Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

The danger of unending monetary stimulus

Global economic recoveries are weak and financial instability is still a threat

The Greek crisis is a stark reminder that the world economy is still feeling the malign effects of the 2008 financial crisis.

Two recent research publications from the International Monetary Fund (IMF) and Bank of International Settlements (BIS) show policymakers are still at loggerheads about the causes of financial crises.

The biggest source of disagreement is the role of loose monetary policy in creating the conditions for a financial crisis. IMF has said in a recent working paper, authored by Bank of England economist Ambrogio Cesa-Bianchi and Alessandro Rebucci of Johns Hopkins University, that the major policy error in the years leading to the financial crisis was not excessively lax monetary policy but the lack of an effective regulatory framework to protect financial stability. The implicit argument is that monetary policy should target inflation while prudential regulations should take care of financial stability issues.

BIS has put forward a dramatically different view in its latest annual report. It says low interest rates have encouraged the growth of indebtedness in the world economy. Loose monetary policy has also led to the misallocation of capital. The BIS annual report questions the current fashion of passing on the responsibility of financial stability to regulation rather than monetary policy.

BIS has given two particularly interesting reasons why interest rates are below equilibrium levels. One, the mainstream habit of trying to gauge the correct levels of interest rates based on inflation alone rather than financial stability as well. Two, central banks have had asymmetric responses: they have been very wary to taking the punch bowl away when the party is in full swing but hastening to slash rates when trouble hits. In other words, the reluctance to raise rates in good times combined with an enthusiasm to cut them during downturns has led to overall interest rates drifting downwards in the past two decades.

The IMF view is clearly a representation of the mainstream analysis of economic policy while BIS seems to be deeply influenced by the Austrian view that a credit boom leads to a misallocation of capital (think of the US housing bubble, for example).

These are more than just academic sparring matches. The debate has important implications for policymakers right now.

The global economy has seen almost unprecedented monetary expansion since 2009. The stimulus perhaps helped prevent a total collapse in that year but the long-term results are less impressive. Global growth continues to struggle while financial instability is once more on the horizon. The emerging markets have meanwhile had to tackle the problem of appreciating currencies as well as asset bubbles because of the extraordinary monetary policy followed in the rich economies.

Just consider one parameter: the output gap, or the difference between the potential growth rate of an economy and its actual performance. This is now a workhorse in economic policy analysis. The basic rule is that monetary policy should be expansionist when the output is negative.

What the neo-Austrian analysis by BIS suggests is that monetary stimulus merely adds to the misallocation of capital in a bid to get growth back on track.

The underlying issues remained unsolved. Such misallocation of capital (think housing bubble once again) eventually hurts productivity and hence growth over the medium term. In other words, money is not neutral.

These economic debates matter against the backdrop of what has happened in the global economy since 2009. There was a massive coordinated stimulus by the major economies that year. Policy paths are now diverging, but the fact remains that the global economy has far more money stock and higher fiscal deficits than it did before the crisis. Yet, real economic recoveries continue to be weak. And financial instability is still a threat.

The upshot: structural slowdowns cannot be tackled with monetary stimulus. Structural reforms are needed. And that is why the BIS analysis needs to be taken more seriously.

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