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Pain killers might work, but economies need antibiotics

Monday 17 June 2013

Stephen King
April 24, 2013

So, more drugs to deal with our collective lack of growth. The Bank of England’s Funding for Lending extension is welcome: the scheme lasts longer than before, contains extra incentives to lend to cash-strapped small and medium-sized enterprises and has been widened to include non-bank sources of credit, including financial leasing corporations. And after some remarkably soggy eurozone data – including purchasing manufacturers index figures suggesting that the German economy is not quite as dynamic as Bayern Munich – investors are increasingly hopeful that the European Central Bank will come to the rescue, buying up equities as if the dark clouds are about to lift.

There can be no doubt that the drugs on offer from central banks can shift markets. But can they also shift economies? That, surely, is the big public policy question. In the immediate aftermath of the financial crisis, the answer was a decisive “yes”. Faced with rapidly melting confidence and a serious lack of liquidity, central banks stepped in to prevent what might otherwise have been a second great depression. The answer now is not so obvious. It is not so much that the drugs don’t work. Rather, they are acting more as pain killers than as antibiotics. They make some of us feel a bit better but the economic results are, to say the least, disappointing. Even in the US, which has done better than most, the pace of recovery is distinctly limp by historical standards.

This is not to criticise the actions of central banks. The Funding for Lending Scheme is better than nothing. An interest rate cut from the ECB would doubtless be welcomed. The Bank of Japan’s actions have already provoked a major change in sentiment. Without a sustained recovery in economic activity, however, the danger is simply that central banks are pumping up asset prices and creating a bigger and bigger gap between financial hope and economic reality.

One reason why this gap is opening up relates to the distributional impact of unconventional policies. Broadly speaking, quantitative easing in all its many forms lowers long-term interest rates, lifts the value of risky assets through the so-called portfolio channel, triggers a capital outflow and, thus, pushes the exchange rate lower. Those who happen to be financially asset-rich will do well. Those who depend on wage income alone – and thus are vulnerable to the impact of a falling exchange rate on import prices and inflation – will not do so well. If, as is likely to be the case, those in the first group have a lower marginal propensity to consume than those in the second group, the risk is that aggregate demand does not pick up as much as desired.

To be fair, those in the second group might initially do well if they happen to have large mortgages and interest rates are not yet at rock bottom. Once, however, rates are close to zero and the yield curve is broadly flat, those initial benefits will fade, as seen in the UK.

The rising value of financial assets thus says more about the ability of central banks to create financial bubbles than their chances of delivering healthy economic recoveries. Of course, if the alternative to a bubble is economic collapse then, perhaps, this is a risk worth taking. Unfortunately, bubbles are too often the prelude to economic collapse, as we discovered with the onset of the financial crisis. Yet, even in the absence of economic collapse, the increased dependency of financial markets on the whims of central bankers and, in some cases, their political masters may lead to increased volatility and dislocation: second guessing the intentions of the central banking community is, in many ways, now more important than offering an accurate forecast of future economic growth, one reason why the prices of all manner of financial instruments – from gold to the yen – are now so hard to predict. Is that healthy? Hardly.

Underneath all of this is a trickier question. At some point, central banks may want to take our economies off painkillers. Yet if the addiction is widespread, that may be no easy task. Governments themselves may resist any such move: with large amounts of debt, they will not be keen to see a sustained increase in borrowing costs. More importantly, if elevated values of risky assets stem from the indiscriminate application of monetary drugs, the removal of those pain killers might only create a financial version of cold turkey. And as no one wants that, drug supplies will remain in abundance for the foreseeable future, whether or not our economies are transformed.

The writer is HSBC Group’s chief economist and the bank’s global head of economics and asset allocation research. He is a member of the Financial Times Economists’ Forum

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