Plague on all houses
The venerable Wall Street firm of Lehman Brothers went belly-up seven years ago. Since then, the Federal Reserve has engaged in an extensive monetary campaign involving near-zero interest rates combined with the central bank’s large-scale purchases of bonds. This experiment has delivered the weakest U.S. rebound on record while spreading what author Brendan Brown calls a “monetary plague” into the furthest reaches of the global economy.
In his new book, “A Global Monetary Plague: Asset Price Inflation and Federal Reserve Quantitative Easing,” Brown turns on Ben Bernanke. The former Fed chairman and head of the Princeton University economics department, he argues, had a misplaced fear of deflation – the dispelling of which became the prime aim of U.S. monetary policy during his tenure at the Fed. Bernanke also failed to notice how massive capital flows into emerging markets, fueled by the Fed’s policy of ultra-low rates, were undermining the stability of the global financial system. Given that the same man failed to spot the American housing bubble or identify problems in the shadow-banking system prior to Lehman’s collapse, Bernanke’s most recent oversights should not come as a surprise.
Bernanke’s “deflation phobia,” as Brown calls it, stems from his lifelong study of the Great Depression. Like many other economists, Bernanke ascribed the severity of the 1930’s economic downturn to the collapse in the general price level. According to this view, by raising real interest rates and increasing the burden of outstanding debt, deflation discourages both consumption and investment.
This conventional economic wisdom, however, doesn’t withstand scrutiny from either a theoretical or empirical perspective. As Brown points out, so long as prices remain stable over the long run, a bout of deflation actually lowers, rather than raises, the cost of funding. Debts, which are contracted when prices are temporarily depressed, can be paid off in a depreciated currency at a later date. If this reasoning is correct, then deflation should act as a spur to investment. Furthermore, as prices fall, the purchasing power of household cash balances increases. The so-called “real balances” effect should induce households to spend more and this spending should help to propel the economy out of recession.
Deflation has a number of other potential benefits. For a start, it encourages deleveraging as over-indebted corporations have an incentive to swap debt for equity. Deflation also boosts productivity. As insolvent and inefficient firms go out of business, their assets can be deployed more effectively elsewhere. Resisting deflation thus hinders the functioning of Schumpeter’s “creative destruction.” The abnormally low level of bankruptcies in the aftermath of the financial crisis – a consequence of Bernanke’s ultra-low rates – partly explains why the U.S. economic recovery has been so tepid.
A recent study of historical periods of deflation by the Bank for International Settlements from 1870 to the present day finds only a weak connection between deflation and economic output. In fact, the deflation bugbear largely stems from the experience of the Great Depression – take away this outlier and there’s no meaningful link between deflation and economic growth. The BIS makes another important point: there appears to be a much stronger connection between a collapse in asset prices, in particular real estate busts, and economic growth than between deflation and output. The BIS argues that a bursting bubble produces a large immediate loss of wealth, albeit wealth of an illusory nature, while deflation simply redistributes a much smaller amount of wealth from debtors to creditors.
This points to a key problem with the Fed’s “Great Monetary Experiment,” namely that it has inflated asset prices to unsustainable levels. Bernanke hoped that by making people feel richer, higher asset prices would induce them to spend more. After a run of good years, however, U.S. stocks have approached bubble valuation levels. Given the dollar’s role as the global reserve currency, Fed policy has also pushed down interest rates around the world, thus stoking real estate booms from Beijing to Vancouver. The trouble is that asset prices – whether stocks, bonds or property, both in the United States and abroad – are now vulnerable to any future normalization of interest rates – just as the housing bubble and the subprime mortgage crisis followed from the Fed’s attempt to exit the Alan Greenspan easy-money era.
In the wake of the global financial crisis, low U.S. rates also fueled a global carry trade, as yield-hungry investors poured into emerging market debt. At the same time, corporate borrowers in these developing nations availed themselves of low U.S. rates by borrowing in dollars, thus creating a potentially dangerous asset-liability mismatch. Global carry trades are nothing new. As Brown points out, Germany in the 1920’s attracted enormous capital inflows from New York where interest rates were lower. After those flows reversed after 1929, the German banking system collapsed, taking down the central European economy with it. This experience provides a worrying pointer for China. In recent years, low U.S. rates unleashed a flood of money into the People’s Republic. Now, China is experiencing capital outflows which if unchecked could wreak havoc on its financial system.
“The Global Monetary Plague” is a timely book. Unfortunately, the author’s ungraceful style and casual editing will put off all but the most persevering readers. Still, Brown identifies key flaws in the Fed’s recent monetary policy. His claim that asset price inflation is a “monetary disease” – a mantra of the Austrian school of economics – has been for too long been dismissed without serious consideration by mainstream economists. Likewise, Brown’s argument that “monetary stability is a necessary and sufficient condition for financial stability” has been overlooked in the post-Lehman era of low interest rates, financial regulation zealots and global carry traders.