It is now official: “We will be mindful of unintended negative side effects stemming from extended periods of monetary easing.” This is how the G-20, the most important country grouping today, put it in the communique they issued Friday night. But what exactly are they talking about?
It all started with the difficulties that most advanced economies faced in generating adequate growth and employment after the 2008 global financial crisis. Rather than catalyze the political system into action, this “new normal” worsened polarization. Feeling a “moral obligation” to step in, central banks (led by the Federal Reserve) embarked on a series of bold and unprecedented policies – or what became known as “QE infinity.”
QE, or quantitative easing, refers to the use of central banks’ balance sheets to manipulate financial prices. It follows the flooring of policy interest rates at zero for a prolonged period of time, and also commitment to keep them there for a lot longer.
The idea is simple: manipulate key financial markets in order to “push” investors to take more risk, thus also stimulating spending and investing. With time, improving fundamentals would validate the artificial prices, thus also allowing central banks to exit.
Most investors have responded to QE as very few wished to take on institutions with a printing press in the basement. Yet, despite the manipulation of financial markets, growth and jobs have consistently fallen short of expectations.
Facing insufficient demand, structural impediments and policy uncertainty, the real economy has not responded as envisaged by central bankers. In response, officials have widened the scope and scale of QE.
The G-20 now recognises what Fed Chairman Ben Bernanke told us back in August 2010: the intended “benefits” of unconventional policies come with “costs and risks.”
So, what exactly are these collateral damages and unintended circumstances?
Modern market-based economies are not wired to function well at artificial prices for any prolonged period of time. The pricing system loses its critical signaling role. Markets operate less well. And, critically, resources are misallocated – both in the financial sector and also in certain parts of the real economy.
So, less than five years after a global crisis triggered by irresponsible risk-taking, concerns are again surfacing about bubbles. The worry is heightened by the fact that both governments and central banks now have fewer weapons to counter the detrimental effects of another financial crisis.
There are also worries about the integrity of central banks, institutions critical to sustaining high, non-inflationary growth. Prolonged QE exposes them to possible losses, potentially undermining their political autonomy.
Then there is the risk of inflation. While not an issue today, some understandably question the optimistic view that central banks will have no problem in soaking up all the liquidity they have injected should this become necessary.
These “costs and risks” are not limited to the country pursuing QE. Since the U.S. is the issuer of the world’s reserve currency, many other countries end up importing complex economic and financial challenges.
All this explains why the G-20 is now recognising what was already obvious to many others. That is the good news. The bad news is that neither the G-20 nor any other official entity can deliver a solution as long as politicians remain divided.
So, we are all like patients compelled to take a medication that has not been clinically tested. We were initially told it was good for us – indeed necessary. Now we are being warned that there may be unpleasant side effects.
Pending good alternatives, we should do more than hope for the best. We should also take steps to manage exposure to the damage should central bank experimentation eventually end in tears.