Economic conditions in Europe deteriorated again last month, said European Central Bank (ECB) President Mario Draghi. He confirmed the ECB will continue its monthly bond purchases of 60 billion euros ($67 billion).
On the other side of the world, Japan’s second-quarter gross domestic product (GDP) unexpectedly sank back into recession yet again, falling 0.4% and 1.6% year on year, in spite of the Bank of Japan’s monthly 8- to 10-trillion yen ($64- to $80-billion) bond purchases.
On top of that, Federal Reserve Board governor after governor made speeches imploring that interest rates not be raised in September.
At the same time, the unlikely team of Larry Summers and Bridgewater hedge fund Chairman Ray Dalio said the Fed should restart a program of “quantitative easing” bond purchases.
Everyone’s trying to goose the world economy. But have our financial leaders finally run out of ideas?
Seven Years Later…
The desire for monetary stimulus after the 2008 financial crisis was rational. The banking system needed time to recover and banks required encouragement to lend to small businesses, which might otherwise have been starved of funds.
But that was seven years ago.
Instead of fading away, the “stimulus” has become even more extreme. And now it’s accompanied by gigantic budget deficits, especially in the United States and Japan.
The United States is now about to enter the 26th quarter of economic recovery, yet real U.S. interest rates are still negative, with core inflation at 1.8% against a Federal Funds target of 0% to 0.25%. (Nominal inflation year on year is only 0.2%. But last fall’s declines in oil prices prices will shortly wash out of the statistics, pushing it up.)
In Japan, the state has run huge budget deficits every year since 1990. Public debt has soared to 230% of the GDP. And now the central bank is running a bond purchase program that, in terms of Japan’s economy, is three times the size of the biggest of Ben Bernanke’s quantitative easing experiments.
Still, central bankers are worrying about deflation, suggesting that bond purchases and gigantic budget deficits have done nothing to improve the economy.
I have one suggestion: If the world’s authorities have found themselves in an economic hole, maybe they should stop digging.
Dead Assets Walking
Application of a little market-based economic theory suggests why this might be the case.
You see, if real interest rates are persistently negative and asset prices rise continually, then lots of projects get financed that don’t yield a real return – they only provide the prospect of some asset price inflation.
We all laughed a few years ago at the empty offices and apartment blocks in Chinese provincial cities, but we shouldn’t have.
All over the Western world are assets that, once the chill wind of reality blows, will be shown to be similarly useless. Meanwhile, asset prices have risen to a level that imposes huge extra costs on the economy. Just think of the burden of London housing prices on Brits who don’t already own and need to work in the city.
Similarly, all the fiscal “stimulus” – where the government spends more money than it has – represents money wasted, or at least allocated sub-optimally.
By and large, governments spending someone else’s money to benefit a third party (possibly with some spinoff freebie benefit for themselves, either political or economic in the form of construction contracts and other baksheesh) aren’t allocating funds as well as the private sector.
However, the money has to come from somewhere. Every penny that governments borrow is a penny that the private sector can’t borrow. Hence diverting money from the private sector to government is reducing economic well-being. (It may not reduce GDP, because GDP was deliberately designed so that all government spending, however useless, was taken at 100% of face value.)
Get With the Plan
Even without the appalling cost of regulations, primarily in the energy and financial sectors, and the hidden cost of $260-billion worth of fines on the world’s banking system, all of which has to come from somewhere, you can see that resource allocation has become a lot less efficient in the last seven years.
Therefore, it’s not surprising that the global economy has sputtered, and may now be breaking down altogether.
The solution is simple, although I have no great insights on how we can persuade today’s politicians to adopt it.
Balance government budgets so that you stop loading the economy with more debt.
Do it by cutting spending back to 2007 levels, not by raising taxes.
Put interest rates at a level safely above inflation. Ideally 2% on the Federal Funds rate immediately (and probably higher later) so that asset prices come back to Earth and we stop funding boondoggles.
And make a bonfire of at least some of the regulations. For example, the one struck down by the Supreme Court in June that imposed $10-billion worth of costs for only $5 million of benefit. That’s a cost/benefit ratio of 2,000 to 1… in the wrong direction.
In the 1990s, not some long-ago decade of evil Gilded Age government, we understood all this.
So why have we forgotten it?
Good investing,
by Martin Hutchinson