Central banks have been engaged in unprecedented monetary experimentation. Unlike scientists developing drugs, fear of the unknown has had no moderating influence on their activities. That in itself is alarming. Nor is it possible to reverse recent policies. Now governments must accept responsibility for resolving an incipient global solvency crisis.
The monetary stimulus provided repeatedly over the past eight years has failed to produce the expected expansion of aggregate demand. Debt levels have risen, especially in emerging market economies, constraining expectations of future spending and current capital expenditures. Consumers have had to save more, not less, to ensure adequate income in retirement.
At the same time, easy money threatens two sets of undesirable side effects.
First, current policies foster financial instability. By squeezing credit and term spreads, the business models of banks, insurance companies and pension funds are put at risk, as is their lending. The functioning of financial markets has also changed, with market “anomalies” indicating hidden structural shifts, and many asset prices bid up to dangerously high levels.
Second, current policies threaten future growth. Resources misallocated before the crisis have been locked in through zombie banks supporting zombie companies. And with neither financial institutions nor financial markets functioning properly, real misallocations since the crisis have been further encouraged.
Perhaps we need look no further for the cause of the alarming slowdown in global growth than the insidious effects of easy-money policies. Two vicious circles are at work with a wounded financial system contributing to both. On the demand side, accumulating debt creates headwinds, leading to more monetary expansion and more debt.
This explanation contrasts sharply with the hypothesis of a “savings glut”: little more than a tautology for slow demand growth. On the supply side, misallocations slow growth which again leads to monetary easing, more misallocation and still less growth. This explanation seems far more convincing than “secular stagnation” in an era of extraordinary technological advances.
Accepting the importance of these varied effects also undercuts the popular argument that central banks must reduce the “financial” rate of interest whenever the “natural” rate of interest (the expected rate of return on capital) declines. If expected profits have collapsed as a side effect of past monetary policies, this hardly seems to justify maintaining such polices.
If central banks should not continue doing what they are doing, what should they do? One tempting option is to say “tighten up”. The problem is that damage cannot be undone. All the problems identified above have rendered both the real and financial side of the global economy enormously fragile.
Fortunately there is a way forward, but it relies on government action rather than that of central banks.
To please John Maynard Keynes, two sets of solutions are commonly suggested. First, governments with fiscal room for manoeuvre should use it. That room could be increased through legislating medium-term fiscal frameworks to ensure debt sustainability over time. Second, emphasis should be put on infrastructure investment with the private sector.
To please Friedrich Hayek, two sets of solutions are also suggested. Excessive debt must be solved by write-offs and restructuring. This might require recapitalisation or closure of financial firms that made bad loans. Second, structural reforms to raise growth potential and the capacity to service debt will pay longer-term dividends.
We must please both Keynes and Hayek. It is not an either/or world.
Evidently, there will be obstacles. We need a paradigm shift in thinking about how the economy and policy works. Further, we need legislation to allow implementation of many of the policies suggested above. Finally, we need the political will to accept that central banks can only “buy time” for governments to act. That time is now up.
The writer chairs the OECD’s economic and development review committee