The Age of Bizarro Economics
by Jim Staudt, PhD, CFA
copyright 2016, all rights reserved
by Jim Staudt, PhD, CFA
copyright 2016, all rights reserved
In DC Comic’s Superman, there is a Bizarro world on the cube-shaped planet htraE (Earth spelled backwards) where everything is the opposite of Earth. Ugliness is worshiped over beauty. Stupidity is preferred over intelligence. And, even bonds are sold that are guaranteed to lose money.
In an age where about 25% of the world’s economies (Japan and much of Europe) are practicing negative interest rates, we have reached a point that might be called the age of Bizarro Economics. A fundamental principle that economists have relied upon for ages is that there should be a cost to borrowing capital because capital is useful, and the cost charged for borrowing capital should increase with the risk of the associated investment. Thirty years ago the thought of a world with negative interest rates would be akin to a world without gravity – something inconceivable. Today, thanks to central bank intervention in many countries we now have a cost to possessing capital. Possessing capital is no longer desirable, but now incurs a burden! Much has been written about the risks of this policy – risks of depositors removing deposits from banks, risks to insurance and pension funds and to savers, risks associated with investment in low return projects that will drag down economic growth for decades, and other risks associated with misallocation of capital. On the other hand, the promoters of low to negative interest rate policies argue that this is what is necessary to promote economic growth. They believe that the failure of Quantitative Easing (QE) to provide sustainable growth is not because QE doesn’t work (unlike pushing a rope?), but that we didn’t have enough QE – in effect we should “double down” on a policy that didn’t deliver. They argue that negative rate policies have prevented the Eurozone and Japan from suffering deflation, although we can’t be certain what might have happened if interest rates had been permitted to normalize.
What I argue is that negative rates are where decades of “growth at any cost” easy monetary policy have led us to. Credit expansion can stimulate economic growth by increasing credit purchases. But, too much easy credit will lead to misallocation of capital, such as people purchasing homes they can ill afford, as happened in the run up to the 2008 crisis. As I argue in Grand Collusion, it also leads to nations being tempted to act recklessly and pursue unnecessary wars. And, use of credit for promoting consumption is by its very nature consuming today in exchange for reduced consumption tomorrow. But, tomorrow does eventually come. In effect, the world economy has grown addicted to easy credit, and for an addict more of what he or she is addicted to always seems like a good solution.
In A Brief History of Financial Euphoria John Kenneth Galbraith wrote “All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.” For many nations, including the United States, debt relative to gross domestic product is currently well above where it was immediately before the Great Depression. Central bankers believe that they are smarter than they were in the past and can navigate the risks of negative interest rates and ever-expanding credit. In 2004 Ben Bernanke, not yet Fed Chairman but a member of the Board of Governors of the Federal Reserve and the heir apparent to Alan Greenspan, stated in his “Great Moderation” speech that improved monetary policy had reduced macroeconomic volatility. In other words, in his view central bankers had played an important role in taming the business cycle. Yet, despite Dr. Bernanke’s words and his succession as Fed Chairman, we suffered the greatest economic downturn since the 1930s only four years after his statement. In light of this, should we really have such confidence in our central banks that this time will be different?
Unfortunately, decades of expansionary monetary policy have backed the central banks into a corner where there are no means left at their disposal to promote economic growth other than entering the Bizarro World of negative rates. But, the bigger question is whether the central banks should have been managing our prosperity in the first place. In other words, is economic growth the responsibility of the central bank? At initial blush, this seems a strange question. In recent decades we have grown so accustomed to the Fed’s role in “managing” the economy that to argue otherwise may seem like heresy. But, the original role of the Federal Reserve was not to manage our prosperity, but to be the regulator and guarantor of our banking system. What we have seen over the past several decades is what military strategists call “mission creep” – where the initial mission morphs into another one and you lose sight of what your objective was in the first place. Managing the economy was never the original intent of the Federal Reserve. What the 2008 crisis proved beyond a doubt is that the Fed failed miserably in both its original mission of ensuring bank stability and its adopted mission of managing the economy.
The Fed and other central banks, increasingly staffed with academics trained in neoclassical economics, have come to have great faith in their ability to “fine tune” the economy with the help of their economic modelling. These computer models have given the Fed and other central banks the mistaken idea that they can actually manipulate the economy to some end - in effect, central banks now think that they can be the "Wizard of Oz" running the economy from behind a curtain. This has tempted central banks to move their attention from their original responsibility of ensuring banking system stability to the role of managing (or trying to manage) our economy. In this respect central banks believe that Adam Smith’s “Invisible Hand” can be put under the control of the Fed and the other central banks.
And, if one accepts the notion that the Fed should manage our prosperity with pro-growth policies (I don’t, but supposing one did), this raises still another question: What level of risk is a society willing to accept to achieve this growth? Is it worth risking severe economic crises to achieve that growth? This is an important question that the central banks are ignoring with their short-sighted perspective and what I believe is hubris in thinking that they can really tame the business cycle.
Unfortunately, the Bizarro World that we live in, unlike that of DC Comic’s Superman, is real. It doesn’t go away when we close a comic book. We have to deal with the effects of decades of credit expansion at rates that far exceeded the growth in the world economy. The debt, unless written down at a large cost to investors, will be a drag on economic growth for decades.
