What if there’s no exit?

Published in Insights, The New Zealand Initiative’s newsletter, 7 June 2013

When the financial crisis started about six years ago, the global policy response was a mixture of monetary and fiscal stimulus. Governments increased spending and hoped for multiplier effects. Meanwhile, central banks slashed interest rates, and when that was not deemed enough, started purchasing assets on a giant scale.

Critics at the time pointed out that the extra government spending might only leave behind more debt and that the multiplier effect, if it existed at all, could be a flash-in-the-pan. They also warned that fresh injections of cheap money could lead to new bubbles that distorted prices and might not be reversible without causing considerable damage.

All such warnings were brushed aside. Politicians and central bankers claimed a) there was no alternative, and b) there would be a benign exit from these strategies as soon as the global economy returned to normal.

Well, six years down the track, it appears the critics have been right with their warnings all along. Despite the concerted efforts of fiscal and monetary policy, Europe, the United States, Japan, and Britain still have not managed to overcome their economic malaise. All their money bought were rallies in bonds, equities and property.

This is bad enough, but what is even worse is that there is no workable exit from their strategy.

Any piece of good economic news is now seen as a threat, and not as a positive. If the economy actually picked up, interest rates would need to be raised to prevent a sudden rise in consumer prices. After all, that’s what the world’s central bankers have been promising for years.

But now, the same central bankers realise they cannot do so without triggering price collapses in precisely those markets into which their ‘cheap’ money previously went.

It is a dilemma from which there is no non-scary escape. The central banks most heavily engaged in the policy of cheap money are condemned to continue their dangerous and ultimately disastrous policies if they do not want to risk a financial crisis that would make the global financial crisis look like a walk in the park. Neither can they continue current policy because that will only make the eventual correction even worse.

The global economy may appear to have calmed somewhat since those stormy days when Lehman Brothers collapsed in late 2008. But it’s just the calm before an even fiercer storm.

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