Economic policy turned inside out

Stephen Roach

May 4, 2015


The world economy is in the grips of a dangerous delusion. As the great boom that began in the 1990s gave way to an even greater bust, policymakers resorted to the timeworn tricks of financial engineering in an effort to recapture the magic. In doing so, they turned an unbalanced global economy into the Petri dish of the greatest experiment in the modern history of economic policy. They were convinced that it was a controlled experiment. Nothing could be further from the truth.

The rise and fall of post-World War II Japan heralded what was to come. The growth miracle of an ascendant Japanese economy was premised on an unsustainable suppression of the yen. When Europe and the United States challenged this mercantilist approach with the 1985 Plaza Accord, the Bank of Japan countered with aggressive monetary easing that fuelled massive asset and credit bubbles.

The rest is history. The bubbles burst, quickly bringing down Japan’s unbalanced economy. With productivity having deteriorated considerably — a symptom that had been obscured by the bubbles — Japan was unable to engineer a meaningful recovery. In fact, it still struggles with imbalances today, owing to its inability or unwillingness to embrace badly needed structural reforms — the so-called third arrow of Prime Minister Shinzo Abe’s economic recovery strategy, known as Abenomics.

Despite the abject failure of Japan’s approach, the rest of the world remains committed to using monetary policy to cure structural ailments. The die was cast in the form of a seminal 2002 paper by US Federal Reserve staff economists, which became the blueprint for America’s macroeconomic stabilisation policy under Fed chairs Alan Greenspan and Ben Bernanke.

The paper’s central premise was that Japan’s monetary and fiscal authorities had erred mainly by acting too timidly. Bubbles and structural imbalances were not seen as the problem. Instead, the paper’s authors argued that Japan’s “lost decades” of anaemic growth and deflation could have been avoided, had policymakers shifted to stimulus more quickly and with far greater force.

If only it were that simple. In fact, the focus on speed and force — the essence of what US economic policymakers now call the “big bazooka” — has prompted an insidious mutation of the Japanese disease. The liquidity injections of quantitative easing (QE) have shifted monetary-policy transmission channels away from interest rates to asset and currency markets. That is considered necessary, of course, because central banks have already pushed benchmark policy rates to the once-dreaded “zero bound”.
But fear not, claim advocates of unconventional monetary policy. What central banks cannot achieve with traditional tools can now be accomplished through the circuitous channels of wealth effects in asset markets or with the competitive edge gained from currency depreciation.

This is where delusion arises. Not only have wealth and currency effects failed to spur meaningful recovery in post-crisis economies; they have also spawned new destabilising imbalances that threaten to keep the global economy trapped in a continuous series of crises.

Consider the US, the poster child of the new prescription for recovery. Though the Fed expanded its balance sheet from less than US$1 trillion (S$1.33 trillion) in late 2008 to US$4.5 trillion by the third quarter of last year, nominal gross domestic product increased by only US$2.7 trillion. The remaining US$900 billion spilled over into financial markets, helping to spur a trebling of the US equity market. Meanwhile, the real economy eked out a decidedly subpar recovery, with real GDP growth holding to a 2.3 per cent trajectory — fully two percentage points below the 4.3 per cent norm of past cycles.

Indeed, notwithstanding the Fed’s massive liquidity injection, the American consumer — who suffered the most during the wrenching balance-sheet recession of 2008 to 2009 — has not recovered. Real personal consumption expenditure has grown at only 1.4 per cent annually over the past seven years. Unsurprisingly, the wealth effects of monetary easing worked largely for the wealthy, among whom the bulk of equity holdings are concentrated. For the beleaguered middle class, the benefits were negligible.

“It might have been worse,” is the common retort of the counter-factualists. But is that really true? After all, as economist Joseph Schumpeter famously observed, market-based systems have long had an uncanny knack for self-healing. But this was all but disallowed in the post-crisis era by US government bailouts and the Fed’s manipulation of asset prices.

America’s subpar performance has not stopped others from emulating its policies. On the contrary, Europe has now rushed to initiate QE. Even Japan, the genesis of this tale, has embraced a new and intensive form of QE, reflecting its apparent desire to learn the “lessons” of its own mistakes, as interpreted by the US.

But, beyond the impact that this approach is having on individual economies are broader systemic risks that arise from surging equities and weaker currencies. As the baton of excessive liquidity injections is passed from one central bank to another, the dangers of global asset bubbles and competitive currency devaluations intensify. In the meantime, politicians are lulled into a false sense of complacency that undermines their incentive to confront the structural challenges they face.

What will it take to break this daisy chain? As Chinese Premier Li Keqiang stressed in a recent interview, the answer is a commitment to structural reform — a strategic focus of China’s that, he noted, is not shared by others. For all the hand-wringing over China’s so-called slowdown, it seems that its leaders may have a more realistic and constructive assessment of the macroeconomic policy challenge than their counterparts in more advanced economies.

Policy debates in the US and elsewhere have been turned inside out since the crisis, with potentially devastating consequences. Relying on financial engineering, while avoiding the heavy-lifting of structural change, is not a recipe for healthy recovery. On the contrary, it promises more asset bubbles, financial crises and Japanese-style secular stagnation.

PROJECT SYNDICATE

ABOUT THE AUTHOR:

Stephen Roach, a faculty member at Yale University and former chairman of Morgan Stanley Asia, is the author of a new book, Unbalanced: The Codependency of America and China.