Easy money

Central banks in the West have been pumping cash into their economies since 2008. Economists agree it saved the world from a depression. But has it done more harm than good?

At the Brookings Institution in Washington, in one of his last public appearances as Federal Reserve chairman, Ben Bernanke said before an audience of economists, "The problem with QE [quantitative easing] is that it works in practice, but it doesn't work in theory." Everyone laughed. The remark was premature. Quantitative easing is one of the most important of a variety of economic stimulus measures currently practised by central banks in the United States, Europe and Japan. They have arguably been crucial in propping up the world economy since the financial crisis. Getting into them was relatively easy — that's the part that Bernanke claims works in "practice." Now comes the hard part: getting out. The next year should show what "practice" tells us about that.

Many economists believe that the various QE rounds that the US Fed went through since 2008 saved the world from a major depression. "Central banks had to choose between two evils: either let some major financial institutions go and provoke an economic disaster or try to ease the fall," says Benoît Durocher, executive vice-president and chief economic strategist at Addenda Capital in Montreal.

Of course, they chose the second route, "but that doesn't keep them from still having to make difficult decisions," adds Durocher. Many economists who look askance at QE practices would say that occasions calling for such hard decisions are definitely in the works.

The amount of money some major central banks have poured into their countries' financial systems is astronomical. In the US, a series of measures, initiated by Bernanke, were launched (carrying various names such as Large-Scale Asset Purchase Program and Operation Twist and Quantitative Easing) from 2008 to today. Through these programs, the Fed purchased more than US$3 trillion worth of assets, mostly mortgage-backed securities issued by Fannie Mae and Freddie Mac and US Treasury bonds.

Such purchases caused bond prices to rise and, consequently, interest rates to decline, helping the residential market, for example, to regain some strength.

However, in the process, the Fed's balance sheet ballooned from US$900 billion before the crisis to more than US$4 trillion at the end of 2013, about one-fourth of the country's US$17-trillion GDP. This is an unprecedented weight on the Fed's books. As long as it remains there, the Fed's capability to intervene in a new financial crisis would be extremely constrained. And liquidating such a vast amount of assets without disrupting markets, well, that's the challenge ahead.

In 2009, the Bank of England developed its form of QE, called the Asset Purchase Facility, to buy government and private-sector bonds. At the end of March, its holdings totalled about US$620 billion. The European Central Bank does not have the authority to carry out QE measures, but in 2012 it did hand out US$713 billion in cheap, three-year loans to 800 financial institutions on top of the US$661 billion loaned to 523 banks in December 2011.

In the spring of 2013, the Bank of Japan announced a massive purchase program of Japanese government bonds — in the amount of about US$100 billion over two years — with the aim of doubling the monetary base and pushing the inflation rate out of its negative rut to 2%.

Canada did not initiate any QE — not officially. But Sprott Asset Management in Toronto calculated that the five largest banks received more than $114 billion in support at a time when their total tangible equity amounted to only $68 billion.


Priming Economic Engines

The stated goals of these QE programs varied, but all ultimately aimed at priming their countries' economic engines. At the outset, they made sure to prop up the most important banks whose survival was threatened by massive quantities of "toxic" debt. Then, they tried to reach out to the larger economy in order to direct investors' money from safe havens (mostly government debt) toward more risky ventures (ideally, productive business investment).

With QE, the Fed has taken away the safest assets in the world (by purchasing massive quantities of Treasury bonds), explains Angelo Melino, a professor of economics at the University of Toronto. "The Fed said, 'If you want to earn money, you need to take risks.' " Since there were fewer bonds left, people had no choice but to purchase other, more risky assets elsewhere.

The results were uneven at best. The US housing market has picked up over the past 18 months, but banks have remained wary of lending because of the uncertain economic outlook and their very fragile capital base. Rather, they have chosen to sit on their massive reserves. And companies, though they hold important reserves, rather than invest are buying up their shares or issuing new ones, causing share prices to rise even if profits aren't growing, says Durocher.

Numbers indicate that the US economy has somewhat stabilized: the unemployment rate is inching down and the housing sector and car sales have picked up. In Europe and Japan, many analysts claim that the different credit easing measures have met with some success.

However, if unemployment numbers look better it's in large part because many workers have simply dropped out of the job market. An Obama editorial cartoon runs this logic to an absurd conclusion: "If only we could stop everyone from trying to get jobs, we could wipe out unemployment."

Canada has not remained insensitive to QE. Since the Fed's vast credit purchases have had the effect of lowering the value of the greenback — on purpose, many argue — the loonie fell along with it, making Canadian exports to the US cheaper and travel more costly.

On the surface, some numbers suggest that the massive credit interventions of the banks have somehow succeeded. But surface numbers can be deceptive. In Japan, for example, though the yen has devalued, in January the trade deficit reached a record level of approximately US$28 billion. And if GDP has grown by 1.5% over 2013, it has followed a downward trend, moving from a whopping 4.1% rise (on a seasonally adjusted annualized basis) in the first quarter of the year to barely creeping up by 0.7% in the last quarter.

In the US, the underlying reality is not particularly encouraging, points out Nobel laureate economist Joseph Stiglitz in a February article on the Project Syndicate website titled "Stagnation by Design." He wrote: "Median real income in the US is below its level in 1989, a quarter-century ago; median income for full-time male workers is lower now than it was more than 40 years ago."

A supremely intriguing fact for many observers, especially economists of the "monetarist" school, is the extremely weak inflation rate that currently prevails. For some monetarists, inflation is always a result of excessive money supply, and the central banks' money printing should normally have created runaway inflation.

But characterizing QE as money printing is a misunderstanding; the Fed has only created the preliminary conditions for inflation to take off by transferring massive amounts of money to the banks through its asset purchasing programs, says Melino. Inflation would pick up if banks started to lend, because monetary creation results from the issuing of credit (loans, mortgages, credit card balances, etc.). "But money has not been going out into the economy," Melino says. "Banks are sitting on it as reserves; they've been very cautious about lending."


Taking Away Life-Support

If the performance of the central banks' interventions has only been lacklustre up to now, what will happen when they cut them off, as the Fed started doing in January with its notorious "tapering" process, which is slowly eliminating its US$85-billion monthly purchase of assets? The economy is barely holding its own thanks in large part to the central banks' regular monetary injection.

What happens when the fix ceases? "That's the $64,000 question to which no one knows the answer yet," says Jurrien Timmer, director of Global Macro at Fidelity Investments in Boston.

The Fed's gamble is that it will be able to slowly take away the recovering economy's life-support apparatus, following which the patient will be able to stand up, walk out of the hospital and go about doing whatever a merry economy goes about doing. Most mainstream economists think the Fed's gamble will work. Others think it won't. Timmer thinks it might, but assigns to it only a 50% probability.

There's another 30% probability, Timmer calculates, that the plan will fail because of its success. How's that? If the economy picks up, that means banks will be called on to lend to companies and individuals because projects will multiply, and that's when inflation, which was patiently lying in wait in the banks' reserves, will kick off.

To cut off inflation, the Fed would have to start selling the bonds it has accumulated in an attempt to drain money out of the system. But that would cause rates to shoot up in the bond markets, resulting in depressing economic activity again. After a while, the Fed would relax its stance, the economy would pick up, driving up inflation again and prompting the Fed to tighten the screws anew.

There are two other possibilities. One is disinflation, when inflation drops and starts moving toward deflation, a beast economists fear even more than inflation, and to which Timmer assigns a 20% probability. Currently, disinflation appears as a tangible threat in the US, where inflation hit 1.1% on an annualized basis in February.

There is also the possibility of a new crisis that could be even more severe than the last one, a probability Timmer does not quantify. But a number of highly regarded economists, including Roubini Global Economics chairman Nouriel Roubini, see the danger of another great contraction. If the Fed does not walk a prudent line, it could precipitate what it wants to avoid at all costs, Roubini, who predicted the last crisis, argues in "Bubbles in the Broth," published by Project Syndicate.

European economic think-tank LEAP 2020 predicts that the world economy will inexorably sink into a deeper state of crisis. The central banks' monetary policies are not just attempts at solving the ongoing systemic crisis, it claims, they are part of the crisis and are only setting conditions for a deepening of it.

Its argument runs parallel to that of Stiglitz, who believes that the US economy "was sick even before the crisis: it was only an asset-price bubble, created through lax regulation and low interest rates, that had made the economy seem robust. ... Policymakers' response to the crisis failed to address these issues; worse, it exacerbated some of them and created new ones — and not just in the US."

In short, the policies of central banks have erected bubble-stimulating conditions similar to those that created the crisis in the first place. Cheap credit and lax regulation helped create a bubble that burst. Now, even though regulation is slightly tighter, credit is cheaper than ever. Some think that bubbles are already inflating here and there (in the Canadian housing market, for example, and in other countries). Those bubbles will likely pop. A major one has already done so in emerging markets, where the Fed's tapering of QE3 has caused a massive exodus of capital out of those countries' stock and bond markets, causing their currencies to fall dramatically. If and when those pops happen, will the government cavalry, which is in a sorry state and riddled with debt, be able to come to the rescue as it did the last time? Everyone hopes Bernanke's gamble wins in the end.