Government cures could be killing economy

Politicians, central bankers and policy advisers share a belief that policy actions will ultimately boost demand and create sufficient inflation to bring the global economy's elevated debt levels under control and restore growth. The debate is about the "right" policy and political ideology.

The Keynesian cure entails government spending financed by taxation or borrowing to restore Mr. Economy's health. There is no evidence it can arrest long-term declines in growth.

Government spending boosts activity temporarily, but may create excess capacity in the absence of underlying demand. As tax revenues have fallen due to slower economic activity, governments have already borrowed to finance large budget deficits.

Government ability to borrow to finance spending is increasingly limited without resorting to innovative monetary techniques. In recent years, the U.S. Federal Reserve has purchased around 60 to 70 per cent of all U.S. government debt issued. The European Central Bank is now financing governments indirectly by lending to banks to purchase sovereign bonds.

The limits of 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.

Having reduced interest rates to zero, central banks are changing the quantity of money available. Central banks believe they can keep rates low and print money to finance government debt purchases indefinitely.

But 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 mean low interest rates are unlikely to encourage borrowing and investment.

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 mean the essential transmission mechanism is broken. Banks are not using the reserves created to increase lending. The reduction in the flow of money or the rate of circulation has offset the effect of increased money flows. The low flow of money, lack of demand and excess productive capacity in many industries mean the inflation outlook in the near term remains subdued.

These policies also have serious side-effects. Low rates entail a transfer of wealth from investors to borrowers, with the lower coupon payment acting as a disguised 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 governments bonds.

Low rates discourage savings, creating a disincentive for capital accumulation.

They encourage mispricing of risk and feed asset bubbles, such as that for income (high-dividend-paying shares and high-yield, low-grade debt) as well as speculative demand for commodities and alternative investments. Low policy interest rates have created massive unfunded pension liabilities for governments and companies.

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. Attempts by nations to increase their competitive position by weakening their currency also threaten tit-for-tat currency wars, trade restrictions and barriers to investment flows.

The policy prescriptions provide symptomatic relief but do not address fundamental problems -- high debt levels, lack of demand, declining employment, lack of income growth or the problems of the banking system.

There is no acknowledgment of the limits to knowledge and policy tools. Economic relationships are poorly understood, complex and unstable.

Cause and effect is uncertain -- does money supply influence nominal income or does nominal income affect flow 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 treatments may be doing more harm than good. As French playwright Molière noted: "More men die of their remedies than of their illnesses."

Satyajit Das is a former banker and author of Extreme Money and Traders, Guns & Money and is a consultant to Jory Capital.

Republished from the Winnipeg Free Press print edition November 20, 2012 B3