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Since the advent of the
quantitative easing (QE), the Fed�’s unprecedented attempt at
reversing the impact of the credit crisis, many long-held beliefs and
assumptions have been demolished. One of the most sacred
assumptions on the part of investors and economists alike is that central
bank money printing always eventually leads to inflation. Yet six
years have passed since the Fed first embarked on its historic attempt at
reversing the effects of the credit crash and alas, no signs of inflation are
on the horizon.
Quantitative easing has
increased the stock of money in economies of the U.S., the U.K. and Japan by
nearly $4 trillion in recent years. The success of this
coordinated monetary policy response to global deflation was an undeniable
success; since 2009 the U.S. economy has been in recovery mode while other
major economies have had varying degrees of recovery. That�’s not to even mention what QE has done for equity markets: several
major U.S. indices are at or near all-time highs as of this writing. So
what could possibly be wrong with the latest idea being bandied about among
several commentators, namely that printing money should be employed more
often by central banks in the coming years?
An old Chinese proverb
says, �“Success
breeds failure, and failure breeds success.�” Unfortunately, this saying definitely applies
to the economic realm. Many economists wrongly assume that since
QE has failed to create inflation the problems normally associated with loose money have been permanently
solved. Nothing could be further from the truth. As we
shall see, the Fed�’s timing in implementing QE was fortuitous
given the current phase of the long-term cycle of inflation/deflation. Circumstances
beyond the Fed�’s control have more to do with QE�’s failure to create inflation than
either policy or infrastructure.
In a recent Bloomberg
Businessweek editorial, Michael Metcalfe,
an asset strategist at State Street Global Markets, suggests that money
printing could be a useful tool for alleviating global poverty. Since
inflation didn�’t jump in the wake of QE as the alarmists
predicted it would, Metcalfe believes the Fed and other central banks should
push the envelope by printing even more money in the name of global poverty
relief. Metcalfe argues that investors are confident of central bankers�’ ability to stop printing if inflation ever does become a problem. He
seemingly falls victim to the trap of extrapolating
current trends into the distant future, never considering that the last five
years could be the exception to the rule.
Metcalfe also maintains
that the lack of inflation is partly explained by the ongoing weakness of
growth, characterized as it is by spare capacity in many industries, tepid
bank lending and low money velocity. �“Nevertheless,�” he writes, �“the experience of quantitative
easing has demonstrated clearly that, under the right economic conditions and
with a credible inflation-targeting central bank, the creation of money by
sovereigns can be an effective policy tool to flight disinflation.�”
Metcalfe also suggested
that as long as it sees little risk of inflation, the Fed could print money
to match the government�’s overseas aid payments up to a
certain limit. He also proposed �“creating money to buy bonds of countries
receiving aid that are directly linked to development goals.�”
Metcalfe opined that �“print aid is technically possible�” and wouldn�’t necessarily create inflation. �“The experience of the financial
crisis has shown that the risks from money creation are more manageable than
previously believed,�” he concluded. �“Now might also be the only time in
which developed nations can actually afford to provide the level of aid to
the world�’s poor they�’ve always aspired to.�”
The theme sounded by
Metcalfe in his Businessweek editorial
is also being echoed by other commentators. In their book Modernising Money, Andrew Jackson and Ben
Dyson argue in favor of governments issuing perpetual interest-free bonds. Under
this scheme, central banks would then be required to purchase these bonds in
certain amounts. The bonds, the authors claim, won�’t add to the national debt since
they never mature.
Money printing schemes
such as the ones proposed by Metcalfe, Jackson and Dyson are symptomatic of
the unusual economic environment of the past five years. An
economist wouldn�’t be an economist if he didn�’t show fidelity to the Cardinal
Rule of their trade: linear extrapolation. They see the success of
the Fed�’s unprecedented QE policy and naturally
conclude that money printing can be pursued to infinity with no inflationary
consequences. What they fail to consider is that the past five
years are likely to prove the exception, not the rule.
More than any other factor,
the final deflationary phase of the 60-year cycle can be attributed to the
lack of inflation in recent years despite QE. With the long-term
cycles creating counter-inflationary undercurrents there was no reason to
believe that inflation would ever be a problem during the years 2009 to
2014. With the start of a new 60-year cycle later this fall,
however, those currents will reverse. Inflation, not deflation or
disinflation, will be the new long-term normal. The danger occurs
if policy makers listen to the wild proposals of economists like Metcalfe and
continue to inflate the money supply above and beyond the demands of the
economy. If they do, then inflation will become a very real
problem at some point in the coming years.
The million dollar
question is what happens when banks, businesses and consumers finally throw
off the caution that has characterized the market since 2008? At
some point the velocity of money will reverse its decline as confidence
increases and investors realize that the threat of deflation has
disappeared. Will the hundreds of billions in sidelined money
enter the economy as a slow, gradual trickle? Or will it re-enter
the channels of commerce quickly as a mighty onrushing
torrent? Since no one can definitively answer this question, the
wisest policy would be to resist the temptation to employ money printing
schemes as a palliative for solving global poverty or anything else.
Instead of exploring the
outer limits of an apparently successful money printing scheme (namely QE), policy
makers would do better to consider the potential pitfalls of the coming
long-term inflationary cycle. Once the new 60-year cycle kicks off
next year and becomes established it wouldn�’t be surprising if the proverbial
termites come teeming out of the woodwork. The unaccountably large
amount of liquidity created by central banks in recent years will likely
contribute to inflation at some point, and it might happen sooner than
economists think.
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