Rajan: Easy money will not create sustainable growth
Raghuram Rajan, one of the few mainstream economists to warn of the US housing bubble, has recently written a piece which is highly critical of US monetary policy. His view, one that I share, is that US policy favours debtors over savers in a way which will not create sustainable growth. On the contrary, easy money will lead to distortions that create asset bubbles and longer-term systemic problems.
He sees the same mid-cycle slowdown that I do – and the same calls for more easy money:
Recoveries are rarely without blips, especially when they are as weak as this one. But, regardless of whether the factors behind the latest slowdown are fleeting or enduring, there will be calls on the US Federal Reserve to do something.
Some Americans view Fed Chairman Ben Bernanke as a modern-day wizard, able to revive the economy through a swish of his monetary wand – first ultra-low interest rates, then quantitative easing, and perhaps eventually money-printing. If inflation is low, they want the Fed to use every spell it knows to revive the economy. Like the World War I generals who reacted to every slaughter of their men by sending even more over the top of their trenches in a vain attempt to overwhelm the enemy, “free money” types react with “More!” if their policy does not seem to be working.
Notice, however, he labels quantitative easing and money printing as two separate phenomena. I am not sure what Rajan means when he talks about money printing but as a point of clarification, I should add that quantitative easing is merely an asset swap of ‘freshly printed’ reserves that are exchanged for existing financial assets. Yes, I know I call it ‘money printing’ as has Bernanke. But despite the freshly printed reserves, total financial assets in the private sector do not change on net.
The Fed makes these kinds of exchanges at the short end of the yield curve in the ordinary course of business to target the Fed Funds rate. By targeting the long end, QE2 is equivalent to issuing treasury bills as a swap for long-term assets. This should have brought down interest rates. But because the Fed has chosen to target quantity ($600 billion of QE) instead of price (offering to peg an interest rate for specific maturities), increased inflation expectations initially worked at cross-purposes with the changing portfolio preferences that boosted risk assets and commodities. Thus interest rates rose initially. See here for a primer on how quantitative easing really works.
Now that the QE prop to asset prices is being withdrawn, portfolio preferences have shifted away from risk and inflation expectations have normalised, reflecting the underlying deflationary force that is private sector deleveraging. Interest rates have plummeted. That this would happen was always apparent. There is no free lunch, not with quantitative easing or with low interest rates.
Clearly, someone is paying a price for ultra-low interest rates: the patient and uncomplaining saver. Interestingly, if traditional spenders such as firms and young households are unwilling or unable to take advantage of low interest rates, low rates could even hurt overall spending, because savers like retirees receive lower financial incomes and curtail spending.
Warren Mosler bangs on about this all the time. Low rates steal interest income from the private sector. QE steals interest income from the private sector too. This is exactly what Bill Gross is calling financial repression. When writing about financial repression last month I said:
The Federal Reserve will be on easy street for a long time to come. Real interest rates will remain low or negative, meaning debtors will be favoured over savers. Investors in fixed–income will take it on the chin.
Bill Gross had some comments on this prospect in an interview on Bloomberg Television. Video below.
My take: the US savings rate will remain low because of the skew in favour of debtors. With private sector debt levels still high, that means future US recessions will be events of extreme levels of private sector deleveraging and public sector deficits.
And this is the systemic risk problem I see.
These low rates induce people to lever up during recovery or at least attenuate their deleveraging. This creates distortions.
Equally worrisome are the distortions that easy money creates. Evidence from the recent crisis suggests that ultra-low rates prompted a wide range of portfolio adjustments, whereby Asian and Middle East central banks and funds ended up holding the safest low-interest securities, while the US and European financial sectors went on a risk-taking binge. History never repeats itself exactly, and those singed by fire do learn not to play with matches, but we should be aware that unnaturally low interest rates have consequences other than inflation.
Finally, what of inflation itself? While wage inflation in the US is contained, global monetary policy is probably excessively loose – one reason that oil prices have taken off. The Fed blames (rightly) foreign central banks that are keeping interest rates too low to prevent their currencies from appreciating against the dollar; but the Fed cannot set policy assuming others respond with a theoretical ideal. High oil prices now curtailing growth in the US are partly an unintended consequence of current policy.
But when recession hits, they are caught out and are forced to delever aggressively as resource misallocation becomes evident. This only invites an aggressive policy response from the Fed in the form of yet more easy money. And because the Fed is already feeling political heat from its previous policy actions, it will allow the economy to slip before it embarks on the next round of QE. And because we are at the terminal stage of the Doom Loop in which cheap financing and lax regulation leads to excess risk and credit growth followed by huge losses and bailouts, the Fed will then be forced to be extremely aggressive in its policy response which could include the purchase of municipal bonds among other more drastic measures.
As Rajan notes in conclusion:
There are many things that the US needs to do to create sustainable growth, including improving the quality of its work force and infrastructure. Easier money is not one of them.