Debt Monetization: From Tokyo to Washington and Brussels
The end-game of the global financial crisis of 2008/9 has begun.
Recently, the World Bank warned developing countries to prepare for the risk of the world going into a slump like the global downturn in 2008-09 owing to an escalation in the Eurozone debt crisis.
Until the global crisis, Washington and Brussels argued that Japan had needlessly drifted into a liquidity trap. Today, all major advanced economies — not just Japan, but also the United States and Western Europe — are sinking deeper into a liquidity trap.
Full recovery remains far away, as evidenced by the U.S. Federal Reserve’s recent announcement that it intends to hold short-term interest rates near zero *“*at least through late 2014.” In the Eurozone, the potential for a catastrophic risk is significantly higher.
Ironically, the worst threat stems not from what could go wrong, but from the way the Eurozone, along with the United States, seeks to resolve the debt crisis.
QE Versus QT
In Washington, the trap was set by the exhaustion of traditional instruments of monetary policy, which prompted the Federal Reserve to initiate quantitative easing (QE) in fall 2010.
At the time, Brazil’s interest rate was close to 11 percent and, following the Fed’s move, it began to prepare ways to retaliate. “It’s no use throwing dollars out of a helicopter,” as Brazilian Minister of Finance Guido Mantega put it. Soon afterward, Germany’s finance minister Wolfgang Schaeuble called U.S. policy “clueless,” while his South African counterpart thought that the Fed´s move undermined the G-20 leaders’ “spirit of multilateral cooperation.”
In the Bush era, the unilateral security policies alienated America from much of international community. Now a deepening global divide set the stagnating United States against many emerging economies and commodity-producing countries. The worldwide impact of QE only aggravated the chasm, reflected by the rifts among the G-20 nations.
As the Fed was exhausting the power of traditional monetary instruments, it was also heading into uncharted territory.
With investors seeking higher returns, more QE has driven “hot money” (short-term portfolio flows) into high-yield emerging-market economies, inflating potentially dangerous asset bubbles in Asia, Latin America and elsewhere.
At the same time, emerging and developing countries have been compelled to move in the opposite direction E, that is, toward quantitative tightening (QT). In China, interest rates were increased to 6.6 percent. In India, the central bank raised rates dozen times to 8.5 percent since March 2010 to bring down inflation. Brazil’s central bank recently reduced rate to 10.5 percent to shield the economy from the Eurozone crisis.
During George W. Bush‘s presidency, unilateral security policies left America without friends. In the Obama era, unilateral economic policies may end up having the same effect..
Using exchange rate policy against deflation
In his famous 2002 speech on the potential of deflation in America, Fed Chairman Ben Bernanke suggested that former U.S. president F.D. Roosevelt’s 40 percent devaluation of the dollar in 1933-1934 shows that the exchange rate policy can be an “effective weapon against deflation”.
… There have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly… The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt’s devaluation.
But that was almost 70 years ago during the high period of nationalism and protectionism. In a global economy, the decisions of the leading countries’ central banks have global implications.
Already in fall 2010, Chen Deming, China’s minister of commerce, complained that the “the United States’ issuance of dollars is out of control and international commodity prices are continuing to rise”. China was attacked by “imported inflation”.
In retrospect, Washington’s hot money was only the first act in the ongoing crisis. The second has already begun — in Europe.
Printing money – the European way
Since the global crisis and the onset of the Eurozone turmoil in May 2010, European leaders have tried a wide array of measures — fiscal pain, monetary easing, hollow growth, bailouts, restructurings — to contain their debt crisis, but with few results.
There is a remaining option: printing money.
Since the global crisis and the onset of the Eurozone turmoil in May 2010, European leaders have tried a wide array of measures – fiscal pain, monetary easing, hollow growth, bailouts, restructurings – to contain their debt crisis, but with few results.
The remaining option: printing money. Naturally, all key leaders are against it, officially. For all practical purposes, playing fire has already begun.
During the past few years, financial institutions from debt-stricken Eurozone countries such as Greece, Portugal and Ireland have borrowed extensively from the ECB. Since May 2010, the ECB has purchased sovereign bonds from crisis-stricken euro-zone member states worth EUR 213 billion ($280 bn). This translates to increasing risks at the European Central Bank, due to the collaterals that banks must post when they borrow money from the ECB.
In turn, the ECB has provided euro banks with massive amounts of liquidity. In December, it injected European banks with EUR 500 billion ($650 bn) with long loan periods of three years. The assumption is that the debt and the collaterals are sustainable.
Instead of passing the ECB money in loans to companies for employment and to stimulate the economy, banks, in turn, have re-parked the money with the ECB. As deposits at the ECB pile up, unemployment in the Eurozone continues to spread.
In early January, Italy and Spain had few problems raising new funds in sovereign bond auctions. This was widely perceived as “easing of tension” in the financial markets. In turn, the ECB defended the abundant liquidity as an “effective policy measure.” In reality, the ECB was allowing some banks to use its liquidity in the auctions to buy the bonds.
What’s going on here? A cynic might call it debt monetization.
Monetizing debt is a many-splendored thing
As the ECB is injecting the banks with cheap money, it is artificially creating demand for sovereign bonds. This allows the ECB to cut bank on its own bond purchases, which has been criticized, while pumping up artificial demand, which is not understood.
Naturally, euro banks love the ECB policy. Now they can borrow easy money from the ECB for three years at low interest rate. If they use that money to buy bonds in crisis economies, they will get a much higher interest rate. Moreover, they can re-park these bonds at the ECB as security, which allows them to borrow even more low-interest money.
In the short term, this financial magic benefits the banks, the struggling economies and even the ECB. In the long-term, it is unsustainable.
And when the money-printing machine eventually falls apart, it could severely harm the banks, bankrupt the cash-strapped countries and undermine the very legitimacy of the ECB.
In order to avoid Japan’s two lost decades, the West has now opted to inflate away its massive debt burden. The domestic effect is immense deflation and continued unemployment.
In the 1990’s, emerging and developing economies were still dependent on growth of the leading advanced economies. In the past decade, these countries have become dependent on Chinese growth. A disruptive decline of the euro or the U.S. dollar – or, conversely, a disruptive appreciation of the Chinese renminbi – could hinder not only China’s growth, but also global recovery.
Both the Fed and the ECB are implementing vast real exchange rate depreciation by printing money. It is the advanced world’s effort to force the emerging world to accommodate drastic inflation and thus nominal rate appreciation.
From the standpoint of the emerging East, it is comparable to successive waves of QE, which amount to debasing the value of the dollar and the euro alike.
The net effect is a massive financial tsunami that has already been ignited, will take time to form, but may eventually sweep over the emerging and developing economies alike.
Printing money is a bad way to play fire.
A shorter version of the commentary, “West sends inflation,” has been released by China Daily (Jan 31, 2012)