11 April 2009

The perils of printing money ~ none, it worked for Zimbabwe

Many major central banks around the world have now spent all their bullets in lowering official interest rates, yet their economies still founder.

Quantitative easing (QE) is now being seen as a last hope for governments in the US, Japan, Britain and Europe to prevent the onset of possible depression following the global economic crisis.

In a nutshell, QE involves central banks printing money to purchase a range of assets from the market. Typically these are government and mortgage bonds. The US and others are, on the one hand, financing their fiscal deficits by issuing bonds to the market, yet on the other hand are supersizing their balance sheets by buying back these and other securities with electronically created money.

If this sounds crazy then you understand the situation. QE advocates say that money supply in the economy is increased which should allow easier borrowing to purchase assets like property. This in turn is designed to halt deflation and raise prices.

But what happens when the party is over? Governments can't print money and buy bonds forever.

The resulting situation is one of a bond market bubble where yields are artificially low and governments are the only major buyers. Investors will stay out of the market, in fear of losses on these bonds when the QE buying program ends. Long-term rates then rise rapidly just as economic recovery is emerging.

This practice is almost as crazy as the whole multi-layer of leverage created in the first place when the US Federal Reserve held rates at just 1 per cent for far too long and produced the great property bubble of the early 2000s. Perversely, it will once again be government policy that spawns this mess.

Credit goes to governments for supporting the global financial markets and guaranteeing bank deposits. Safeguarding the integrity of the financial system is paramount to a free and law-abiding society. Credit also for establishing programs to relieve banks of toxic assets so that they may get back to good old-fashioned money lending. Future re-regulation of the banking system will prevent many of the unfortunate aspects of runaway capitalism from returning.

That said, the practice of widespread QE implementation is fraught with folly and may get us into a situation just as dire as the one we are currently in.

Clearly central banks consider the downside of QE (surging inflation and rapidly rising borrowing costs) a far more fixable problem than what we are currently in, using traditional monetary policy measures.

So why go from one disaster to another or bust to boom and back again when we have the opportunity to get things sorted in this current downturn? Clearly the world needed to deleverage and many bad industries and enterprises had to consolidate by either merging, rationalising or bankruptcy. It is likely we have already suffered the majority of the pain. The US car makers will emerge much greener and more globally competitive. Many weak banks have already fallen or been consumed by the large. The huge discount in many stocks will open the door for investors to prudently rebuild their portfolios.

There has already been massive government fiscal stimulus, record low rates and huge equity injections into the private sector … maybe, just maybe it is time to step back a little and see what happens from the sidelines without authorities thinking they need to continue to coach from the middle of the pitch with untested and possibly dangerous policies.

Closer to home, the Reserve Bank has wisely lowered its benchmark rate to 3 per cent to support the economy yet still has ammunition to do more. It believes a combination of historically low rates and fiscal stimulus will be enough to see Australia through the storm. Luckily for us, an extremely solid economic foundation built up over the past 15 years should mean that QE never gets into the minutes of RBA policy.

Then there is the folly of blanket hand-outs. Surely they should be saved. The Rudd Government is wrong to be giving huge incentives for the public to go out and leverage themselves again in this economic environment. Did excessive leverage not cause the problem in the first place?

Neale Muston, the former managing director of fixed income at Morgan Stanley Australia, now runs a global markets trading business in Sydney.

Source: The Sydney Morning Herald

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