Why the global monetary makeover is wearing off

Published in Business Spectator (Melbourne), 13 June 2013

It’s another week in the never-ending euro crisis. There is talk about the need for another Greek haircut before the end of the year. The ECB is pressuring the German constitutional court not to declare its bond buying activities illegal. And, believe it or not, French President François Hollande has (once again) officially declared the euro crisis over. Let’s hope the euro crisis was told.

It is tempting to discuss the political complications of that Greek haircut, the intricate details of German constitutional law, or indeed the sanity of the French president. But I am not going to do that – at least not today.

Instead, I want to reflect on a quote by Austrian economist Friedrich August von Hayek, coined more than 76 years ago. After he had just laid the foundations of modern information economics in the famous Economics and Knowledge lecture to the London Economic Club. Hayek concluded his path-breaking contribution with astonishing understatement: “You may even feel that most of what I have said has been commonplace. But from time to time it is probably necessary to detach oneself from the technicalities of the argument and to ask quite naïvely what it is all about.”

I first came across these words during the research for my doctoral thesis, and they have provided reassurance and guidance ever since. To me they mean that especially when issues are complex, analysis is difficult, and solutions are hard to find, it often pays to step back and take a sober, detached look at the problem.

Such an approach may indeed be helpful in looking at our global economic challenges – both the euro crisis and Japan’s more than two-decade economic malaise. Asked quite naïvely then, what is this Great Recession really all about?

If you prefer to miss the wood for the trees, there are plenty of trees in our current crises to choose from. These past years have been full of events and issues, from the subprime crisis to the euro crisis, from Lehman to Greece, from Target2 to QE3, from TARP to LTRO. What is less clear is the common denominator behind all these seemingly separate issues.

In as far as there is one, it seems to me that the original sin of the past years has been to treat structural and fundamental economic problems with monetary means.

There is hardly a problem in today’s world economy for which monetary policy does not pretend to be the answer. But this belief in monetary solutions has now almost been tested to destruction, and the longer this belief persists the clearer its folly becomes: Monetary policy is part of the problem, not part of the solution.

To illustrate what I mean, there is no better example than Japan and its ‘Abenomics’ experiment. The strategy of Japanese Prime Minister Shinzo Abe to flood markets with fresh central bank money in the hope of creating inflation, depreciating the yen and boosting exports is the most extreme manifestation of the belief in the power of monetary policy. And despite some short-term successes in lifting economic growth in the first quarter of this year, ultimately this policy is doomed to fail.

The reason for the foreseeable fiasco of Abenomics is that what Abenomics is trying to cure is a fundamental weakness of the Japanese economy. But it is aiming to bring this about through monetary policy.

Japan has at least three structural problems. The first is the toxic legacy of more than two decades of fiscal stimulus programs. Trying to revive the economy after the bursting of the real estate and Nikkei bubble in 1991, successive Japanese governments have sought to revive growth by economic packages leaving behind only grossly grotesquely oversized infrastructure and gigantic public debt.

The second problem for Japan is its impending demographic catastrophe. It already has the world’s oldest population, but due to a combination of increased longevity, subdued fertility and minimal migration the Japanese population will shrink from 128 million today to 87 million in 2060. Over the same period, its working-age population will almost halve.

The third problem for Japan is its highly regulated labour market, which has driven up unit-labour costs. For Japan’s largest corporations, it is hard to restructure since it is almost impossible to fire any workers.

These three problems – public debt, demographics, and an inflexible economy – are painfully real. Dealing with them in a meaningful way would require tough actions, sacrifices and political courage. Instead, thanks to Abenomics, it is monetary policy that is promising to solve them.

Monetary policy, however, can only provide temporary relief at best. It is akin to treating cancer with painkillers. Though the patient may feel better for the moment, the medicine does nothing to attack the underlying disease.

It is a similar story in Europe. At the root of Europe’s problems we find structural issues, many of which are comparable to Japan’s. Government has become too large and too indebted; the demographic transition of European society is in full swing; the regulation of Europe’s economy has damaged the continent’s global competitiveness.

The euro, which is effectively a system of fixed exchange rates, has mercilessly revealed these weaknesses of European economies. The response, however, has again been to a large part one of monetary policy. Through ingenious schemes, the ECB has been trying to take the pressure off European governments by helping them refinance their debt. But in doing so, addressing the actual and real underlying problems has been successfully avoided.

Detaching oneself from the technicalities of our global crises, it is plain to see that to a large part these are caused by real, structural economic problems. But the predominant way of dealing with them has been monetary policy. And one may well wonder whether lax monetary policies of the past have not been one of the root causes of many of the problems we observe today.

The naïve questions that I am increasingly asking myself are these: Will people eventually realise that the printing press is no substitute for good policy? And where will this leave the global economy? And what will happen to the monetary order?