The fear over the city as the US Federal Reserve contemplates a modest increase in interest rates is yet another indication of how the world economy has got addicted to cheap money.
Any hint of tightening leads to volatility and nervousness in the financial world. Clearly, liquidity is the only game in town, though the Federal Reserve is not the only central bank responsible for this. The reason for the addiction to cheap credit is that central banks have allowed governments in the developed world to paper over structural faults in their economy by printing money.
In effect, the central banks have been asked to cure economic ailments caused by loose monetary policy by providing an even bigger dose of cheap money. This will only lead to further damage to the global economy. The Group of Thirty, a Washington based think tank with former Federal Reserve chairman Paul Volcker as chairman-emeritus and former president of the European Central Bank Jean-Claude Trichet as chairman, is the latest organization to flag the potential danger from more of the same.
In a recent study, the policy group said: “Supportive actions by central banks can be useful, but there are serious risks involved if governments, parliaments, public authorities, and the private sector assume central bank policies can substitute for the structural and other policies they should take themselves.”
Earlier in the year, the Bank for International Settlements had raised similar concerns in its annual report. It had said that monetary policy has been overburdened after the financial crisis. It called for policy rebalancing away from demand management to initiatives that are more structural in nature.
Excessively low interest rates have resulted in misallocation of resources and have significantly added to the debt stock, particularly in emerging markets. The Global Financial Stability Report of the International Monetary Fund, released earlier this month, showed that between 2004 and 2014, corporate debt in major emerging markets has quadrupled. The rise in debt has been led by a sharp increase in foreign currency exposure by companies in the developing world. Naturally, tightening of global credit conditions will increase risk in the emerging markets.
Matters may become even more complicated as the composition of debt has shifted from loans to bonds. Policymakers in the emerging markets would do well to avoid excessive build-up of leverage in the corporate sector, since it can put financial stability at risk even with minor tightening of credit conditions.
Even in advanced economies, the benefits from unconventional monetary policy is diminishing. Output is barely growing in the euro area and Japan, while inflation is undershooting its target. Clearly, central banks in the advanced economies are in uncharted territories and are trapped in a policy bind because of the lack of alternatives. The overriding fear is that a reversal in monetary policy trajectories will create financial market volatility and instability, which will in turn further damage the fragile real economy.
But continuing with the policy, as there is no exit strategy in place, can create excesses in the marketplace—evidence of which is already visible—and result in another crisis in the future. As former Reserve Bank of India governor D. Subbarao had famously said, central banks are a bit like Abhimanyu—they know how to enter the chakravyuha of low interest rates but have no idea how to exit it.
It is important to understand that the problem in the advanced economies is no longer monetary, but real. The 2008 financial crisis has led to real effects such as the drop in total factor productivity, through a process of hysteresis. Money has not been neutral. Structural solutions are needed. To be sure, accommodative monetary policy was needed in the immediate aftermath of the crisis to prevent a complete seizure in global financial markets. But the world will slowly discover that interest rates at the zero bound and massive increases in money stock are not the solution for persistent economic problems.
