Wrong medicine: Why continued monetary easing will not solve the world’s economic problems

Image by © Randy Faris/Corbis

Countries in the throes of economic turmoil have come to view Quantitative Easing policies as the  catch-all medicine they can use to cure their nation’s ills, saving them from having to perform the serious and painful surgery necessary to get at the heart of their problems.

Indeed, the extraordinary persistence of loose monetary policy is the result of widespread failure among governments to attend to the known structural problems of deleveraging, correct sector imbalances and address solvency issues. Put another way, central banks are being cornered into prolonging monetary stimulus as governments delay the bitter medicine of much-needed structural adjustments.

The unfortunate consequence of ongoing government inaction is that QE (I,II and most recently, round III) is showing signs of being less and less effective in solving the world’s economic maladies. At the same time, QE seems to be increasing the risk of serious side effects.

Both conventional and unconventional accommodative monetary policies are mere palliatives and cannot solve every economic and financial problem. (See the chart below which plots the velocity of M2 in the U.S.). As we have seen, near zero interest rates combined with abundant and nearly unconditional liquidity have dramatically weakened incentives for the private sector to repair balance sheets and for fiscal authorities to curb their appetite for borrowing.

What’s likely to happen as a result of this artificial stimulation and structural paralysis?

With nominal interest rates staying (very) low and central bank balance sheets continuing to expand, risks are rising. To a large extent they are the risks of unintended consequences, and they need to be anticipated and addressed head on. These consequences include the wasteful support of effectively insolvent borrowers and banks – a phenomenon that haunted Japan in the 1990s – and artificially inflated asset prices that generate risks to global financial stability.

One message of the credit crisis was that central banks could do much more to avert a collapse. An even more important lesson is that underlying structural problems must be corrected during the recovery or we risk creating conditions that will lead to the next crisis.

Moving the global economy to a path of balanced, self-sustaining growth remains a difficult and unfinished task. A number of interacting structural weaknesses are hindering the reforms required in advanced and emerging market economies. Those hoping for a miracle cure will continue to be disappointed, and central banks – already overburdened – cannot repair these weaknesses alone.

All of these distressing realities are understood by advanced economy consumers who are reducing debts and are reluctant to spend; by firms postponing capital spending and hiring; and by investors wary of the weak and risky outlook. Why else would they so willingly accept negative real interest rates on government bonds in many advanced economies?