The chatter has it this week that the US Federal Reserve Bank will allow its $85 billion a month bond buying programme to wane, with the eventual death of quantitative easing and a return to economic normalcy. Not only is it too soon for the Fed to back off, its too soon to even be discussing it. The global economy is extraordinarily fragile. We need solutions that are more radical than QE, not a retreat into orthodoxy.
The global economy is threatened by conditions in both developed and emerging markets. In the US and Europe, debt has been transferred from the private to the public sectors and debt levels have climbed faster than economic growth has been able to keep pace. The G7 nations borrowed $18 trillion since the financial crisis and have only $1 trillion in economic growth to show for it.
Meanwhile, both private and public borrowers in the emerging markets have larded up on cheap debt, much of it denominated in dollars and euros. They are borrowing in other currencies and paying with their own, leaving corporate and government treasuries vulnerable to currency shocks, just like we saw during the Asia Crisis of the 1990s.
These are not hypothetical risks; they have already manifested in economic data. Last week, Deutsche Bank analyst Jim Reid and his team released their annual Long-Term Asset Return study in which they examine the worlds raw economic output by measuring the worlds nominal GDP. Nominal GDP is the value of goods and services produced by the worlds developed and emerging economies without adjustment for inflation. We live in a nominal world, writes Reid. We receive wages, pay our debts and manage our savings in nominal terms. This is the world economy as the people who live in it actually experience it and, in nominal terms, says Reid, it is growing at its slowest rate since the 1930s.
You have no doubt been told that the global economy is recovering. But the recovery argument rests, in part, on the Fed using the wrong meter for growth. The Feds dual mandate requires it to maximise employment while controlling the rate of inflation. Fed Chair Ben Bernanke and his governors have been comfortable with inflation at a maximum of 2% annually, a cue followed by other bankers in the developed world. The problem with this, argues Reid, is that if inflation comes in at anything less than 2%, the Fed notches a win. If inflation is 1%, the price level is not as high as it would have been at 2%. The Fed has left economic growth on the table. Focusing on nominal GDP targeting would keep this from happening, assuming that the Fed can actually make up for lost ground through unconventional stimulus. As we have seen, the Feds typical stimulus response, which is to lower short-term interest rates, has its limits because rates cant go lower than zero.
With a level target if the central banks objective is to hit a level of nominal GDP 2% higher at the end of the year than at the start, and it achieved only a 1% increase, then in the next year it has to make up for lost ground and put in place expansionary policies, Reid argues.
This is where the Fed would get more radical than QE. Were the Fed to target nominal GDP growth, it would have to work closely with the government to determine what the growth rate should be. The old ideas of central bank independence would have to be modified in favour of something closer to what is happening now in Japan, where the central bank is actively working with the prime minister in order to combat long-term deflation. For the US, the problem is slow growth, not deflation (Bernanke whipped inflation but was unable to fully reinvigorate animal spirits). In concert with the government, the Fed could conceivably target job-creating industries for direct financial injections or no-interest loans. This could devalue the dollar though that is not the goal and, thus far, countries that export to the US have managed to maintain a desirable balance between their currencies and the greenback (indeed, the bigger global risk is not a falling dollar but crashing emerging market currencies).
Such targeted stimulus falls under the rubric helicopter money. QE supports asset prices. The Feds purchases of government bonds keeps interest rates low so return-seeking investors have to buy stocks, real estate, corporate bonds and emerging market securities that are riskier but offer potentially greater rewards. The hope is that asset price inflation creates a positive wealth effect. Helicopter money cuts out the middleman. At the extreme, the Fed could write checks directly to citizens. It operates on the basic premise that people who have more can spend more. Under this line of thinking, it would also be possible for the Fed to buy and cancel private debts.
The Fed has always worked through the financial system and independent of the government. But the old ways have proven inadequate to the task. The economy is missing $25 trillion worth of output as a result of the Great Recession. In response, developed world central banks only expanded their balance sheets by $14.5 trillion.
Inflation, you say China and other emerging market exporters are saving the world from that by flooding markets with cheap manufactured goods. But the tenuous strength of emerging market economies makes the Feds mission urgent. Mere chatter about QE tapering has driven investors out of some emerging markets. Hedge fund investors like Jeffrey Gundlach of Doubleline Capital and Ray Dalio of Bridgewater already see India as a big short.
If, when the next crisis hits, the emerging markets are disrupted while the West is enchained by debt, the Fed will find itself with far less freedom than it had. Bernankes successor might well wish that radical action had happened sooner.