Mr. Global Economy's delusional mental state
Editor's note: Satyajit Das held a live chat on Aug. 2 to discuss readers' comments and questions.
SYDNEY (MarketWatch) -- Dear Doctor: As requested, I have assessed the psychological condition of Mr. Global Economy, complementing earlier physical examinations.
Mr. Economy appears delusional, believing complete recovery is imminent. Keynesian and Monetarist regimes, he believes, will boost demand and create sufficient inflation to bring his elevated debt levels under control. Read more: Mr. Global Economy's physical report card.
The Keynesian cure entails government spending financed by taxation or borrowing to restore Mr. Economy's health. There is no evidence that it can arrest long-term declines in growth.
Government spending boosts activity temporarily, but may create excess capacity in the absence of underlying demand. Nostalgia for President Franklin Roosevelt's infrastructure projects during the Great Depression is misplaced. Excess electricity generation capacity from dam projects was only absorbed by wartime demand for defense equipment.
Having reduced interest rates to zero, central banks are giving Mr. Economy the Monetarist cure, changing the quantity of money available. They buy government bonds, injecting money into the banking system (QE or quantitative easing) to lower borrowing costs and increase the supply of money to stimulate demand and inflation.
As tax revenues have fallen due to slower economic activity, governments have borrowed to finance large budget deficits. The limits of a government's ability to borrow and spend are highlighted by the European debt crisis. Investors are increasingly concerned about public finances, becoming reluctant to finance nations with high levels of debt or demanding high interest rates.
Faith and fantasy
Mr. Economy's faith healers argue that central banks can keep rates low and print money to finance government debt purchases indefinitely. In recent years, the Federal Reserve has purchased around 60%-70% of all U.S. government debt issued. The European Central Bank is now financing governments indirectly by lending to banks to purchase sovereign bonds.
Greater government spending, lower rates and increased supply of money may not boost economic activity. Crippled by existing high levels of debt, low house prices, uncertain employment prospects and stagnant income, households are reducing, not increasing, borrowing.
For companies, the absence of demand and, in some cases, excess capacity, means that low interest rates are unlikely to encourage borrowing and investment.
Moreover, loose monetary policies may not create the hoped-for inflation needed to lower real debt levels.
Banking problems and the lack of demand for credit means that the essential transmission mechanism is broken. Banks are not using the reserves created and money provided to increase lending. The reduction in the velocity of money or the rate of circulation has offset the effect of increased money flows. The low velocity of money, the lack of demand and excess productive capacity in many industries means the inflation outlook in the near term remains subdued.
The faith healing cures also do not address fundamental problems -- high debt levels, lack of demand, declining employment, lack of income growth or the problems of the banking system.
Truth and consequences
The treatments also have serious side effects. Low rates entail a transfer of wealth from investors to borrowers, with the lower coupon payment disguising a reduction of the principal amount of the loan. They provide an artificial subsidy to financial institutions, allowing them to borrow cheaply and then invest in higher yielding safe assets such as government bonds.
Low rates discourage savings, creating a disincentive for capital accumulation. They encourage mispricing of risk and feed asset bubbles, such as that for fixed-income (high-dividend-paying shares and high-yield low-grade debt) as well as speculation in commodities and alternative investments.
In the long run, economies become dependent on low rates, as high debt levels cannot be sustained at higher borrowing costs.
Internationally, low interest rates distort currency values and also encourage volatile and destabilizing short-term capital flows as investors search for higher yields.
Economic relationships are poorly understood, complex and unstable. Cause and effect is uncertain: Does money supply influence nominal income or does nominal income affect velocity and the demand for and thereby the supply of money?
The ability of governments and central banks to influence economic activity is overstated. As economist Wynn Godley put it: "Governments can no more control stocks of either bank money or cash than a gardener can control the direction of a hosepipe by grabbing at the water jet."
The placebo effect of these cures is considerable. But it is not clear how any of the treatments being pursued can create real ongoing growth and wealth to restore Mr. Economy's health. Transferring debt held by the private sector to the public sector has little impact on behavior and demand.
To paraphrase Voltaire's observation on doctors, Mr. Economy's faith healers prescribe medicines of which they know little, to cure diseases of which they know less, in economic and financial systems of which they know nothing.
Ironically, these same faith healers until recently oversaw Mr. Economy, prescribing regimes that caused the present financial and economic calamity. Perhaps like writer Samuel Beckett they are keen to fail better next time.
Through it all, Mr. Economy remains remarkably optimistic. Perhaps he recognizes the truth of Mark Twain's observation: "Don't part with your illusions. When they are gone you may still exist, but you have ceased to live."
Satyajit Das is a former banker and author of "Extreme Money" and "Traders, Guns & Money."