Central bankers have not given up yet. Both the European Central Bank and the Bank of Japan continue to pump up their unconventional policies of quantitative easing and negative rates. But while unconventional policy tools are increasingly prevalent, growth rates continue to weaken and the debt overhang that triggered the financial crisis has worsened. Hitting central banks’ inflation targets remains a distant hope.
While the financial crisis was brutal, it was nothing like a Flanders field. Policymakers did everything possible to avoid the day of reckoning, desperate to prevent the crisis developing into another Great Depression. Creative destruction was taboo. The tonic was unprecedented and aggressive monetary stimulus that cushioned economies from the inevitable deleveraging that was needed.
This allowed some afflicted governments, but not the eurozone’s austerity economies, to run counter-cyclical budget deficits, selling the debt to finance them (indirectly) to central banks. The feared hyperinflation that printing money risked has failed to materialise. And monetary policymakers were elevated to gods by markets as reward for reflating asset prices beyond their pre-crisis peaks.
But that is where the success story ends. Quantitative easing has simply replaced one bubble with others. Sovereign debt burdens have jumped. But even more lethal may be the recent surge in corporate debt in many Asian economies.
The crux of the problem is that targeting an inflation rate, typically 2%, in a world where there is excess capacity and structural deflation does not work. It might when dealing with a normal business-cycle recession, but not a financial crisis where past credit excesses take much longer to work through. This is because credit bubbles build up stocks of unproductive assets and loans and divert other resources, particular labour, into low-productivity sectors.
The legacy problems of the financial crash have been further exacerbated by a structural slowdown in trend growth rates. This change is partly demographic, as working age populations peak. But it’s also due to fundamental changes in demand, away from mass consumption of manufactured goods, where the excess capacity lurks, towards services, in which the old ‘economy of things’ is gradually replaced by an ‘economy of non-things’.
This is not necessarily bad for the consumer, who is also the worker. His/her costs of consumption have fallen, insulating real incomes. Cheap, or free, convenient internet services have also hefted living standards. But it fundamentally alters the traditional link between a tighter labour market and inflation and the upward path of nominal GDP growth, which has historically dictated the pace of debt absorption.
It also helps explain woeful total factor productivity (TFP). The growth of lower-paid services jobs, which has been a feature of the US recovery, has more than outweighed rising productivity in the new technology sectors.
These are the modern challenges that central bankers are trying to tackle with their traditional, rear-view, monetary policy toolbox.
A square peg for a round hole.
In the short history of the ECB, its president, Mario Draghi, has been a revolutionary. His celebrated Outright Monetary Transactions might have been a policy defined by words not practice, but it was highly effective at diffusing the eurozone debt crisis. And he has managed to sidestep German objections to quantitative easing with his Asset Purchase Programme (APP) alongside a move to a negative deposit rate. But rather than APP and negative rates boosting demand, they have become tools to fight a rearguard action against the slowdown in global growth and rebalancing away from manufacturing, where overinvestment is concentrated, towards services and those disruptive technologies, which need far less capital.
In Japan, the BoJ campaign started with the adoption of a 2% inflation target, accompanied by an aggressive monetary easing programme, which is adding 15% of GDP to the monetary base annually to get it there. As a result, the BoJ’s balance sheet is on course to hit 100% of GDP.
Other central banks share the BoJ’s policy dilemma. Their initiatives are starting to influence markets less and less. A law of diminishing returns has set in.
One reason is because so many central banks are making the same policy moves. The law of diminishing returns then compounds pressure on a central bank to do more to meet its monetary policy commitments – in Japan’s case that elusive inflation target. None of this is too far from the toxic races to the bottom that have fed earlier global crises.
Watch this space.