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Why we should fear easy money
TO widespread applause in the markets and the news media, from conservatives and liberals alike, the Federal Reserve appears poised to cut interest rates for the first time since the global financial crisis a decade ago. Adjusted for inflation, the Fed's benchmark rate is now just half a per cent and the cost of borrowing has rarely been closer to free, but the clamour for more easy money keeps growing.
Everyone wants the recovery to last and more easy money seems like the obvious way to achieve that goal. With trade wars threatening the global economy, Federal Reserve officials say rate cuts are needed to keep the slowdown from spilling into the United States, and to prevent doggedly low inflation from sliding into outright deflation.
Few words are more dreaded among economists than "deflation". For centuries, it was a common and mostly benign phenomenon, with prices falling because of technological innovations that lowered the cost of producing and distributing goods. But the widespread deflation of the 1930s and Japan's more recent experience have given the word a uniquely bad name.
After Japan's housing and stock market bubbles burst in the early 1990s, demand fell and prices started to decline, as heavily indebted consumers began to delay purchases of everything from TV sets to cars, waiting for prices to fall further. The economy slowed to a crawl.
Hoping to jar consumers into spending again, the central bank pumped money into the economy, but to no avail. Critics said Japan was too slow to act, so its economy remained stuck in a deflationary trap for years.
Many Western economies appeared to face a similar threat following the global financial crisis of 2008. Since then, led by the Fed, central banks have responded aggressively to every hint of a downturn, making money ever cheaper and more plentiful to try to juice growth.
Yet, in this expansion, the US economy has grown at half the pace of the post-war recoveries. Inflation has failed to rise to the Fed's target of a sustained 2 per cent. Meanwhile, every new hint of easy money inspires fresh optimism in the financial markets, which have swollen to three times the size of the real economy.
In this environment, cutting rates could hasten exactly the outcome that the Fed is trying to avoid. By further driving up the prices of stocks, bonds and real estate, and encouraging risky borrowing, more easy money could set the stage for a collapse in the financial markets.
And that could be followed by an economic downturn and falling prices - much as in Japan in the 1990s. The more expensive these financial assets become, the more precarious the situation, and the more difficult it will be to defuse without setting off a downturn.
The key lesson from Japan has been that central banks can print all the money they want, but can't dictate where it will go. Easy credit could not force over-indebted Japanese consumers to borrow and spend, and much of it ended up going to waste, financing "bridges to nowhere" and creating debt-laden "zombie companies" that still weigh on the economy.
Today, politicians on the right and left have come to embrace easy money, each camp for its own reasons, both ignoring the risks. President Donald Trump has been pushing the Fed for a large rate cut to help him bring back the post-war miracle growth rates of 3 per cent to 4 per cent.
But much as in Japan two decades ago, an ageing population and falling productivity have sapped the capacity of the American economy to sustain its previous pace. According to the Congressional Budget Office, the economy's growth potential has fallen by half from its postwar average to less than 2 per cent now. With the domestic economy already growing a bit above that pace, injecting more easy money into the engine won't make it run much faster, particularly not after 10 years of trying.
UNCONVENTIONAL EASY-MONEY THEORIES
At the same time, liberals like Bernie Sanders and Alexandria Ocasio-Cortez are turning to unconventional easy-money theories as a way to pay for ambitious social programmes. But they might want to take a closer look at who has benefited most after a decade of easy money: the wealthy, monopolies, corporate debtors. Not exactly liberal causes.
By fuelling a record bull run in the financial markets, easy money is increasing inequality, since the wealthy own the bulk of stocks and bonds. Research also shows that very low interest rates have helped large corporations increase their dominance across US industries, squeezing out small companies and startups. Once seen as a threat only in Japan, zombie firms - which don't earn enough profit to cover their interest payments - have been rising in number in the United States, where they account for one in six publicly-traded companies.
All these creatures of easy credit erode the economy's long-term growth potential by undermining productivity, and raise the risk of a global recession emanating from debt-soaked financial and housing markets.
A 2015 study of 17 major economies showed that before World War II, about one in four recessions followed a collapse in stock or home prices (or both). Since the war, that number has jumped to roughly two out of three, including the economic meltdowns in Japan after 1990, Asia after 1998 and the world after 2008.
Recessions tend to be longer and deeper when the preceding boom was fuelled by borrowing, because after the boom goes bust, flattened debtors struggle for years to dig out from under their loans. And lately, easy money has been enabling debt binges all over the world, particularly in corporate sectors.
As the Fed prepares to announce a decision this week, growing bipartisan support for a rate cut is fraught with irony. Slashing rates to avoid deflation made sense in the crisis atmosphere of 2008, and cutting again may seem like a logical response to weakening global growth now. But with the price of borrowing already so low, more easy money will raise a more serious threat.
By further lifting stock and bond prices and encouraging people to take on more debt, lowering rates could set the stage for the kind of debt-fuelled market collapse that has preceded the economic downturns of recent decades. Our economy is hooked on easy money - and it is a dangerous addiction. NYTIMES
- Ruchir Sharma, author of The Rise and Fall of Nations: Forces of Change in the Post-Crisis World, is the chief global strategist at Morgan Stanley Investment Management and a contributing opinion writer.