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Concern about sluggish growth and poor productivity is now high on the political agenda across the developed world. Yet the debates around the UK Budget and the US presidential election have failed to touch on one of the most important factors behind this trend, namely a monetary policy over-focused on near-term inflation targets and too little concerned with developments in credit and debt markets.
The widespread adoption of 2 per cent inflation targets has been, at best, a mixed blessing. For a start, equating 2 per cent inflation with price stability — a nebulous concept — is highly questionable. Such a target prevents a natural downward adjustment of prices after increases in productivity or positive supply shocks. If price rises are not allowed to go below 2 per cent, there will be an inbuilt bias towards inflation and against long-run price stability.
Conventional economic wisdom tells us that monetary policy has no lasting effects on the real economy. This simply does not square with what has happened in the era of financial deregulation which has been marked by repeated, ever larger financial bubbles that threaten growth prospects.
William White, former economic adviser at the Bank for International Settlements, points out that the first three of the four interest cycles we have seen since the late 1980s — ending in 1990, 2001, 2008 and 2020 — finished with a financial crisis, while the fourth upturn was cut short by the Covid-19 pandemic. Each crisis had its origins in monetary stimulus intended to foster recovery from the previous recession but each ended in financial bust and a new recession. He adds that although the pace and magnitude of monetary easing increased over successive cycles, recessions still became yet more severe. That indicates repeated use of the monetary cure for the downturn may have aggravated underlying problems.
Note, too, that because post-bust monetary easing was always more aggressive than the subsequent tightening, peaks and troughs in policy rates ratcheted down over time, eventually reaching zero or slightly below zero. That forced central banks to resort to unconventional measures such as asset buying programmes known as quantitative easing.
This progression, says White, suggests that monetary easing might not provide even the temporary support it was able to in the past when the next bubble bursts and causes a deep recession. The outcome would be deflationary or even highly inflationary if monetary expansion were pursued regardless.
What we know for sure is that ultra-low interest rates after the 2007-09 financial crisis were morally hazardous, encouraging a huge increase in borrowing. According to the Institute of International Finance, global debt rose from 280 per cent as a percentage of GDP in 2008 to nearly 360 per cent in 2021. The IIF notes that this rise coincided with diminishing productivity growth and declining potential GDP across major economies.
This trend, it adds, suggests that a persistent reliance on sovereign intervention to mitigate macroeconomic and social-economic volatility might exacerbate moral hazard and lead to the misallocation of resources towards low-productivity projects and “zombie” companies that produce profits short of debt servicing costs.
Also morally hazardous has been the tendency of central banks, since the stock market crash of 1987, to put a safety net under market prices. They moved from being lenders of last resort to buyers of last resort. The general perception that the central banks will always come to the rescue helps explain why effervescent equity markets have decoupled from sluggish economies.
Excessive monetary easing has had other unintended consequences. Long before Donald Trump introduced his tariffs as US president, central banks were encouraging a more subtle form of economic nationalism. Brigitte Granville of Queen Mary University of London points out that during the period of negative policy rates, the inflation targeting rationale of the European Central Bank and Bank of Japan camouflaged an exchange rate target. The aim was to weaken the euro and the yen and boost activity by tapping foreign demand. This was an antisocial policy when the global economy badly needed stronger domestic demand in Europe and Japan rather than increased trade imbalances.
Meanwhile, the search for yield drove European and Japanese savings into US assets. This savings glut effect intensified the unhealthy combination of booming asset markets and mediocre growth, Granville points out. For good measure, booming markets exacerbated inequality.
We are now left with an intractable debt problem that acts as a drag on consumption and investment. And the world is at risk of severe financial instability whenever central banks raise rates. A debate is urgently needed around monetary policy’s neglect of credit and debt developments. The politicians’ growth agenda will never be properly fulfilled unless we find an escape route from the endemic bubble, bust and ballooning debt cycle.