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.

Question – where next for Japan

An inquiry from a reader prompts Your Neighbourhood Economist to look into the prospects for Japan

There has been another knock at the door of Your Neighbourhood Economist, with a reader what I thought Japan should be doing in the short and medium term?  The question arrived just days before another big policy development in Japan with the central bank ramping up its monetary policy.  This is the latest attempt by policy makers in Japan to resurrect an economy that has been languishing for decades.  To get an idea of what Japan should be doing, we need to start with what went wrong and why Japan has not made much progress.

What is not going right?

Japan got itself into trouble in the 1980s with the spectacular collapse of a financial bubble from which it has never recovered.  Property prices have fallen almost every year for two decades while prices for consumer goods have been inching lower for almost as long.  Japan has repeatedly tried to use fiscal stimulus but higher government spending has been unable to mask deeper problems with the economy.  Along with numerous roads and bridges which are hardly used, the main result of these rescue attempts has been a ballooning amount of government debt which only adds to Japan’s woes.

Monetary policy has been adopted recently as the potential saviour in the fight against what has been deemed as the main problem – deflation.  Falling prices were seen as prompting consumers to hold off spending and preventing companies from investing.  With this in mind, the central bank in Japan announced plans to double the money supply in early 2013.  But the policy of pumping more money into the economy was based on the false logic that deflation was a problem rather than just the symptom of a weak economy.  Instead, it is likely the case that deflation persists because prices rises had gotten out of hand in the past and need to fall back to appropriate levels.

Fix-up job not working

The result of this monetary policy has been as Your Neighbourhood Economist might have expected with just a brief and temporary boost to inflation.  Prices for consumer goods cannot rise consistently if consumers themselves do not get a similar rise in pay.  Higher wages in Japan seem unlikely as a declining population hurts aggregate demand and Japanese firms invest more overseas than domestically.  Yet, rather than change tact, Japan’s central bank has opted for more of the same. 

This involves the Bank of Japan aiming for an even larger boost to the money supply in Japan with annual purchases of 80 trillion yen (US$720 billion or £450 billion) in government bonds.  The timing of the new policy comes as the Japanese economy is faltering under the added weight of a tax hike designed to fix the government’s finances.  Japan has gotten itself deeper and deeper into trouble and seems likely to be an example of what not to do in terms of fiscal and monetary policy.   

Where to from here

The best option left to the Japanese government is to reform the economy so as to increase competition and improve efficiency.  There is substantial domestic opposition to reforms even within the current government headed by Prime Minister Shinzo Abe who included reforms as one of his key policies.  An easy way to sidestep domestic politics would be to jump on-board to plans for the Trans-Pacific Partnership (TPP).  This is a free trade agreement with the United States, Australia, Mexico, Chile, and other countries around the Pacific Rim.

Left to themselves, Japan will probably continue to stagnated due to the stifling effects of its consensus style of politics which make it tough to come up with reforms that keep everyone happy.  As such, Japan has a history of positive change only coming when imposed from the outside and this free trade agreement looks likely to follow this trend.  Greater competition from foreigners will help lower costs of business and create impetus for freeing up businesses in Japan from a host of restricting rules.  Facing up to the outside world looks like the best way to inject life back into a Japanese economy that has been slowly decaying for years.

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.

Monetary Policy – Losing its Power?

With the finance sector already awash with cash, we can no longer rely on central banks to help us out of trouble

After having worked like a charm for a long time, monetary policy now seems to be losing its mojo.  The source of power for central banks mainly comes through their tricks of printing money and controlling interest rates.  With many governments mired in debt, it has only been the wizardry of central banks that has stood between us and a greater tragedy.  It is of great concern that the capabilities of the once almighty central banks to manipulate the economy are under threat from the large amounts of liquidity in the financial system.  The spells with which central banks hold sway over the economy may amount to little more than illusion when there is already lots of cash around.

Where has the magic gone?

The power to create money seems nothing short of sorcery; however, the rise of digital cash means that it is in fact easier than ever.  Central banks have even lost their monopoly over generating electronic cash with normal banks able to pull off the same trick by making loans.  It was thought that control of interest rates would be sufficient to steer the economy through any ups and downs.  Yet central banks left interest rates too low in line with their narrow focus on keeping inflation in check and banks were free to churn out loans at an unprecedented rate.  The prices of assets such as property have surged upward as a result but only until the inevitable crash in prices.

Central banks stepped in with record low interest rates and new policy tricks such as quantitative easing.  Yet these measures lack potency considering that cash was already cheap and in abundance.  Both banks and businesses hoarded cash – the former worried about their own survival while the latter had few investment options available due to the weak economy.  To add to this, many emerging markets such as China had been building up massive reserves since well before the global financial crisis. 

With the international financial system already flooded with cash, it has been no surprise that monetary policy has not worked as well as expected.  It has been like trying to use sweets to modify the behaviour of a child that lives in a candy shop.  Instead of being much help, the extra funds from central banks have seen the financial markets deformed and distorted as if suffering from some form of voodoo.  Some emerging markets have also suffered from this black magic with their banking sectors unable to handle the volume of cash on offer.

Nothing up their sleeves

Central banks have been looking to develop new powers to influence different sectors of banking.  The Bank of England has been given greater scope to deal with a runaway property market.  Yet, the central bank seems ill at ease with its new policy options, such as restrictions on mortgages, and prefers to rely on its old act of manipulating interest rates.  If central banks no longer have the power to bewitch the economy, it will be tougher to clean up after a crisis like the one we have just been through.

This shifts the goal of policy to stopping problems forming rather than merely attempting to limit the ensuing trouble.  Restricting the dark arts conjured up by banks will be essential to preventing future disasters.  The fairy-tale time when we could believe in the magic of central banks may have passed – we will need to rein in the wicked elements of the economy now that there is nothing to save us from potential misfortune.

Inflation – More friend than foe

Inflation plays the role of the bad guy in economic theory but this may change now that we are faced with a greater threat to the economy

Inflation has been cast as a villain by economists but it could be a source of salvation.  Rising prices are often seen as one of the main evils in an economy – they push up the cost of living and eat into savings.  This may be the case in a normal economy but may not hold true considering that things are far from normal.  Instead, it might be that the high levels of debt weighing down the economy prove to be a greater menace.  In an ironic twist of fate, it is inflation that may prove to be our best weapon in our fight against high levels of debt.

I’ll be back (as the good guy)

Villains can turn into heroes with a twist in the storyline.  Just think of Arnold Schwarzenegger’s character in the second Terminator movie.  The havoc wrought by inflation in the past is almost on the same scale of a cyborg from the future but it has left economists with an innate fear of its return.  Inflation has been tamed and no longer poses the same danger to the economy having been the focus of monetary policy for decades.

It was the global financial crisis that led to a new peril.  Interest rates that were kept too low along with creativity in the banking sector set the scene for a surge in the amount of loans.  The problem of excessive debt was made worse by policies designed to bring the economy back to life.  Monetary policy has left interest rates at record lows while also resulting in a flood of liquidity in the financial markets through quantitative easing.  This combined with government policy to revive the housing market has seen a dramatic rise in the volume of mortgages.

As we have seen with government spending, a large burden of debt can result in cutbacks which damage an economy.  If consumers are also saddled with debt, the resulting limits on consumer spending have serious implications for economic growth.  Debt is not only bad for borrowers but the resulting sluggish economy dims the prospects for everyone else as well.

More inflation now to save the future

While not a new technology sent from the future, something as simple as inflation could be one way of alleviating the burden of debt on both consumers and the government.  Inflation helps by increasing the size of the economy relative to any debts.  If wages increased along with inflation, households would also have more money for repayments of their loans and the greater tax revenue will be a boost for the government. 

There are a range of measures (including one preferred by Your Neighbourhood Economist) which could be used to nudge inflation upwards in a controlled manner while also adding momentum to the economic recovery.  Many economists would recoil from the idea of higher inflation almost as fast as they would run from a cyborg.  But this has more to do with economists being stuck in the past than the destructive powers of inflation.

There are some negatives to factor in but the overall effect of increased inflation would be positive.  Inflation will eat into our spending power through higher prices for many of the things that we buy.  However, spending on everyday items takes up a smaller portion of the earnings of borrowers compared to paying off debt.  Even though a policy of allowing more inflation would be biased towards those with debt, everyone would benefit from a more vibrant economy.  As the Terminator movies have taught us, our current actions shape our future and a little more inflation would be a small price to pay to bid hasta la vista to our burden of debts.

Drowning in Debt – Need Help

We are being pushed into borrowing our way back to economic growth but staying afloat also involves selling off our future

The last thing a drowning man needs is more water but this is how policy makers have chosen to react to the global financial crisis.  The global financial crisis came about due to consumers being allowed to take on too much debt in the past.  Yet, the policy response has been to push for greater borrowing by lowering interest rates and feeding money into the banking system.  Higher debt now can only mean greater repayments in the future.  This would be acceptable if a swift return to economic growth was on the way but this seems too optimistic.  Instead, while the economy is getting a temporary boost now, growing levels of debt are being forecast to depress the economy for years to come.

Cheap loans anyone?

The debt and water analogy works on many levels.  In the same way that water is essential for life to flourish, debt is needed for an economy to grow.  Yet, like water, too much debt can be as bad as not enough.  The appropriate level of debt depends on the pace of economic expansion.  Rapid economic growth will create greater demand for loans as business opportunities arise and asset prices rise.  Like a garden requires watering when the weather is hot, a booming economy can absorb more debt as the money generated through the loans makes it easier to fund debt repayments. 

The opposite is also true.  It is desirable to have fewer loans as an economy cools since paying off debt is tougher.  It seems a strange time to convince people to rack up more debt but that is what central banks are pushing for.  This is because the tools of monetary policy work by reducing the cost of money (through lower interest rates or printing more cash) when the economy is floundering.  Such policies make sense when assuming a rapid recovery in economic growth but even economists are pessimistic about the prospects for the global economy.

The other bail out option is for the government to ramp up spending through increased borrowing.  This is the typical response to dampened economic growth but concerns about high levels of government debt have limited the capacity for such a fiscal stimulus.  This has resulted in monetary policy having to take on the bulk of the heavy lifting in getting the economy moving again.  Businesses have typically not made use of the cheap credit on offer through the low interest rates (except to buy back their own shares).  It is the increased debt taken on by households that has been the main driver of economic recovery but this is neither balanced nor sustainable. 

Debt – paying the price

It is the role of policy makers to create an environment for encouraging economic growth.  Tough choices are necessary when few options are available but relying on households to pile up more debt seems irresponsible and short-sighted.  The ratio of earnings to house prices is on the rise at a time when wages are standing still.  This means that consumers will be saddled with debt repayments for longer (especially if house prices stagnate as is probable) and this will depress consumer spending in the future.  It seems a poor trade-off even at a time when the economy is underwater. 

This policy seems even dafter when considering that consumer debt is mostly unproductive.  Buying a house off someone else does not add anything to the economy (while spending on renovations does help a bit).  On the other hand, if the government were to borrow and spend more on education or infrastructure, this would increase the output capacity of the economy.  Yet, this sensible alternative is being dismissed even though investors are no longer shunning any government with excessive debt and interest rates on government debt are near record lows for many countries. 

It will ultimately be people like you and me who pay the price.  Our spending power is being put at risk at a time when the government’s own finances are drained and businesses are not putting their balance sheets in jeopardy.  It is likely to remain tough for many people to keep their heads above water and an economy saturated with debt may not provide much help.

Central Banks – false illusion of power

The Bank of England shows how little central banks can do with their limited resources

Everyone looks to central banks as the custodians of the economy.  Once upon a time, central banks were regarded as having almost mythical powers to control the forces of the economy.  However, this fairy tale was shattered by the global financial crisis and central banks have since been trying to regain their previous status as economic titans.  Central banks have fought back with extra powers such as quantitative easing which have helped bolster their popularity.  In contrast, the trouble that the Bank of England is having in dealing with the conflicting problems of a fragile recovery and a booming housing market shows central banks at their most impotent.

The myth and the reality

Much of what central banks do relies on creating a belief in their resolve and ability to call on seemingly unlimited resources.  Chronic inflation in the 1970s was reined in by central banks flexing their muscles and inflation has stayed low ever since.  Even in the throes of a crisis, the European Central Bank kept the Eurozone together merely by proclaiming that it was willing to do “whatever it takes” to do so.

With the power to print money, central banks have the godlike ability to create something out of thin air.  It is often only the ideas of economics that keep central banks from unleashing the full force of their powers.  The ability to summon money from the ether is of limited use when most economists are scared of rising inflation following an increase in the supply of money.  Economics has also restricted central banks to operating only in a small arena, which reduces their capacity to act as a power for good.

One example of this is quantitative easing which helped ease the pain over the downturn but came with side effects.  The purchases of bonds through quantitative easing helped to shore up the financial markets but did little to alleviate a chronic shortage of demand in the actual economy.  A slightly different way of using quantitative easing could have had more punch with less mess but also came with the possibility of some inflation. 

Like something from Greek tragedy 

The Bank of England operates in this world of possibilities, but with only limited options.  It has made use of what was available (low interest rates and quantitative easing) but the economic recovery has struggled to gain much traction even after five years.  Yet, the consequences of its policies have shown up as a housing market boom at a time when the Bank of England still has its hands full nursing the economy.

One thing that the Bank of England is missing is a bit of help from the government.  Not only is the government dragging down the economy with its austerity measures, but it is creating problems with policies such as Help to Buy which stoke up the property market just as the central bank is praying for it to cool down.  For all of their potential power, central banks still have to steer clear of politics putting any criticism of government policy out of bounds.  The government with all of its populist tendencies still trumps an institution established to look out for the long term health of the economy. 

Instead, the Bank of England and its governor, Mark Carney, have tried to use the media to communicate their concerns about the property market.  However, this is having little effect as the Bank of England can be ignored since there are few actions it could actually take to back up its words.  Its main weapon would be higher interest rates but the economic recovery is seen as not yet being strong enough.  It would be a shame to see the Bank of England fall from grace battling a wayward government and a run-away property market but it will take a heroic feat to stop that happening.

Banking – Back to Basics

Time for banks to return to their bread-and-butter operations after having almost poisoned the global economy

Banking is like food – best kept simple with as little processing as possible.  This is because, in their role as the intermediaries controlling flows of money in an economy, banks provide the nutrients which help the economy grow.  What was supposed to be a straightforward process became convoluted as banks cooked up ways to move loans onto others.  The resulting concoctions were devoured by investors around the globe, resulting in serious indigestion once the toxic nature of the ingredients was discovered.  Given that the packaging of dodgy debt was one reason for the scale and severity of the global financial crisis, the common sense move would be to change back to a plain vanilla variety of banking.

A recipe for trouble

We rely on food getting from the farms where it is grown to our supermarket shelves every day.  Too much or too little food would cause problems as would food ending up in the wrong places.  We also rely on banks to look after our money in the same way.  Savers leave their surplus cash in banks who make it available for others to borrow.  This simple analogy is how we tend to perceive the role of banks but, as with many things, the reality is more complicated.

Banks have access to a growing range of funds allowing them to lend as much as demand allows.  This gives them a substantial amount of control over how much money there is in an economy.  Central banks look to control lending using interest rates but the global financial crisis has shown that this is insufficient.  Interest rates tend to be too low when economic growth is booming, giving banks scope to lend more than is optimal.

This problem has been exacerbated with banks being able to sell on loans to investors in the form of bonds.  By passing on the risk associated with lending to others, banks circumvented the normal limits on lending and levels of debt exploded as a consequence.  Debt from banks was sold on as bonds such as CDO and MBS with this alphabet soup of financial instruments eventually proving sickening to the financial system.  Banks had our cake and ate it and the result has been years with the economy being starved of credit.

Creating these nauseating bonds was like using MSG to flavour food – an easy way to get an immediate boost but not good in the long term.  Most of us would steer clear of extra nasty additives in our food for fear of the future consequences.  Bankers, on the other hand, gobbled up any magic pills which boosted their profits in the knowledge that it would not be the banks themselves that would pay the price.  This is a problem which is endemic to banks operating without sufficient regulation.

Smaller is better

Considering the propensity for banks to poison the entire economy, their operations should be pared back to a more traditional and wholesome role.  One means to do this would be to limit the activities of banks and break up larger financial institutions that have parts which operate like conventional banks.  Banks should be limited to a scope within which they cannot get into trouble and need to rely on the government for support.  More speculative aspects of their business should be left to others who should be prevented from accessing our deposits.  Other forms of financing are flourishing and this is already replacing part of what banks do.

The basic idea behind this is already out there and is known as the Volker rule.  It has been endorsed in principle by many in politics including President Obama.  Yet, the implementation of this idea has stalled due to opposition from an unsurprising source - the banking sector.  This highlights another benefit of having smaller banks – a reduction in the dominance of the finance sector.  The wealth generated by banks has given them the political clout to push for more freedom to chase profits.  Banks have built themselves up to be the champagne in the economy (providing skilled jobs and lots of tax revenues).  Yet, since it is all too easy for the bubbles to go flat, a return to a bread-and-butter setup would be preferable.

US Monetary Policy – Investors face stormy future

US investors have been blessed with calm seas of late but their good luck is unlikely to last

Monetary Policy has entered a period of calm after enduring something of a turbulent passage through the global financial crisis.  The unprecedented tempest which buffeted the banking sector led central banks to trial a number of measures never seen before.  Yet, since tapering of quantitative easing was launched at the end of 2013, it has been relatively smooth sailing.  Tapering has been implemented in steady waves so as to not shake the delicate stomachs of investors.  However, rather than signalling the end of the choppy weather in the financial markets, the current lull could just be the eye of the storm.

Skies clear following predictable monetary policy

Investors prefer favourable conditions in the same way as sailors.  A view far ahead to the horizon is prized in the financial markets as well as by mariners.  One element that helps investors to better plan a course for the future is having a predictable monetary policy as a guide.  Investors had come to rely too much on the Federal Reserve as a steady hand at the helm using quantitative easing to put some wind back in the sails of the US economy.  Problems thus arose when the Federal Reserve first floated the idea of trimming back its expansive monetary policy in the middle of 2013.

What was a stiff breeze for the US hit many emerging markets like a financial hurricane.  This is because a considerable portion of the money printed in the US had travelled the globe in search of more bountiful returns.  Some developing countries had become a haven for the extra cash but the money left in a whirlwind once the prospects for returns in the US picked up.  The resulting market turbulence pushed some countries to the brink of going under, but investors eventually settled down again after adjusting to the new forecasts.

The outlook for US monetary policy has brightened considerably with the steady progression of tapering.  The Federal Reserve has cut back its purchasing of bonds by US$10 billion at each of its meetings, which happen almost every month.  As a result, bond purchases have been reduced a few times already in 2014 and fell from US$85 billion in late 2013 to US$45 billion at the most recent meeting at the end of April.  The predictability of US monetary policy also survived the potential shipwreck that was the change in skipper from Ben Bernanke to Janet Yellen at the beginning of the year.

Forecast for storms ahead

All is well for now.  However, there may be trouble on the horizon as tapering is just the start of the Federal Reserve relinquishing its role of propping up the economy.  A bigger storm may be coming next year as interest rates have to be raised from their current record low levels.  The Federal Reserve has pledged not to change interest rates for a while as it monitors the economic recovery.  Interest rate hikes must happen sometime in the next year or so especially in light of the surprising improvements in the US job market.

The end of quantitative easing and higher interest rates are all part of a voyage back to normality.  It has been a strange new world in terms of both the financial markets and monetary policy following the waves of financial havoc over the past several years.  The recent squalls that hit emerging markets can be seen as a necessary part of this journey.  Nevertheless, other rough patches may still lie ahead considering that it is far from normal for US stocks to be pushing on record highs despite slow economic growth. 

While it is tough to gauge what normal should look like in terms of the financial markets, the signs indicate that rough seas lie ahead.  Emerging markets have already taken a beating which makes it likely that the next storm may strike US investors closer to home.  

No mystery behind banks behaving badly

Banks were misbehaving in the lead up to the global financial crisis but the blame lies elsewhere

Many fingers have been pointed (and fists waved) at the banking sector.  Bankers have been receiving massive pay-outs despite having acted irresponsibly in getting us into trouble.  While they deserve much of the blame for our current woes, it is like blaming students who are left in charge of running their own school.  Bankers were left to run their own affairs on the mistaken assumption that they could do so responsibly.  But the few rules in place to keep banks from acting out proved insufficient.  This raises the question – why were banks given so much leeway in the first place?

A recipe for trouble

Banks are in business to make money.  The most common way for a bank to do this is to loan out money at a higher interest rate than they pay to get access to the funds.  Given these basic guidelines, anybody running a bank would lend out as much money as possible.  This would not be a problem if there was only a relatively fixed amount of cash to go around.  To make more loans, a bank would have to get its hands on more cash which would involve higher costs if spare funds were in short supply.  The extra charges for banks would then result in higher interest rates and this would put off some potential borrowers.

Unfortunately, this is not how things work in finance.  Instead, using tricks such as electronic money, banks can create as much money as they want.  Any limits to lending have been further diluted as banks have come up with ways of getting loans off their books.  Financial wizardry has enabled loans to be repackaged as bonds and sold off to investors.  Such bonds (known as mortgage-backed securities) were popular due to a combination of a decent rate with seemingly little risk.  With lots of money sloshing around the global economy before the financial crisis, investors did not bother to delve into what the bonds actually entailed.

Banks had reduced their lending standards to include sub-prime borrowers as they no longer had to worry about whether the loans were actually repaid.  So what investors got were bonds that would drop in value once the debt-fuelled property boom came to its inevitable end.  The situation was made worse by the way in which bankers were paid.  Their substantial remuneration packages were linked to profits giving bankers an extra impetus to undertake risker actions.  Levels of pay got out of hand as it was easy to make money by tapping into the demand for credit. 

Even if bankers themselves were motivated to cash out after quick gains, it was thought that prudent business practices would keep banks running through thick and thin.  Yet, the number of banking bailouts showed that bankers favoured short-term profits (and big bonuses) over long-term survival.  With the government and the central bank expected to step in if banks got into trouble, it was worth taking extra risks as there were millions to be made and only the possibility of losing their jobs if things backfired.

No one in charge

With it seemingly obvious that bankers were heading for trouble, there was a glaring need for oversight and regulation.  Despite this, banks were increasingly given a free rein following a couple of decades of deregulation of the finance industry.  A wave of free market ideology had convinced a generation of politicians that any government interference would hamper the industry.  The result was that the finance sector was put on a pedestal and afforded the status of teacher’s pet as a source of tax revenues as well as jobs for skilled workers.

Any attempt at oversight typically succumbed to something known as “regulatory capture” where the government agencies designed to monitor the banking sector are too closely intertwined with the banks.  This is because personnel move back and forth between government and finance, always keeping the industry’s best interests at heart.  Even the central banks that were charged with ensuring financial stability did not find fault with the banks.

Instead of taking on the inherent problems in the banking system, central banks developed a narrow focus on inflation.  Interest rates were the main tool with which central banks attempted to rein in the vagaries of the finance sector.  But higher interest rates only target the demand for loans rather than the supply of credit from banks (who actually make more money when interest rates rise).  Interest rates went up too slowly to stave off the credit boom as easy loans from banks opened the way for us to get ourselves deeper into debt.  Given too much freedom, we can all get into trouble and banks have shown themselves to be no exception. 

Bitcoin – Geek’s Gold

Geeks use technology to make things better and may be close to coming up with a better form of money

The rise of Bitcoin has been as meteoric as its price.  Your Neighbourhood Economist had dismissed the phenomenon as a fad but decided to take more notice after even my recently retired father showed an interest.  The best way to describe Bitcoin to my father was like geek’s gold – a new form of money for techies who no longer trusted traditional forms of money (even though there are other reasons for holding bitcoins).  Bitcoin’s surge in popularity is a sign of a new era of abundant computing power coupled with feckless printing of new bundles of regular cash.

Bitcoin is a type of digital money where each bitcoin is a piece of complicated computer code.  The Bitcoin system operates so that bitcoins only increase at a fixed rate – new bitcoins are given to individuals who maintain a gigantic ledger which keeps tabs on the entire history of all bitcoin transactions.  This setup allows for a public record of transactions to ensure that nothing goes awry while allowing access to bitcoins without going through a central dealer.  This is all made possible through the freedom of the Internet and masses of computing power.

Boom and bust of a gold rush

The key to forming any new currency is that people believe in it as something of value.  A bitcoin was worth less than one dollar in early 2011 before a steady rise to just over 10 dollars by the end of 2012.  It was in 2013 that the price of bitcoins exploded, reaching a record high of 1,242 dollars in late 2013.

One reason behind the dramatic rise of Bitcoin has been that it is relatively difficult to track down the individuals who use it.  Users are known through a Bitcoin address which allows for a high level of anonymity compared to a bank account.  This aspect of Bitcoin makes it popular with those who obtain cash through dubious sources and wish to remain undetected.  Once Bitcoin had shown that it could at least hold its value (with a steady, if not rising, price), it attracted the attention of people with money to hide.

The relatively long period (in terms of technology fads) during which the price of Bitcoin rose sparked a surge in interest from speculative investors.  The quest for a quick buck lifted the price for bitcoins beyond what was sustainable with bitcoins trading below 500 dollars in early April.  Bitcoins are likely to continue to have a volatile price but the price variability will probably decrease over time as bitcoins are used in more transactions.

Money doesn't grow on trees

The key driver for interest in Bitcoin is as an alternative to the normal notes and coins type of money.  The relative ease and lower costs of online transactions make it popular with people that buy and sell via the Internet.  However, Bitcoin has been thought of as something more.  At a time when central banks are printing a deluge of new cash, Bitcoin is seen as a form of money that is not overseen by a profligate governing body. 

The number of bitcoins can only increase by a fixed amount over time whereas it is possible for a virtually endless amount of notes and coins to be produced.  For techies that are always dreaming up new and better products, the case for a new type of money must have seemed a no-brainer.  Limited and always sought after, gold has typically been the main option for investors worried about excessive expansion of the money supply.  In this way, Bitcoin could be considered gold for geeks.

While gold is an out-of-date (but still valuable) form of money, Bitcoin is a potential model of how money might be in the future.  Despite only being accepted in a few offline locations, over-the-till payments with bitcoin are now possible using mobile phones.  So digital currencies could become commonplace although Bitcoin itself may not last the test of time.  A limit to the eventual number of bitcoins could prevent its spread into the mainstream.  Yet, alternatives may be created to build on the concept. 

It just remains to be seen whether digital currencies will be the latest tech fad to go from geek to global. 

Tax Hike in Japan to test fight against Deflation

The Japanese government has been proactive in its battle with deflation but higher consumption taxes will show how much progress has actually been made

There is a big test coming up for the Prime Minister of Japan, Shinzo Abe, and his own brand of economic policies which have been labelled “Abenomics”.  Abe has launched a range of aggressive measures to end deflation and get the Japanese economy moving again.  However, a rise in the consumption tax from 5% to 8% in April will provide a thorough examination of the economic recovery in Japan.  The results will matter not only for the long-suffering Japanese citizens but may also provide crucial lessons on how to combat the growing threat of deflation.

Economic Policy - could do better

A report card for Japan's Prime Minister might see him get an “A” for effort but a “C” for execution.  Abe has had a busy first year in power and has attracted plaudits for his three arrows of economic policy encompassing fiscal stimulus, monetary easing, and structural reforms.  This has translated into 10.3 trillion yen (or around US$100 billion) in extra government spending and the Japanese central bank aiming to double the money supply over a two year period.

Hopes were buoyed as the Japanese economy perked up in early 2013 while the stock market in Japan was one of the best performers last year.  Unfortunately, Abenomics did not live up to the hype with economic growth slowing and many investors selling their Japanese shares in 2014.  The shortfall against expectations has been due to an unwillingness to push through the reforms which are key to getting the economy moving again.

Your Neighbourhood Economist had always been sceptical about the outlook for the reforms as Abe is a conservative in a political party which is known as a bastion of old-school traditions in Japan.  The Japanese government is not alone in using expansionary monetary policy as a shortcut to improving the economy.  Yet, two decades of stagnation show that there is no easy route to scoring good marks where the economy in Japan is concerned.

Economic recovery put to the test

The hike in the consumption tax (which has been on the cards for decades) is a move to sort out the government finances but threatens the goal of defeating deflation.  Consumer prices have begun to edge upwards but this depends on the central bank in Japan continuing to print a torrent of new yen notes.  Rising prices are a novelty in Japan after decades of deflation with the higher consumption tax set to bump prices up a further notch.

It is not clear whether Japan is ready for this real-life lesson on the effects of inflation.  Many companies in Japan are not yet convinced that inflation has taken hold with some even lowering prices to absorb the higher taxes.  As a result, wage gains have been timid despite the government's efforts to bully Japanese firms into paying their workers more.  Inflation without higher wages is even worse than deflation as consumers increasingly feel the pinch.  The increase in consumption tax could exacerbate this trend and depress spending.

Little to learn

A poor showing in economic policy in Japan will seldom make the news elsewhere but it does not bode well as other places look set to face a similar set of problems.  The causes of deflation in Japan are becoming more prevalent in Europe – high government debts, an ageing population, a stagnating economy, and companies struggling amid globalization.

Lessons learnt in Japan could be applied elsewhere.  Yet, successes have been few and far between.  Japan does not make a good case study for fiscal stimulus (more due to problems within Japan rather than problems with the idea of a stimulus).  Neither has monetary policy had much impact with an increase in the supply of money only having a limited effect on inflation (due to the link between money supply and inflation being weaker than assumed).  Europe is instead contemplating negative interest rates which is something that Japan has not tried.

Too much inflation will drag down the grades of central banks but deflation could earn them a fail.  Part of the reason is that deflation has been seen as a cause of the malaise of the Japanese economy (even though deflation is more likely just a symptom).  If the Japanese economy could return to being the star pupil it was in the 1980s, deflation would no longer come with such a bad reputation.

Interest rates - how not to manage the money supply

How central banks thought they had slain the main threat to the economy but the real menace was lurking elsewhere

Economics is a narrative on how the economy is supposed to work, but the path to economic success and riches is often fraught with danger.  The cautionary tale of interest rates and money supply serves as one such example.  The hero of the story was meant to be central banks whose role was to control monetary policy which involves looking after the amount of money in the economy.  Interest rates were deemed the best weapon to regulate the money supply and a couple of decades of success ingrained a belief in this view of the world.  However, the global financial crisis put an end to hopes for a happy ending and economists are still struggling to come up with a new script.

What was supposed to happen

The original scenario relied on central banks being able to influence the money supply by setting interest rates to the appropriate level.  Central banks would not target money supply directly but focus on inflation instead.  Economic theory states that inflation is the result of an expanding amount of money in the economy.  More money equals higher prices.  So, if prices are rising too fast, this is due to an excess of money in the economy.  Higher interest rates act as a damper on inflation because the amount of money moving around the economy drops off as the demand for loans falls and consumers leave more cash in the bank.

The focus on inflation also stemmed from its leading role in telling how well the economy was doing.   Inflation has gotten out of hand and wreaked havoc in the past so economists are determined that this storyline was not to be repeated.  Inflation is also easy to keep tabs on compared to money supply which is tough to define, let alone measure (the money supply could include cash as well as money in banks (current or savings accounts) and other funds).

All good in theory.  And it even worked in practice for a couple of decades from the late 1980s.  Economists thought that their ideas had enabled them to conquer inflation and smooth out the boom and bust cycles.  But all of the good work of economic policy was undone due to an inherent flaw in the theory.  Growth in money supply not only affects consumer prices, which central banks watched over-closely, but also in asset prices, which were not seen as a concern.

Need for a new narrative

It is no surprise that the villain in this story is the banking sector.  Banks were left in charge of setting the money supply which rises and falls depending on the amount of lending.  The volume of loans (along with the money supply) exploded during the favourable economic conditions over the years leading up to the global financial crisis.  Banks were able to take advantage of the growing demand for credit due to innovations in finance that meant that banks could pass loans onto others and not have to worry about loan repayments. 

A large portion of the loans was used to buy existing assets such as houses or shares.  The resulting gains in asset prices, which surged ahead of growth in the underlying economy, sowed the seeds for the crisis to come.  Meanwhile, a dramatic increase in global trade meant that inflation was no longer determined in the domestic economy but was highly influenced by global markets.  Cheap imports from China reduced the prices of products like clothes and electronics.  Imports were also on the rise and the prices of any internationally traded goods no longer depended on the money supply in any one economy.

Subdued inflation meant that the results of the rampant increase in money supply did not jump out at central banks.  Their focus on consumer inflation led central banks to disregard the asset price bubble growing in their midst.  Instead, it was argued that financial markets would always set the appropriate prices and that central banks should not get involved.  The irony is that any extra cash tends to influence asset prices even more than consumer prices (as shown by the effects of quantitative easing) but this effect is near impossible to separate from other factors (hence the reliance on inflation).

It was revealed that central banks had been setting interest rates too low to keep the economy from getting into trouble.  The whole messy chapter could have been avoided if the money supply had been kept under control.  A simple solution would be for the economy to be left to its own devices with a relatively stable money supply.  Greater demand for loans would push up interest rates, stopping debt levels from becoming excessive while also benefiting savers. 

Despite the obvious solution, economists are loath to give up on the fairy tale they always believed would come true.  It may take time for a new economic story to be written but the changes should mean a brighter turn in the future of the economy.  With this, at least the sobering ending to the latest chapter of the economy should come with a silver lining. 

Global liquidity: have we created a monster?

Money in the financial system overwhelms all it encounters making it a growing threat that needs to be dealt with

We are being overrun – by money.  There may be worse things to have battering down one's door but a surplus of cash in the financial system can have scary consequences.  The financial system was set up to facilitate the movement of cash to parts of the economy where it is needed but has instead become a behemoth exerting a dominating influence over the creation of goods and services in the actual economy.

Quantitative easing feeds the beast by flooding the banking system with even more cash in the hope that a few crumbs will drop down into the actual economy.  However, not only is the financing no longer having the desired effect, but the extra money is becoming increasingly erratic and hard to control.  Policies are needed to yank banking back into line.

Money getting out of hand

Spare cash in the form of savings is the basis for economic growth.  Surplus from current production is invested to enable higher output later on.  Banks were first created to shift extra money elsewhere so that production could be expanded.  Yet, banks have gone beyond the basic operation of allocating money and moved into the business of making money from money.  This is a waste of resources considering our best and brightest could be put to better use.  But more than that, the colossal size of the financial sector is in itself a problem – it is like a giant trampling everything in its path.

Money is free to move around the globe on a whim.  Too much free-flowing cash turns into a menace in terms of stability.  The danger always seems close at hand – banks and others creating more cash out of thin air by increasing leverage when times are good while central banks unleash a mass of new money to shore up the economy when things turn bad.  Yet, money is not always forthcoming - the impact of the global financial crisis was exacerbated by a flood of cash fading to a trickle.

The money is out there lurking and waiting.  The skulking leviathan surfaces only in a few places but creates distortions wherever it emerges.  A clear example is the property prices in London and other places in the UK which are booming at a time when the underlying economy is stuck in a faltering recovery.  Emerging markets have also fallen victim to the ebb and flow of global finances due to their less developed financial markets and limited domestic savings.

Making money work for us

If massive money movements are causing chaos, it is only sensible to conclude that greater controls should be put in place to rein in the rampaging.  The current direction of policy on finance has turned to re-regulation after decades of deregulation gave banks the freedoms which allowed the phantom cash to wreak havoc.  The finance sector has railed against any restrictions, but the monster now rearing its ugly head cannot be left uncaged.

It is argued that free movement of money is essential despite the risks, as credit is cheaper as a result.  But even the cheap cash from central banks has not been enough to convince banks to lend which suggests that easy money does not bring the benefits previously thought.  This means that we should not fear the utilization of policies as controls over the movement of money, the separation of retail banks (which take in savings and give out loans) from investment banks (which deal in financial wizardry), or the introduction of higher standards for banks in each individual country.  Money in itself is not evil – it just needs to be kept in its proper place.