If Central Banks Are the Only Game in Town, We’ve Lost
Relying on monetary policy to prop up asset prices and smooth out global volatility is a recipe for disaster.
Just since December 2018, central banks have collectively injected as much as $500 billion of liquidity to stabilize economic conditions. The U.S. Federal Reserve has put interest rate increases on hold and is contemplating a halt to its balance-sheet reduction plan. Other central banks have taken similar actions, fueling a new phase of the “everything bubble” as markets careen from December’s indiscriminate selling to January’s indiscriminate buying.
The monetary onslaught appears a reaction to financial factors -- falling equity markets, rising credit spreads, increased volatility -- and a perceived weakening of economic activity, primarily in Europe and China. If they heeded Walter Bagehot’s oft-cited rule, central banks would act only as lenders of lastresort in times of financial crisis, lending without limit to solvent firms against good collateral at high rates. Instead, they’ve become lenders of first resort, expected to step in at any sign of problems. U.S. central bankers are currently debating whether quantitative-easing programs should be used purely in emergency situations or more routinely.
Since 2008, the global economy has grown far too dependent on huge central bank balance sheets and accommodative monetary policy. The U.S. economic boom President Donald Trump loves to tout is largely fake, engineered by artificial policy settings. Such dependence is dangerous and, for various reasons, could well backfire.
For one thing, central banks are poor forecasters. GDP growth, inflation and labor markets may prove more resilient than feared, remaining at or above trend. Key risks, such as the trade dispute between the U.S. and China, may recede. Financial markets and asset prices have already recovered substantially. It’s possible that central banks may be forced to make another U-turn to reduce the risk of reflating asset price bubbles and overheating economies. This flip-flop would be destabilizing and affect decisionmakers’ credibility.
While monetary measures boost asset prices, too, their influence on consumption and investment is unclear. Unlike fiscal or micro-economic initiatives, they can’t target specific sectors or precise objectives. Where central banks finance governments, they blur the distinction between fiscal and monetary policy.
In fact, lowering the cost of money and increasing liquidity may reduce rather than boost economic activity. Lower costs of capital encourage automation, displacing workers and reducing bargaining power for higher wages. This problem is compounded when low interest rates encourage investors to look to shares for income; that forces companies to increase dividends or buy back stock, frequently by reducing their workforce to improve earnings and cash flow.
Lower rates reduce the incomes of retirees and thus their spending power. They also increase the funding gap of defined benefit pension plans, which could lead to a reduction in benefits. With investment yields low, investors have to set aside additional savings for future needs, shrinking their disposable income. If consumers then borrow more to finance routine consumption, debt levels will rise.
Indeed, central bank actions are already an implicit acknowledgement that rising debt levels are unsustainable at higher rates and under tighter liquidity conditions. In the U.S., a record 7 million Americans are 90 days or more behind on their auto-loan payments, according to the Federal Reserve Bank of New York -- a significant signal of distress among low-income groups who typically prioritize such payments. The actions also recognize that government funding needs, for example in the U.S., require central bank support.
Easy monetary conditions also perpetuate the problems of zombie borrowers, weak businesses that survive only because cash flows cover loan interest at low rates. This prevents the reallocation of capital from underperforming businesses.
An overreliance on central banks exacerbates the crisis of trust. The emphasis shifts from elected governments to unelected finance officials, reducing accountability and undermining democratic forces. That allows other economic actors to avoid dealing with the real issues. It creates the impression that the central banks favor banks and the financial system, rather than the real economy.
Central banks’ new activism looks like a panicked capitulation to markets and political pressure. This encourages market participants to expect intervention regularly to prop up asset prices and smooth out volatility. Ultimately, this reduces the effectiveness of lower rates and additional liquidity infusions. As with any addiction, increasing doses become necessary. That will increase the strains on central bank balance sheets and tools, undermining their ability to respond in a real crisis.
Printing money was always going to be easier than withdrawing it later. In effect, central banks are boxed into a situation where they can’t normalize policy and must maintain low rates and abundant liquidity, lest they destabilize fragile asset markets and spur low growth and disinflation. This state of “infinite QE” risks miscalculations and major policy errors. If central banks are, as is now fashionable to state, the only game in town, then the game is lost.
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