The nagging fear that QE itself may be causing deflation
The European Central Bank looks poised to cut the discount rate below zero on Thursday, becoming the first of the monetary superpowers to venture into these uncharted waters
By Ambrose Evans-Pritchard
8:55PM BST 04 Jun 2014
This is not an easy task, not least because land sales and taxes make up 39pc of state revenue in China, and the property sector employs 20pc of workers one way or another. It is clearly a bubble of epic proportions, and already losing air. Mao Daqing from Vanke - China's top developer - says total land value in Beijing has been bid up to such extremes that is on paper worth 61.6pc of America's GDP. The figure was 63.3pc for Tokyo at the peak of the bubble in 1990. "A dangerous level," he says.
China faces this delicate task with deflation lodging in the economic supply chain. Factory gate inflation is -2pc, with prices falling for 27 months. It has no safety buffer against a shock, and is facing demographic headwinds. The workforce has already peaked and is now shrinking by 3m a year, much like the squeeze that played such a big role in the onset of Japan's deflation.
The question is why the world economy cannot seem to shake off this "lowflation" malaise, even after QE on unprecedented scale by the US, Britain, Japan and in its own way Switzerland. America's core PCE inflation is still just 1.4pc five years after the Fed embarked on $3 trillion of bond purchases.
Part of the reason is a glut of factories flooding the world with goods, bearing down on global prices. China's investment last year was $5 trillion, as much as in Europe and the US together. But another argument is taking hold, which I pass on to readers though it is not my view.
Narayana Kocherlakota, the Minneapolis Fed chief, suggested as far back as 2011 that zero rates and QE may perversely be the cause of deflation, not the cure that everybody thought. This caused consternation, and he quickly retreated.
Stephen Williamson, from the St Louis Fed, picked up the refrain last November in a paper entitled "Liquidity Premia and the Monetary Policy Trap", arguing that the Fed's actions are pulling down the "liquidity premium" on government bonds (by buying so many). This in turn is pulling down inflation. The more the policy fails - he argues - the more the Fed doubles down, thinking it must do more. That too caused a storm.
The theme refuses to go away. India's central bank chief, Raghuram Rajan, says QE is a beggar-thy-neighbour devaluation policy in thin disguise. The West's QE caused a flood of hot capital into emerging markets hunting for yield, stoking destructive booms that these countries could not easily control. The result was an interest rate regime that was too lax for the world as a whole, leaving even more economies in a mess than before as they too have to cope with post-bubble hangovers.
The West ignored pleas for restraint at the time, then left these countries to fend for themselves. The lesson they have drawn is to tighten policy, hoard demand, hold down their currencies and keep building up foreign reserves as a safety buffer. The net effect is to perpetuate the "global savings glut" that has starved the world of demand, and that some say is the underlying of the cause of the long slump. "I fear that in a world with weak aggregate demand, we may be engaged in a futile competition for a greater share of it," he said.
The Bank for International Settlements says the world is suffering from addiction to stimulus. "The result is expansionary in the short run but contractionary over the longer term. As policy-makers respond asymmetrically over successive financial cycles, hardly tightening or even easing during booms and easing aggressively and persistently during busts, they run out of ammunition and entrench instability. Low rates, paradoxically, validate themselves," it said.
Claudio Borio, the BIS's chief economist, says this refusal to let the business cycle run its course and to purge bad debts is corrosive. The habit of turning on the liquidity spigot at the first hint of trouble leads to "time inconsistency". It steals growth and prosperity from the future, and pulls the interest rate structure far below its (Wicksellian) natural rate. "The risk is that the global economy may be in a deceptively stable disequilibrium," he said.
Mr Borio worries what will happen when the next downturn hits. "So far, institutional set-ups have proved remarkably resilient to the huge shock of the Great Financial Crisis and its tumultuous aftermath. But could (they) withstand yet another shock?" he said.
"There are troubling signs that globalisation may be in retreat. There is a risk of yet another epoch-defining and disruptive seismic shift in the underlying economic regimes. This would usher in an era of financial and trade protectionism. It has happened before, and it could happen again," he said.
Masaaki Shirakawa, the former governor of the Bank of Japan, says wearily that the world might have learned something if it had studied QE in his country. The monetary base was doubled after 1997, yet deflation ground on.
"We deployed all sorts of unconventional monetary policy measures ahead of other major central banks. Japan has been living in a world of zero interest rates for almost all of the past 15 years. The Bank of Japan hugely expanded its balance sheet, purchased non-traditional assets and adopted forward guidance on future policy," he said recently.
"It is not an exaggeration to say that almost all the policies adopted by other central banks after the Great Financial Crisis, were policy measures which the Bank of Japan had “invented” much earlier, in uncharted waters, and without textbooks or precedents."
Critics of course say the BoJ acted timidly, dabbling in QE. What it is doing now under Haruhiko Kuroda is entirely different, buying $75bn of bonds each month, much of it long-term debt outside the banking system that does most to boost the broad money supply. This has lifted Japan's inflation to 1.5pc, stripping out VAT rises. The great test will be whether this lasts as the sugar rush wears off, and whether it flows through into higher spending and wages, breaking the deflationary psychology once and for all.
The evidence in Britain and America is that QE has had a potent effect, preventing double-dip recessions as fiscal austerity began to bite, in stark contrast to Europe. The story is not over, nor have the Fed and the Bank of England extricated themselves. The contraction of US GDP in the first quarter is a warning sign.
Personally, I am not yet ready to accept the claim that QE is drawing the world deeper into deflation but the arguments cannot be dismissed lightly. If they are broadly correct, the case for such stimulus collapses.
My view is closer to the monetarists who say Western central banks have brought this mess on themselves by concentrating all their zeal on interest rates, viewing QE merely as a tool to drive yields ever lower, even pledging to hold down them down for years through "forward guidance". The sin is Ben Bernanke's heresy of "creditism", ignoring three centuries of orthodoxy and the traditional quantity of money mechanism.
What they should have done is to target M3 money growth of 5pc, or nominal GDP of 5pc, and let interest rates find their own level. Indeed, rates should naturally rise as recovery takes hold. Trying to force them down come what may is a formula for trouble. The BIS is absolutely right about that.
Yet the ECB is about to make the same mistake, fiddling with interest rates rather than going to the heart of the monetary disorder. Such a policy is what Japan did for a decade and is likely to disappoint.
If Europe is at risk of deflation, the proper response is a monetary barrage of such force that nobody can be in any possible doubt about the outcome. As Napoleon said, if you say you are going to take Vienna, then take Vienna.