the obvious solution. 

This takes more political willpower when the many countries of Europe are involved but is not something beyond the realms of possibility.  Ironically, the chances for such a deal may be improving as deflation becomes more of a concerns and the economic stagnation in Europe also spreads to Germany.  Japan has already paid the price for years of economic mismanagement – there is no reason for Europe to do the same.

Monetary Policy – Germany to feel the pinch

A taste of its own medicine may prompt Germany to rethink its tough guy approach to Europe

No one like a bully but that seems to be Germany’s role in Europe.  It makes other countries walk the line in policy terms (for their own good) even amid simmering discontent among its neighbours.  Germany has been mean in terms of pushing for monetary policy to be less expansive as elsewhere in spite of struggling countries needing help.  Yet, things may change as the German economy is starting to suffer from similar problems to those it bullies.  Germany is likely to be stuck with monetary policy that is too harsh for even its own economy and this may result in it softening up its approach to others in Europe.

Help wanted

It is a given that the economy in Europe could do with a boost.  Weak demand from consumers and firms means that unemployment remains stubbornly high and inflation for Europe as a whole is not far off zero.  But Germany continues to push its policy of tough love onto Europe.  As with most other developed countries, fiscal stimulus is not an option as governments deal with high levels of public debt.  Germany has gone further in cajoling other governments in Europe to sort out their budget deficits despite the likelihood of adverse economic effects.  

Germany has also not allowed the use of monetary policy as an alternative means of stimulating the economy.  Measures such as quantitative easing have been utilised with some benefits in the US and in Britain but not in Europe even though Europe needs a boost more than anywhere else.  The reasoning behind this approach by Germany is that, by offer laggards in Europe an easy way out, the current problems which are holding them (and Europe as a whole) back will remain in place.  As a result, the European Central Bank has had to be creative and try other measures such as negative interest rates.  But it is difficult for monetary policy to have much effect when its scope is limited.

Turning the tables

Germany may have been able to bully others in Europe but it may be the Germans turn to feel the pain.  The German economy is beginning to flag amid weakening demand for its exports from places such as China.  Forecasts for economic growth in Germany are being cut as its prospects deteriorate while inflation has fallen to below 1%.  The normal response to a weakening economy anywhere else would be for looser monetary policy.  But having not allowed other European countries this option, Germany’s tough stance on others may result it also being tough on itself. 

It is funny to think that the Germans would have likely allowed itself to have more stimulus via monetary policy if there was just a German central bank looking after just the German economy.  But its own actions in influencing monetary policy will mean that Germany may have to endure monetary policy that does not reflect the weak state of its economy (along with most everyone else in Europe).  When framed in this way, Germany must rethink its ideas on economic policy for Europe if just for its own good. 

Continued stubbornness by the Germans would be unconstructive even in comparison to the often dysfunctional politics in Europe.  Deflation is another concern that will only get worse with the current policy measures.  Germany was never going to go easy on others in Europe while its economy was riding high.  It is only a Germany that has been laid low that may soften up and be more willing to help itself by helping others.

Europe – finding a way out

Europe seems trapped with a sluggish economy but a way out may be close

Getting out of a hole that you have dug for yourself can be tough.  This is what Europe is struggling with as the Eurozone crisis seems to have passed only to be replaced with a slow strangling at the hands of deflation.  Infighting among politicians about the best way to deal with the economic stagnation in Europe has resulted in few reasons for hope of an escape.  Yet, this may change due to recent developments such as a flagging German economy and the rise of reform-minded governments in some countries.  Sometimes things need to get worse before a way out is possible and the situation in Europe may have finally got bad enough for positive change to occur.

An economic escape route…

An economic recovery is typically an automatic progress but may not always be easy.  Companies going bankrupt and workers losing their jobs cause considerable pain but is actually something that is good for the overall health of the economy.  A cull of weaker businesses provides more space for more successful firms to grow and prosper.  This process has the label of “creative destruction” in economic theory due to the idea of the old needing to give way for the new. 

In this way, economic growth returns after a recession as resources such as workers move to more productive uses.  The economy can grow faster as a result but a certain level of economic freedoms are needed to allow this to happen.  In this way, there is a trade-off between economic growth and the potential for instability.  It is not possible to have the former without the latter but any instability can be limited through controlling economic excesses (which often show up in the financial system).

Getting the balance right is not easy.  Companies in finance have been given too much leeway and created havoc as a result.  Yet, in other areas, businesses have been burdened with too many rules.  One example is regulation which makes it difficult for firms to fire workers.  This may seem like a good way of keeping people in jobs but such regulation has an adverse effect in that companies will not want to take on new workers if their employment is almost permanent.

… and the politics to make it happen

Many countries in Europe are in desperate need of policies to free up business from such regulation but implementation is often tricky.  At a time of rapid change, voters often crave stability of bygone eras that are no longer viable.  This does not stop populist parties making false promises to turn back time and dismissing the need for reforms.  It is heartening for the outlook in Europe that some countries such as Spain have made progress with its reforms.  Others such as France and Italy also have governments that are making the right noises in terms of reforms even if not actually putting new policies in place.

The lack of reforms has been preventing the recovery in Europe in other ways.  Germany, who has a firm grip on the reins of power in Europe, has stubbornly refused to offer much help to struggling European countries.  The reasoning behind this is that offering an easy way out would mean that these countries would not deal with the problems within their own economies.  The flip side is that, once reforms begin, Germany may be more accommodating in providing support. 

This opens up the possibility of a grand bargain, such as reforms as a trade for looser monetary policy and less focus on austerity.  More action from the central bank seems likely as the German economy is beginning to falter and genuine fears about deflation in Europe grow.  Its own weak economic growth and low inflation will highlight to the Germans that the problems are plaguing Europe as a whole rather than just individual problem countries.

Your Neighbourhood Economist penned this posting with comments from readers in mind.  Europe and the euro was seen as a lost cause by one reader while others have been annoyed that this blog always had to be so pessimistic.  Hopefully, this post will hopefully prove them wrong (but in a good way).

Deflation – déjà vu with a twist

Signs of deflation I have seen before start showing up in my neighbourhood but falling prices have been with us for a long time

Your Neighbourhood Economist has been getting a sense of déjà vu recently – to do with deflation.  My past experiences of falling prices come from years spent living in Japan and I am seeing the same things again in my neighbourhood in London.  Japan and deflation make for a scary combination considering that Japan is a byword for prolonged economic stagnation and poor policy choices.  But deflation may have already been lurking around unnoticed for a while. 

This looks familiar

The symptoms of déjà vu started with the fast food chains such as McDonald’s and KFC offering cheaper menu options.  This first started in London a few years back but it was a sign that consumers did not have much cash to spend.  It is a sorry state of affairs when even the least expensive places to eat out need to provide food with even lower prices to attract customers.  But it is the same tact that similar companies had adopted in Japan around a decade ago in the face of increasing price conscious consumers.

The other memory of deflation in Japan was from buying groceries at the supermarket.  The most notable place was shopping at my local 100 yen store (which is like a pound shop or a dollar shop).  While the prices of the products on the shelves did not change (obviously), there was a noticeable increase in the range of goods that could be brought for 100 yen.  The same trend is becoming more obvious in the UK in the success of discount supermarkets such as Lidl and Aldi.  To keep up, the mainstream supermarkets have been slashing prices but shoppers are still switching to their cheaper rivals. 

The only areas in the economy where prices are still rising are sectors where the pressures of price competition are less fierce.  UK companies such as energy providers or train operators function in imperfect markets where consumers have less choice and few other options.  Spending on energy or transport often cannot be avoided so companies do not have to try hard to sell their products.  As such, it is large energy bills and higher transport costs that are increasingly responsible for inflation.  With nowhere else to go, consumers have increasingly turned to the government to prove an answer despite there being little that politicians can do.

We live in deflationary times

Yet, for good or bad, this may be the new world that we live in now rather than just a temporary blip amid a slow economic recovery.  In a new global era, firms and consumers can scourge the world for the cheapest places to buy whatever they want.  This impacts what we buy off the shelves at our local store as well as what we can purchase off the internet.  Technology further aids this trend by providing information on what is on offer outside of our neighbourhoods and for what price.  And we are increasingly consuming services through the internet at cheaper rates than ever before.

This is great for us as consumers but the flipside is that companies in our local economies face growing pressures and will not be able to provide the same level of employment opportunities or pay the same wages as before.  This is a problem for governments who want their national economies to prosper.  Jobs are seen as the primary gauge of the health of the economy but boosting employment is tricky when competing on a global scale.

Here today and here tomorrow

Deflation is often seen as a problem in itself.  The standard economic theory goes that, if prices are falling, consumers will wait to spend as goods will be cheaper tomorrow.  Yet, globalization and technology are not something new and we have had downward pressure on prices for a long time.  Inflation has been low for the past few decades suggesting that deflation may have not been that far away.  It is perhaps only the voracious appetite for raw materials in China and elsewhere that pushed up global commodity prices and stopped deflation setting in sooner.    

If it has been around for so long, deflation by itself may not be so bad after all.  Yet, an overreaction by policy makers might be.  The European Central Bank seems set to ramp up its measures to fight off threats of deflation (and a morbid economy in Europe).  The central bank in Japan has launched a renewed onslaught against falling prices but to little avail.  Yet, the forces of globalization and technology cannot be reversed using just monetary policy.  Falling prices are something that may be with us for a while so it is better to get used to living with the potential for deflation and focus our efforts on other economic evils.

Quantitative Easing – Waiting while Europe Sinks

As Europe cries out for more action against deflation, the central bank must wait until the situation gets even worse

It would be strange to hold off saving people in a sinking ship until the ship is just about to go under, but this is how monetary policy works in Europe.  The situation in European grows continues to get worse as economic growth stagnates and deflation sets in.  Yet, the central bank cannot help, as it is hamstrung by politics, and must hold off until the cost of inaction is too high.  This means that Europe will have to take on a lot of water until a rescue package can eventually be put in place. 

Politics muddies the water

Monetary policy is tough enough in one country, let along for the 18 countries which use the euro.  The European Central Bank has acted boldly when given the chance.  It took a stand in 2012 stating that it was willing to do “whatever it takes” to save the Eurozone.  This was the lifeboat that saved Europe from collapse at a time when national governments were absorbed riding out wave after waves of turmoil.  But the European Central Bank was only free to jump in once it seemed as if Greece and other countries were about to let go of the euro. 

Despite a temporary reprieve, the economies of Europe have been like a listless ship with leaks.  Reforms have been put off in the hope that the worst is over and economic growth would return without any further encouragement.  Yet it is not a surprise that Europe is close to being sunk again but this time in slow motion.  The problem is the rules and regulations that get in the way of more efficient ways of doing business.  Economic growth cannot be seen as a given and government policies must allow resources to move to more productive uses.   

Such reforms tend to be unpopular as the costs are borne upfront while it takes time for the benefits to show.  So politicians in Europe have put off these measures as pleasing voters is proving tough enough as it is.  Instead, it has been easier to blame others and wait in the hope that economic growth will return.  This wait-and-see approach relies on the central bank to help out with the economy but this is beyond what the European Central Bank can achieve.

The politics behind the European Central Bank is made even more difficult in dealing due to some countries floundering more than others.  Amid all of the concerns about deflation, it is already a fact of life in some countries such as Greece and Spain.  Yet, even Europe as a whole is edging closer to deflation which is typically the symptom of a sluggish economy.  The fear is that deflation will create its own problems if falling prices prompt consumers to hold of spending in the hope for cheaper goods in the future.

Waiting until things get worse

The central bank has already responded to the threat of deflation through a policy of negative interest rates.  Quantitative easing, which has already been used (with limited success) in other countries, is the obvious choice to ramp up monetary policy.  This option has been kept off the table due to its potential to cause inflation which raises hackles among Germans.  Since any measures by the central bank could be deemed to be inflationary, Germany has used its influence to restrict the ability of the central bank to act. 

Yet, even the Germans will eventually have to see deflation as the greater threat.  But, at the same time, it is tough to gauge when too little inflation (or too much deflation) will be enough for a change of tack.  Germany has stuck to its guns since the outbreak of the Eurozone backed by an economy which had until recently remained buoyant.  So Europe is likely to get quantitative easing sometime (soon) and hopefully before the Eurozone is too far under water.

Central Bank – Emperor's New Clothes

With the myth of its power having been shattered, central banks need to get nasty to win back respect

Central banks are looking a bit naked as if stripped of their power.  Previously, central bankers such as Alan Greenspan were held in awe and ruled over the hearts and minds of investors.  This position of power stemmed from the perceived ability to soothe the fire-breathing financial markets.  Yet, the global financial crisis and its aftermath have shown this to be but a myth.  Part of the problem was that central banks wanted to be liked and keep investors onside.  With its generosity proving its downfall, the naked emperor may need to stop being so nice.

Pretenders to the throne

This fall from grace has happened swiftly.  The powers of central banks reached their peak just before the crisis hit.  Quick to blow their own trumpet, economists talked of a “Great Moderation” – a prolonged period of steady and stable economic growth coupled with low inflation.   Central banks had also shown themselves willing to step in during moments of strife and prop up the stock market.  This won them a strong following among investors who could be sure that central banks would send in the cavalry if there was trouble. 

The proverbial crown slipped and fell dramatically with the global financial crisis.  Not only were central banks proved to be not suitable guardians of the economy but their capacity to rally at times of trouble was limited.  Low interest rates and quantitative easing offered little respite from the plague eating away at the economy.  The potency of central bank policy has been eroded as its primary source of power, the ability to print money, does not mean much in a world awash with money.

The problem was exacerbated by central banks not having the freedom to act as their almighty reputation might suggest.  Part of this was due to internal restraints such as a chronic (but misplaced) fear of inflation.  Such worries about rising prices keep central banks from unleashing their full firepower when faced with crisis.  In addition to this, politics also often acts to stifle central banks.  Germans’ heightened aversion to inflation has kept the European Central Bank from doing more.  The Federal Reserve has also had to be mindful that its actions did not draw ire from Republicans who are typically hostile to any government intervention. 

Cursed by hubris

It also became obvious with hindsight that central banks may have built their dominance on a dubious myth.  The “Great Moderation” may have just resulted from good luck rather than good management.  It is easy to keep inflation down when cheap goods are flooding in from China while money was cheap as China was sending a considerable portion of its earnings as reserves and sending it back to the US.  Yet, the misplaced belief in the rule of central banks over the economy lead to ignorance of risks that central banks thought they had slayed. 

Central banks were happy to live off this aura while also being generous in its dealing with investors.  Yet, this kindness turned out to have a cruel twist with the support shown by central banks to financial markets sowing the seeds of crisis.  Although lauded at the time, the reign of Alan Greenspan has instead been shown to be like a king trying too hard to please his subjects.  Over this period, the Federal Reserve kept interest rates too low while investors made merry amid a booming stock market.   

Better to be feared than loved

The unruly nature of financial markets coupled with the flood of cash sloshing around in global finance means that a guiding hand is needed more than ever.  Having been knocked from their high towers, central banks have to restore some assembly of order in a world where the pull of its ability to print cash is diminished.  It may be best to follow the words of Machiavelli, a renaissance philosopher who theorised on power struggles in Medieval Italy, in that it is better to be feared than loved. 

In this vein, if it was a need-to-be-loved that got central banks, and the rest of us, into trouble, it might be time to get nasty.  Taking a harsh line against any potential distortions in the economy (using macroprudential policies) would win more respect than being too friendly.  To rule with a firmer fist seems a better fit at a time when the consequences of financial excesses are so pertinent.  This would help to usher in a more peaceful period if combined with greater regulation to keep the banking sector from getting out of hand.  More stability may even get investors to appreciate the value of tough love.  

Global Economy - Half-time Report

It is game on in Brazil but many are hoping for less thrills in the financial markets in the second half of 2014

Just like in a football match, the half-way point (of 2014) is a good time to assess progress so far and look ahead to the second half.  The first six months have been relatively boring but in a good way, after participants and spectators of financial markets have been riding by the seat of their pants over the past few years.  The game plan so far has been an emphasis on defence with central banks in Europe and Japan providing more support for their economies while tapering by the Federal Reserve has been at a measured pace.  Investors are betting on a quiet second half to 2014 but this will depend on whether the markets can hold their nerve when confronted by the prospect of tighter monetary policy.

Tension is building

The start of 2014 could be considered a success on a number of fronts.  There are reasons for optimism in terms of the economic recovery such as swiftly falling unemployment in many countries.  Share markets are buoyant suggesting that investors are willing to take on risk.  Interest rates on government debt have dramatically fallen for most countries in Europe whose debt has previously been shunned by investors.  The focus of policy makers is no longer on dealing with the potential for crisis but instead on bolstering the economy recovery.

The only problem with this is that much of the progress has been built on loose monetary policy which is due to come to an end.  Investors will have to manoeuvre around the winding up of quantitative easing and higher interest rates.  This will be like a football team losing one player in defence – not the end of the world but it opens up the potential for calamity.  One consequence is that it is unclear how the second half of 2014 will play out.

May 2013 proves us with one example of what is likely to happen sometime soon .  In this month last year, financial markets went into spasms as the Federal Reserve signalled that it would cut back on its monthly bond purchases that constituted its quantitative easing program.  A repeat of what has since been labelled “taper tantrum” seems likely but with higher interest rates as the trigger (maybe prompting headlines of “rates rampage”).  Another popular phrase has been “fragile five” after countries who suffered at the hands of financial market who can turn nervy at any time.

When will things kick off?

The game plan from policy makers adopted so far this year is likely to stay in place considering the relative calm in the financial markets.  The aim will be to not let in any goals (especially any own goals) rather than pushing to score gains in economic growth.  As a result, it is tough to see any big changes in the economy itself.  Dramatic improvements in the economy are not likely with governments continuing to mend their finances.  Loose monetary policy may also not be as useful as hoped in boosting spending by consumers or investment by firms even as the economy shows sign of getting a second wind. 

Whether the benign economic conditions continue into the next six months depends on the fickle nature of investors.  Like an erratic football striker who often gets stroppy, investors need to get their way in order to be kept happy.  Central banks will likely take a cautious approach so investors don’t retreat to the side-lines.  This is likely to result in the first hike in interest rates by the Bank of England, which is ahead of its peers in this regard, being pushed back to at least next year.  Further reasons for delay include other policy options being available to the UK central bank and a likely negative effect on the pound from any rise in interest rates.  Others such as the European Central Bank and the Bank of Japan likely have even more to offer in terms of loose monetary policy to play ball with investors.

The football world cup in Brazil has been notable for its outstanding goals and nail-biting action.  In contrast, many will be hoping that the financial markets in the second half of 2014 will be as exciting as a nil-all draw. But just like a game going into extra time and penalty, some excitement is inevitable as monetary policy tightens and it is something that the financial markets will have to cope with this year or next.

Economics – more religion than science?

Economists claim to offer salvation but the tenets of economics need reforming before we can be saved

Economics is sometimes like a religion in that its adherents keep the faith irrespective of evidence to the contrary.  The global financial crisis has tested the conviction of many economists but few seem ready to renounce their previous beliefs.  This might seem strange with a discipline that aims to be more like a science but there are factors which mean economics relies more on faith than on facts.  Considering the positions of power held by economists, we can only hope that the moment of revelation is not too far off. 

In Markets We Trust

Economics claims to offer a path to the Promised Land.  The role of God is assumed by the concept of the invisible hand which prophesies that markets will bring about the most favourable outcomes in terms of output and prices.  One of the most sacred beliefs in economics is that we must defer to the invisible hand as much as possible.  Economists help this along, with central banks keeping down inflation while governments open up their economies to global markets.   This ushered in over two decades of unprecedented economic progress until financial turmoil struck like a plague in 2008. 

Yet, despite the economic Armageddon that followed, economists have remained stubbornly tied to the same creed.  The response to the financial crisis has relied on the traditional tonic of lower interest rates with newer orthodoxy calling for the use of quantitative easing when conventional measures did not work.  Central banks have stuck with these policies despite the resulting growing distortions in the financial markets which would be anathema for economists in normal times. 

Believing in false idols

One element which makes economics more like a religion and less like a science is that it is difficult to prove when someone is wrong.  Scientific theories can be tested by experiments carried out in laboratories or similar places where the conditions can be kept in check.  Economic hypotheses cannot be proven in such controlled environments.  The sheer volume of transactions by consumers and firms means that there may be any number of reasons behind a certain outcome.  The impossibility of isolating specific cause and effect relationships means that truths in economics can only be subjective. 

This means that economists can piously hold onto their previous ideas on how the economy works despite any evidence to the contrary.  Economists tend to become wedded to their ideas as they hone them over many years in long careers in academia.  Any newcomers to economic are also indoctrinated into the existing dogma with little scope for breaking out of the mould.  The current generation of economics students have risen up in arms against being taught theories that have little relevance to economic events.

One of the more old-fashioned ideas that economists cling to is a fear of inflation.  The full range of tools for monetary stimulus has not been available as central banks have been adamant that inflation should not be allowed to get out of control.  This stems from psychological scars in the minds of economists due to damage done by inflation in a bygone era (the 1970s).  Europe has suffered the most under this economic fanaticism and has had to deal with the added difficulties of the Eurozone crisis with few policy options available. 

It is not a coincidence that the global economy and economic theory are both stagnating at the same time – economic deliverance for us all may depend on a second coming of economics in a more practical form.

Greece – On the mend but still broken

The Greek government is selling bonds again but its debts require a further fix

Greece was always broken but it was not obvious until the Eurozone crisis.  With its increasingly shabby façade finally stripped away, Greece's dilapidated economy was shunned by investors and needed to be bailed out - twice.  But, with help from others, Greece is on the mend and recent progress has been rewarded by the Greek government regaining the ability to borrow from financial markets.  While this is a key step in putting the pieces back together again, a big chunk is still missing.

Shoddy foundations

The Greek economy had never been on the firmest footing.  A raft of regulations sapped the dynamism of the economy, making Greece an alluring holiday location but an unattractive place to do business.  To avoid cumbersome rules, companies typically remained small and often hide out in the shadow economy.  This resulted in Greece being mired in low productivity and chronic tax avoidance.

Investors were willing to overlook all of this once Greece joined the euro.  Despite its obvious faults, Greece was treated as if it were the same as any other country using the euro.  This gave Greece access to funds at a lower interest rate, triggering a boom in investment in property among other things.  The government joined in and ramped up spending on the assumption that the good times were here to stay.

Yet, what was seen as a blessing at the time proved to be the wrecking ball that was to bring down the house.  Cheap financing dried up with the onset of the global financial crisis and the weakened economy collapsed under the weight of excessive levels of debt.  The government needed to borrow more and more as the economy sank into recession but investors were no longer forthcoming with their cash. 

With no one willing to lend to the Greek government, the IMF and others stepped in to prevent a default due to fears that other countries in Europe would be put in peril.  The result was a prolonged economic slump as Greece struggled with the aftermath of its borrowing binge as well as with austerity measures needed to shore up the government’s finances.  The situation was so bad that Your Neighbourhood Economist was one of many who thought that the Greeks would leave the Eurozone lured by the illusion of an easy way out.

Major repairs still needed

The economic stagnation in Greece has continued with six consecutive years of recession leaving GDP around 25% lower.  Forecasters are now optimistic enough to predict that the Greek economy will grow slightly in 2014 with austerity measures expected to ease as government finances improve.  Another sign of progress is that investors are again willing to lend the government money.  The Greek government sold 3 billion euros worth of bonds earlier in April offering a yield of just under 5% after yields spiked to over 30% around two years ago.

Investors are keen to snap up debt from other peripheral countries in Europe.  This reflects brighter prospects for some countries such as Ireland and Spain.  Yet, in the case of Greece, it is more a reflection of a dearth of other investment options offering similar returns and of investors being more willing to take on risks.  That Greece can sell bonds again is a sign that the Eurozone crisis is over but the Greeks are still left with the harsh reality of excessive debt.

Exacerbated by the sharp drop in the size of the economy, the debt to GDP ratio is around 175% and still edging upwards.  Considering that the Greek economy is unlikely to generate enough of a surplus to pay off this debt, another bailout has always been on the cards.  The Greek people are also unlikely to be able to live with the burden that this brings.  Until the shackles of debt are removed, the Greek economy will never be properly fixed.

Another New Policy - Negative Interest Rates

Another unconventional policy measure may be trialled in Europe as its central bank struggles to revive the moribund economy

The on-going economic troubles have been demanding in many ways – including having to learn the meanings of an ever-increasing range of new economic terms.  This is due to central banks implementing a range of practices to breathe life into an economy which seems impervious to their best efforts at resuscitation.  The list of unconventional policies started with quantitative easing, which was soon followed with forward guidance.  The next piece of headline-grabbing jargon may be negative interest rates.  This latest innovation is expected to come from the European Central Bank (ECB) even as other central banks look to wind down their operations.

The What, How, and Why of Negative Interest Rates

The policy of negative interest rates is just as simple as it sounds – paying someone to hold money instead of receiving interest on any deposits of cash.  Fortunately, the humble blogger on the street will not be required to pay negative interest rates by his or her retail bank; instead, the banks themselves will be charged for their holdings at the central bank.  Banks tend to park any surplus funds with the central bank so the idea of negative interest rates is to spur banks into making better use of their reserves.  In particular, the policy is intended to boost lending by banks which has remained sluggish despite record low interest rates.

The policy is all about creating the right incentives.  The actual payments themselves would be small.  For example, the ECB is said to be considering an interest rate of -0.1% in place of its current rate of 0.25%.  Central banks have been frustrated by the failure of low interest rates to generate the desired result – more lending.  Both forward guidance and negative interest rates are policies aimed at achieving this.  

Timing – why now?

Now we understand the basics of negative interest rates, the final question is one of timing – why now?  The ECB is driven by two key factors – the changes to monetary policy in the US and fears about deflation in Europe.

The effects of the Federal Reserve printing money to buy bonds (known as quantitative easing) have reached far beyond the US borders with some of the money also finding its way to Europe.  Less loot leaving the US will likely lead to less liquidity in the European banking system.  Low levels of inflation (0.7% in January) have led to fears about consumer prices starting to fall, something already happening in places like Greece.  There are concerns that such deflation could further undermine demand and result in debts increasing in size relative to the economy.

The potential adverse consequences of these developments have pushed the ECB to act and negative interest rates are one of the few options available.  This is because the actions of the ECB are restrained by divergent views among the member countries of the European Union.  In particular, Germany has been adamant in upholding rules that limit the ability of the ECB to purchase bonds. 

Negative interest rates would also bring their own complications.  European banks may struggle to deal with negative interest rates which are not the norm.  The extra costs may weaken banks by lowering their profits, making them more cautious lenders and exacerbating the problem.  Low lending rates have had only a muted effect so the benefits of going negative may be limited.  Even if the policy is seen to be effective, Germany would be loath to offer more help to struggling countries in the periphery of Europe as it may encourage them to put off crucial reforms.

It is too early to say whether negative interest rates will ever make it into our everyday lingo.  Either way, we can only hope that it does not take many more new policies until we can shake off the current economic stupor.

UK government needs to play its part to lift the economy

The government and the Bank of England should be working in tandem but one is taking a free ride

A good partnership is crucial in many aspects of life.  Take the UK economy for example - it is vital that the government and the central bank work in harmony if they are to provide support for the stumbling recovery.  Both seem to share a common view of the task in hand, painting a gloomy picture of the economy.  Yet, to borrow an analogy from the recent Winter Olympics, the combination is more like an ice skating duo that not only can’t stay in synch but where one is sabotaging the efforts of the other.

Working from same play sheet

The starting point of the government and the Bank of England is the same.  Economic data coming out of the UK shows that the country is performing better than most – GDP was up by 1.9% in 2013 with unemployment down to 7.2% in the three months through December.  Yet, if an economic upswing is on its way, neither the government nor the central bank wants anyone to know.  “Neither balanced nor sustainable” is how Mark Carney, the head of the Bank of England, described the UK economic recovery.  The Chancellor, George Osborne, claims that the “recovery is not yet secure”.  A more pessimistic outlook on the UK economy is actually closer to reality.  GDP in the UK is still lower than before the onset of the global financial crisis.

Despite some signs the economy is picking itself up, a fully-fledged return to form is still some way off.  Key drivers of growth are still frozen with UK businesses neither investing nor finding much business in overseas markets.  The economy also scores poorly in terms of long-term prospects with low levels of investment translating into few gains in productivity as well as stagnating wages.

Are you pulling my leg?

The UK central bank is the more diligent of the pair.  It has been working hard to convince people that interest rates will not be rising anytime soon.  The hope is that businesses and households can be convinced to borrow if they feel secure that interest rates will remain at their current low levels.  Mark Carney has tried to use forward guidance to this end but the policy fell flat (as outlined in a previous post).  Downbeat comments on the state of the UK economy are another avenue for soothing concerns over interest rate hikes.

George Osborne seems to be skating off in a different direction.  His remarks on the economy are part of a routine designed to push his austerity program promoted as painful but necessary due to the high levels of government debt.  Austerity did seem to have its merits amid the Eurozone crisis when investors with cold feet were pulling their money out from indebted countries.  Worries about debt levels have eased but the UK government is still sticking with its harsh spending cuts.

Doing more harm than good

The austerity measures are proving harmful in two ways.  Firstly, there is a shortfall in demand in the UK economy which is exacerbated by lower government spending.  The ideal response to weak demand is a fiscal stimulus with the actual benefit to the economy larger than the actual increase in government spending.  Yet, despite the negative effects, the UK government has chosen to do the opposite due to an ideological dislike of large government.

The other negative is that the Bank of England has been left solely in charge of generating an economic recovery.  It is bad enough that the duet has turned into a solo performance but the austerity measures act as a further handicap.  The one-man act has proven tough even for someone with the stellar reputation of Mark Carney but this situation also creates its own problems.

Loose monetary policy has been a factor behind increased asset prices showing up in the property valuations and the stock market.  This has helped to push up consumer spending as households with property or stocks feel wealthier.  Yet only a small portion of the population are benefitting.  Monetary policy by itself is not the route to a balanced or sustainable recovery (as argued in a previous blog).  A change in direction by the government is needed to give more balance or the economic ice may prove thin indeed.

Not so Great Expectations

Economists are sticking to old ideas about our behaviour but is it time to ask them for some more?

Economics has grown in popularity as people try to make sense of the troubles in the economy.  At the same time, what is taught as economics is being challenged after economics provided little help in predicting the global financial crisis or dealing with its aftermath.  Your Neighbourhood Economist has a particular issue with the common view among economists about how people think about changes in prices and interest rates.  This way of thinking has pushed monetary policy in the wrong direction as economists rely on theory which is increasingly being shown to be detached from reality.

The above position is based on the concept of rational expectations where people’s predictions of the future are built into economics models.  This first came to prominence during the 1970s where persistent inflation was a problem - high inflation had resulted in demands for higher wages which pushed up the costs of businesses and thereby led to businesses charging even higher prices.  The notion of expectations enabled economists to explain the reasons behind rising wages.  Since then, inflation has been tamed through new policies which make price stability the main focus of central banks under the rationale that people will not expect inflation to get out of hand if the central banks are on the case.

Central banks have been successful in handling inflation but other problems such as reigning in financial crises and dealing with the aftermaths of such have proved harder to manage.  Economists have been using the same tools through forward guidance which aims to boost lending by instilling expectations that interest rates will stay low for an extended period of time.  At the same time, measures to restore the economy have been restricted by concerns about the possibility of triggering a surge of inflation if central banks are seen to be less vigilant.  Surveys of people’s perceptions of inflation are now commonplace and followed by inflation-fearing economists almost as anxiously as politicians track polls on their popularity.

Yet times have changed.  Inflation is no longer such a big deal - globalization has resulted in increased competition which keeps down prices and weaker labour unions are unable to impose the industry-wide wages hikes of the past.  The average person on the street is not overly concerned about inflation in comparison to other worries about the economy so our actions are no longer shaped much by changes to prices.  The same is true for deflation - although the faltering economy in Japan is brought out as an example of what can go wrong, it is likely that Japan is an anomaly rather than a model applicable to other countries.  The old ideas on economics have not served us well in getting the global economy up and running again suggesting that economists ought to change their thinking to help deal with the hard times. 

Good Deflation better than Bad Inflation

Central banks seem to be keen on avoiding deflation at any costs but inflation for its own sake is likely to be worse  

Inflation is on the retreat in much of the world giving rise to concerns about deflation.  Economic theory along with the experiences of Japan makes deflation one of the most feared outcomes in economics.  The central bank in Japan is planning to double its money supply as part of its battle to end deflation while the European Central Bank cut interest rates after inflation figures in October were too low for comfort.  The fears about deflation have resulted in policies which suggest that inflation in any form is better than deflation.  But deflation is a symptom of bigger problems and the prescribed cure may do more harm than good.

Economics textbooks paint a grim picture when it comes to deflation – lower prices translate to less money to pay off debts for both businesses and governments with consumers holding off on purchases if today’s prices are likely to be lower tomorrow.  Japan has been a case study of the damage done by deflation –the bursting of a gigantic financial bubble in 1989 resulted in around two decades of falling prices seen as sapping the life out of the Japanese economy while government debt has reached around 230% of GDP.  The years of deflation reinforced the notion of deflation feeding upon itself to reduce demand for goods and services and further drive down prices.

However, according to this rationale, deflation is the cause of the problem rather than simply a sign of a sluggish economy.  The reasons behind deflation are based on prices being too high as a result of unsustainable price increases in the past.  We can see an example of how this works in that stock prices in Japan are still less than half their peak value, highlighting the extent to which prices can be massively overinflated.  Prices for consumer goods are not subject to the same price pressures as in the stock market but the example illustrates the consequences of economic overheating.

There are parts of Europe with similar issues but nowhere is close to being on the same scale.  So, while Japan shows what can happen, its relevance to Europe is likely to be limited.  The deflation emerging in Europe, such as in Greece and Spain, is the result of weak demand coupled with falling wages which helps businesses by lower their costs.  The lower wages are needed for these countries to regain their competitiveness relative to the rest of Europe as other options, such as currency devaluation, are not available for countries in the Eurozone.

The response of central banks in Japan and Europe has been to use monetary policy to weaken their respective currencies but this targets the symptom and not the problem.  A weaker currency increases the price of imports and is tantamount to paying foreigners more to buy stuff just to create inflation for its own sake.  However, higher prices are more likely to result in consumers tightening their belts as their purchasing power diminishes.  The idea that low inflation requires more of the same approach misses the fact that these monetary policies bring their own costs with little benefit.  Deflation doesn't seem so bad in comparison.

Monetary Policy – via the currency market

With the banking system clogged up, the European Central Bank is looking for other ways to make monetary policy work

Unconventional - this is a term currently used to describe many new elements of monetary policy such as quantitative easing.  It could also be employed in relation to the manner in which monetary policy works nowadays.  The European Central Bank (ECB) cut interest rates in November 2013 due to concerns about deflation (for more info, see previous blog) but the effects are not expected to work through the banking sector as would normally be the case.  Instead, the unspoken target of the policy change was the value of the euro.  This is stuff that you won’t find in any economics textbook, so how does it work and why is the ECB having to rely on such disingenuous tactics for its policies?

The normal result of a cut in interest rates would be a boost to the economy through an increase in lending with lower borrowing costs convincing more households and businesses to take out loans.  The extra spending that this generates would spur on the economy.  But this policy route is not working at the moment as demand for new loans is weak irrespective of how low interest rates are.  The fall in inflation has prompted growing concerns about deflation and the ECB felt the need for further action to signal its intent to prevent this.

Accordingly, the ECB is targeting another avenue (without stating it outright) to achieve the desired results – the currency market.  Europe has been burdened with a currency which reached a two-year high against the US dollar in October.  This is relevant to the fight against deflation in two ways – a stronger currency hurts the economy by making exports more expensive (and harder to sell overseas) as well as reducing the prices of imports (which adds to downward pressure on prices).  A reversal of this trend, that is, a weaker currency, would then work in Europe’s favour and is one of the few levers available to the ECB.

A lower interest rate helps to drag down the value of a currency by reducing the benefits of holding cash in that currency and providing an extra incentive to sell.  This effect is further magnified by the large amount of cash sloshing around in the global financial system at present.   But it is not so easy - some other central banks (namely the Bank of Japan) are keen on achieving the same results through similar policies and not all countries can have weak currencies.  This has resulted in the coining of the term "currency wars" as countries battle to drive down the value of their currencies.  It all sounds rather dramatic but it is evidence of how things in the system of finance are far from normal.