There has been quite a bit of distress in some political, financial and business circles, regarding the unconventional measures taken by the Fed and some other central banks, most notably the ECB, to add liquidity to the system on a massive scale and to prop up the bond market. The era of unprecedented massive monetary stimulus has arrived.
This major concern is very legitimate, given that these kinds of measures are indeed unprecedented not only in scale, but also in many respects. The chief worry is that the aggregate of these measures might be planting the seeds for future high inflation, without ruling out the possibility of hyperinflation sometime in the not so distant future.
Assuming everything else remains equal, a gargantuan injection of liquidity to any economy will, in due time, inevitably generate extremely powerful and very difficult to control inflationary pressures down the road. Of critical importance, the premise “assuming everything else remains equal” does not hold at all during the period when those extraordinary liquidity measures referred have been taking place.
On the opposite side of the ledger, however, the significant belt-tightening of government finances as a response to the subprime crisis as well as to the European debt crisis, have been simultaneously generating tremendous deflationary and contractionary pressures in their respective economies.
A deleveraging process is indispensable to put public finances on a strong foot again after a severe debt crisis. Belt-tightening, in turn, is also an indispensable ingredient of any deleveraging process. If left unattended, the contractionary and deflationary forces that substantial belt-tightening produce will certainly create a significantly higher pain to the economy and the job market, aggravating the recession and the unemployment picture even further, not to mention the possibility of ending up in a catastrophic depression/deflation spiral. Granted, the solution has not been perfect; no human creation ever is. A well orchestrated deleveraging process will simply attenuate the otherwise more severe and painful outcomes.
With so many deep imbalances in the US economy when the subprime bubble burst, it would have been naive to have expected a quick full restoration to normality afterwards. Achieving high growth in any economy under a severe slashing of government spending, including paying off national debt, is a virtual impossibility. In addition, there is also a very powerful factor working against the resumption of vigorous growth, the shrinking labor force in the developed world.
To avoid the most pernicious vicious cycle that deleveraging implies, when appropriately done, it must be simultaneously accompanied by a parallel process of a relaxed —or extremely relaxed, as conditions dictate— monetary policy, to compensate the contractionary and deflationary effects of deleveraging itself. Otherwise, a sharp contraction —recession— with high propensity to outright deflation develops. History has unequivocally shown that a deflationary recession quite easily morphs into depression, like in the 1930s in the US.
The balancing act, the optimum calibration is probably not as difficult to accomplish as it is normally perceived to be. The underlying strength of a recovering economy —mainly measured by the unemployment rate— coupled with the inflationary pressures —or their lack thereof— undoubtedly are the best indicators available to measure when a significant policy change is required. If appropriately acted upon, this duo of indicators should be constantly monitored, for at one point they will signal when it is time for the Fed to begin lifting the extremely lax monetary conditions.
For the time being, inflation is basically dead. There shouldn’t be so much confusion about it. The behavior of inflation is completely logical. In fact, this is a confirmation that the ultra-easy monetary policies are working, since they have not yet materialized in significant and generalized inflationary pressures. Likewise, the US economy —and the EU’s more so— are far from overheating.
The US, Europe, and all the developed World are growing well below their economic potential. That’s one hundred percent compatible with the absence of inflationary pressures. We must always keep in mind that, most of the time, the economy must be close to overheating condition for inflationary pressures to become unbearable and truly dangerous if unattended.
In summary, through lax monetary policies, central banks must provide adequate liquidity and credit support for the economy in a deleveraging process, in order to:
Offset, as fully as possible, the contractionary and deflationary forces at work, while tight fiscal conditions and austerity prevails. In this way, the pain will be significantly lower, and above all, this is the only known way to…
Avoid falling into a depression within a pernicious deflationary environment.
Ray Dalio, the founder and principal of Bridgewater Associates, the prestigious hedge fund, has referred to a well implemented deleveraging process as a “beautiful deleveraging”. We couldn’t agree more with him in this regard. We highly recommend watching Dalio’s video How the Economic Machine Works, for an excellent description of this process.
Ray Dalio very appropriately summarizes a beautiful deleveraging, when the following three conditions are met:
Positive growth in the economy,
Nominal GDP growing above nominal interest rates, so that…
A falling debt/income ratio is observed.
Wrapping up, although in many respects both the US and the EU are in uncharted territory, as long as outright deflation is avoided, even if the rate of growth is rather anemic, like the current case, the outcome is far better than the multi-mentioned unpalatable alternative. A more vigorous growth rate can be attained anywhere anytime through genuine structural reforms and deregulation to improve the ease of doing business status. Monetary policy alone can’t and shouldn’t be expected to do everything for any economy.