No free lunches

Published: Sep 2013

In this day and age, it pays to remember Milton Friedman’s famous adage: “There is no such thing as a free lunch”. What he meant, among other things, was that a central bank cannot print money (to boost the economy) with impunity. This figures – creating a wealthy society simply by cranking up the printing presses would be too easy, with Zimbabwe being a case in point.

What Friedman was really saying was that too much money creation eventually leads to inflation, which makes people poorer. This, in particular, is the price that has to be paid.

So why would a central bank pursue such a policy? After all, there is every chance that the drawbacks of liquidity creation will eclipse the benefits in the long run. The problem is that initially, the effects are benign. In almost every situation growth picks up, whereas inflation is nowhere in sight and only starts to bite at a later stage. As a result, politicians are often tempted to head in this direction. They are also encouraged to do so because they have a perfect excuse: the policy provides temporary relief in a difficult situation.

With this in mind, one could wonder what most central banks thought they were doing in the past.

The Federal Reserve, for example, has quadrupled its balance sheet in just a few years. Equally, the Bank of England (BoE) and the European Central Bank (ECB) have created a lot of money, as well as the Bank of Japan (BoJ).

Chart 1: Federal Reserve balance sheet
Chart 1: Federal Reserve balance sheet

Source: Thomson Reuter Datastream/ECR

Regardless of their motives, the main question now is what will the fallout be? The answer will determine prices and rates in the financial markets. This Market View takes a look at the costs of “paying the piper“in the US.

Countering the crisis in the US

During and after the credit crisis in 2007-2008, growth slowed so much that there was downward pressure on asset prices on an ongoing basis. Owing to plunging asset prices, the banks suddenly needed to write down their debts. Consequently, credit seized up, asset prices kept falling, the economy started to contract more and more, and inflation threatened to morph into deflation. In other words, a vicious cycle was taking hold. Many debts could no longer be serviced, let alone repaid. To offset this, the government intervened on a massive scale. One implication was that its deficit mushroomed within a couple of years.

It soon turned out that this wasn’t enough to save the day and that, in any case, high deficits would not be sustainable, due to the ageing population. So the Fed needed to step in. The central bank embarked on a large-scale bond-buying programme, which drove down long-term interest rates and created a lot of “new money”, which boosted asset prices (albeit artificially).

The Fed policy helped to gradually turn the tide. As asset prices rose, consumers became more inclined to borrow and banks started to supply credit again. Instead of a collapsing financial sector and general downturn, the economy saw modest growth and credit picked up. At first glance, this is a fantastic achievement for the central bank, and completely in line with what can be expected during the first stage of a large-scale monetary stimulus.

Free lunch today?

However, it would be unwise to ignore Friedman’s comment. In other words, at what cost did all of this happen? This is a very relevant question even if, for the moment, inflation does not loom large – quite the opposite (which is why several Fed members appear more worried about deflation). The following can be expected.

The absence of inflation – so far – is understandable. After the credit crisis erupted, credit stagnated and the money multiplier, as well as money velocity, dropped sharply. The money created by the Fed merely compensated for this.

The problem is that in order to prevent deflation in the US, economic growth needs to be at least 2.5%. And as long as real disposable incomes increase marginally, this can only be attained if credit eases. The Fed accomplished this through asset inflation. Yet, success in this respect is a double-edged sword: as the money multiplier and the rate of money circulation accelerate, deflation risks will disappear but inflation will increase rapidly. Simultaneously, interest rates will spike until inflation is no longer a threat and/or until nominal interest rates exceed the expected rate of inflation considerably.

In the circumstances, interest rates will have a long way to go, the Fed having considerably depressed interest rates. Short rates are below inflation. However, long rates are not. For instance, the yield on ten-year US Treasury bonds is approximately a percentage point higher than the current inflation rate.

Of course, bond investors tend to look ahead. They know that once credit takes off properly, economic growth will reach 3% and inflation will rise to 2%. If so, nominal growth will hover around 5%. As long as the rate of interest remains below that, it will be profitable to borrow money and credit will continue to ease. As a result, the money multiplier and money velocity will increase and so will the risk of future inflation. In other words, whereas long-term interest rates exceed the present rate of inflation they are bound to go up at some point, which makes it even more attractive to borrow money, and so on.

Bond market limits growth potential

Owing to the massive money creation of the past years, the bond market will not tolerate a much higher money multiplier/velocity. In practice, this means that once borrowing picks up, bond yields will climb to levels where credit stagnates again.

Therefore, the price for the recent liquidity creation is that it will not be possible to expand credit supply much in the coming years. This could well imply that the US economy faces a prolonged period of low growth as deflation continues to threaten. To counter this, the Fed will have to keep on boosting asset prices artificially, eg. create more money. However, as money supply expands, interest rates will tend to shoot up at an ever earlier stage (and more steeply) as credit eases.

Chart 2: Problem of deflation
Chart 2: Problem of deflation

Source: Thomson Reuter Datastream/ECR

Too much market optimism

The markets are too sanguine about the long-term growth prospects for the US economy. It is praiseworthy that the Fed has managed to prevent a deep depression after the credit crisis broke out, but that is not the same as returning to the growth percentages of the past decades. The latter would require a functioning credit system but precisely because of the policy the Fed has pursued in recent decades, this may well be impossible.

Therefore, many years of sluggish growth is on the cards. If growth threatens to slow too much, the central bank will – again – try to create asset inflation through money creation. But once credit eases, interest rates will skyrocket, until credit starts to tighten again. It seems that the US economy has now arrived at this stage.

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