THE OTHER SIDE

The so-called unconventional monetary policy pursued in several of the advanced industrial economies since the crisis of 2008, namely ultra-low to negative interest rates and quantitative easing, has not only not achieved the inflation objective but has also had a number of unintended consequences:

The most indebted government in the world, namely Japan, with public debt of more than 200 per cent of gross domestic product, is issuing long-term bonds at negative rates;

So do some companies, not to invest for expansion but to buy back their shares;

Even as the real economy continues to flounder, financial assets — equities, bonds — keep going up;

Pension funds and life insurance companies are running huge deficits, given the standard way their future liabilities are valued — the present value calculated by discounting future liabilities at the ruling interest rates. Hungry for yields, they are buying even junk bonds, despite the obvious credit risks, on the seller’s terms — and investing in 100-year maturity Belgian and Irish government bonds, with coupons of 2.3 per cent and French 50-year debt at 1.9 per cent;

Central banks are not finding enough risk-free assets to buy in order to support quantitative easing: they are forced to buy corporate bonds and even equities;

The good old interest parity principle on which the relationship between spot and forward rates or swaps is based, is no longer working in global markets as investors pursue higher yields;

Banks’ net interest income has been squeezed even as they need more capital to comply with Basel III norms.

I could go on. The other side is that monetary policy theory itself is now being questioned by some economists. To be sure, the tools have undergone changes in recent decades: At one time, the fashionable variable to be monitored was money supply, narrow, broad or some other “M”; as this became unreliable, fashion changed to short-term interest rates and “anchoring” inflation expectations through policy statements — these have not worked because policymakers are as powerless to predict the future inflation as you and I; now it is quantitative easing, but that too has not worked so far. Some policymakers are even questioning the fundamentals of monetary theory. Recently, Noah Smith, a Bloomberg columnist, quoted Steve Williamson of the Federal Reserve Bank of St Louis as arguing that central bank policy works in reverse, that low interest rates lead to low inflation! In another column, Smith has quoted research based on empirical evidence, which suggests that people tend to consume more when interest rates are high! The conventional wisdom is exactly the opposite. Low returns on savings would persuade the consumer to buy more and save less, thus increasing demand and therefore inflation. Do Keynes’ “animal spirits” matter far more than Friedman’s “permanent income hypothesis” that consumption depends on how much an individual rationally expects to earn over her lifetime?

One unintended consequence of the unconventional monetary policies is increasing inequality: the rich have grown richer as stock and bond prices have gone up, even as the worse off are finding it difficult to get employment and are being forced to use retirement savings even faster. And, increasing inequality itself contributes to lower growth. In a recent book, Fed Power: How Finance Wins, Lawrence Jacobs and Desmond King argue that the US Federal Reserve is a political institution, beholden to markets, that drives rising inequality.

Two other corollaries of the unconventional monetary policies: for one thing, what will happen if and when interest rates return to their normal levels? By any logic the market price of the assets, bonds and equities held by central banks would register a sharp fall: given their huge gearing, would central banks be bankrupted? Second, given the negative interest rates, banks have started charging a fee to companies and individuals who keep money in their accounts. Individuals are preferring to keep cash rather than hold bank deposits at negative rates: in Japan the demand for household safes has gone up! As the Bank of England’s chief economist, Andy Haldane, said, “I sympathise with savers but jobs must come first” (Financial Times, September 24, 2016).

One wonders whether the recent experience would make policymakers and economists in emerging economies rethink the virtues of much of the accepted wisdom of the last few decades: fiscal austerity, market-determined exchange rates, targeting low inflation irrespective of demographics, etc. All of these seem to benefit the richest one per cent at the cost of the remaining 99 per cent.