How to kill a zombie

Age is rich in disappointments. One is resignation to the immunity of all institutional contrivances to uncongenial ideas. Only this explains why the same solutions to the same problems recur in every generation, despite their proven ineffectiveness. Keynes famously said that the true source of institutional conservatism was not vested interest but the longevity of bad ideas.

Age is rich in disappointments. One is resignation to the immunity of all institutional contrivances to uncongenial ideas. Only this explains why the same solutions to the same problems recur in every generation, despite their proven ineffectiveness. Keynes famously said that the true source of institutional conservatism was not vested interest but the longevity of bad ideas. He would doubtless be gratified by the Methuselah-like life of his own contributions to monetary economics. Whether this testifies to their continuing utility, or reflects the career-long investment in them by thousands of economists working in treasury departments, central banks and banks, is a matter for those who seek aboriginal authority for their views, or relish how interests and ideas can coincide. What matters is that the response of the official minds of the developed economies of the world to the present crisis is untainted by novelty, or even old ideas whose time might have come. It is in fact shaped exclusively by the relatively recent but largely unspoken rapprochement between Keynesian and Friedmanite ideas neatly described as output gap monetarism. Its principal tool is the rate of interest, and its aim is to keep spending on goods and services, the supply of money and the output of goods and services, as closely aligned as such vast aggregates will permit. The artificial suppression of the rate of interest since 2008, and the increases in the supply of money through quantitative easing, are merely the application of this consensus to extreme conditions.

The degree of monetary stimulus is certainly exorbitant enough to make the accompanying debate about whether cuts in public spending boost or retard economic growth seem scholastic by comparison. In its celebrated QE2 program in the first half of last year the Federal Reserve purchased $600 billion of government debt. Since the total amount of money in the American economy at the beginning of 2011, as measured by M1, was $1.86 trillion, purchases on that scale were tantamount to an annual rate of growth of the money supply of more than 30%. Likewise, the Bank of England has since March 2009 added 325 billion to a money supply that totaled 2 trillion at the start of the process. That amounts to a compound annual rate of growth in the money supply of 5% in an economy that managed to raise real output by just 3.5% even at the height of the boom in 2007. Rates of growth of these magnitudes are by any standards a powerful set of stimulants. Even in the 1950s, when there was virtually zero growth in the money supply on either side of the Atlantic, prices rose by 1.5% a year in the U.S. and 4.1% a year in the United Kingdom.

So inflation of some kind is a near-certainty. But the policy is working, to the extent that the economies of both the United States and the United Kingdom have grown in each of the last three years. The curiosity is that growth is accompanied by an extraordinary propensity to hold cash. Since the success of the policy ultimately hinges on the willingness of the investors that have sold bonds to the central banks reinvesting the proceeds in private sector securities, this is not an encouraging phenomenon. If the money simply accumulates in bank accounts, equity and bond prices will not rise, companies will not find it easier to raise finance for investment and sustainable increases in output and employment will not follow. Yet this is what appears to be happening. Cash deposits at BNY Mellon, State Street and Northern Trusta good proxy for the propensity of fund managers and institutional investors to hold cashwere 70% higher at end of last year than they were when the crisis began in 2007. Worldwide, despite nugatory rates of interest, aggressive repatriation of customer liquidity by the banks and three consecutive years of economic growth, another $4.7 trillion is sitting in money market mutual funds.

In short, money is being hoarded. To describe this as counterintuitive when real rates of interest are negative, and even banks can think of no better use for cash than to return it to the central banks, cannot do justice to the absurdity of this phenomenon. Fund managers are reluctant to invest cash in securities (though the rate of return on cash could scarcely be lower) and businesses are reluctant to borrow cash (though the price of doing so could scarcely be cheaper). In other words, despite the most extreme experiment in the printing of money since John Law controlled the finances of the Kingdom of France 300 years ago, economies are still suffering from the problem Keynes was born to solve: the fetish for liquidity. As Keynes pointed out, the paradox reflects a lack of confidence in the future. Our desire to hold money as a store of wealth is a barometer of our distrust of our own calculations and conventions concerning the future, he wrote. The possession of actual money lulls our disquietude, and the premium which we require to make us part with money is the measure of the degree of our disquietude.

That disquietude reflects a distrust of financial markets, and of financial market intermediaries, which has deep roots in recent experience. Over the past quarter century, investors have endured a succession of systemic crises (the Latin American debt crisis of the 1980s, the Tequila crisis of 1995, Asian flu in 1997, the Russian default of 1998, the Argentine crisis of 2001 and the global financial crisis of 2007-09), stock market crashes (1987, 1998, 2000-02, 2008-09), repeated excesses in the retail banking industry (the S&L crisis of the 1980s, sub-prime mortgage lending, multiple bank failures in 2007-08), the collapse or near-collapse of investment banks (Drexel Burnham Lambert in 1990, Bear Stearns, Lehman Brothers and Merrill Lynch in 2008, MF Global in 2011), the demise of insurance companies (Equitable Life, AIG), accounting scandals (Enron, WorldCom, Satyam), insider dealing (Ivan Boesky, Raj Rajaratnam), hedge fund implosions (LTCM, Tiger, Amaranth), dubious practices in the mutual fund industry (late trading and market timing), a money market fund breaking the buck (the Reserve Fund), outright fraud (Bernie Madoff, Allen Stanford), rogue traders (Yasuo Hamanaka, Nick Leeson, Jerome Kerviel and Kweku Adoboli), litigation alleging markets are rigged against investors (notably in FX and securities lending), and levels of pay and bonuses that seem to render senior bankers and corporate executives immune to the economic cycle. So far, bankers have borne the brunt of public disquiet, but the fund management industry is now engaged in the early rounds of a reputational disaster stemming from public perception of the large gap between performance and costs. It is not surprising that some investors have preferred cash, gold and real estate to the securities markets. Indeed, what is surprising is that the level of engagement with the equity markets in particular remains as high as it does.

In this politically charged environment, purely technical solutions such as quantitative easing damage confidence as much as they reinforce it. The public see the willingness of the authorities to reduce every aspect of the crisis, from the rescue of AIG to the bailout of Greece, to a mere problem of financeability, as the monetary policy equivalent of the accounting practices at Enron or the sub-prime mortgage approvals process. In other words, they see it as a mask drawn over reality for long enough to ensure that bankers are paid and banks repaid. This conviction that financial markets and their inhabitants are guilty of acting in bad faith is not dissolved by the desperate series of measures taken by the central banks to rescue the financial system since 2007-08. Indeed, they have had the reverse of the intended effect. Far from imbuing investors with confidence, they have added to resentment a chronic sense of crisis. The suppression of the natural rate of interest, the manufacturing of money by the Federal Reserve and the Bank of England, and the recent introduction of the heads-I-lose-tails-you-win carry trade by the European Central Bank, speak not of central banks in control of events but of events in control of central banks.

Current monetary policies are widely perceived to be fundamentally unsound. Investors anticipate inflation, or deflation, or both. Entrepreneurs, convinced that cheap money cannot persist, are reluctant to borrow. To the extent that it fuels inflationary expectations, quantitative easing does not blur these perceptions but makes them more vivid. So too does the specter of unredeemed public and private sector debt, whose scale is now so great that it is impossible to conceive of any politically acceptable solution short of inflating it all away. Artificially low rates of interest also make it much harder for banks to rebuild their balance sheets quickly, since their chief source of incomenet interest margin, or the difference in the price at which they borrow and the price at which they lendis constrained. With regulators simultaneously forcing banks to operate to higher liquidity and capital ratios, their appetite for risk is attenuated. Not the least of the madnesses of the current crisis is that it has proved possible for bank lending to contract even as the supply of money has increased.

So perhaps it is time to heed the insight of Maynard Keynes and pay the premium necessary to make people part with their cash by raising the rate of interest. The conventional wisdom is of course utterly opposed to this idea. It holds that higher rates of interest would lead to an increase in bad debts before the banks were strong enough to absorb the losses, sparking a new credit crunch. Bond prices would plummet. House prices would collapse. Consumer confidence would implode. The corporate sector would abandon its investment plans. Though there are constituencies for higher rates of interest (savers), lower bond prices (pensioners), reduced house prices (young people on modest salaries) and the redeployment of scarce resources from support of the banking industry (entrepreneurs in every other sector), their voices are ignored. The idea that it is the role of the central bank to counter asset price falls by lowering the rate of interest and infusing the markets with liquidity is so uncontested that the interests of savers, pensioners, first-time buyers and entrepreneurs are regarded as irrelevant. Indeed, even to mention such a deflationist notion as raising the rate of interest in mid-financial crisis is to reopen some of the deepest psychological scars of the terrible history of the 20th century. It is to claim membership of an historical freak show. It is one of such primitiveness that analogues are usually found in the misplaced enthusiasm of those who welcomed the onset of war in 1914 as a cleansing tonic for decaying civilizations, or in the prototypical sado-monetarism of Treasury Secretary Andrew Mellon, who in 1930 advised president Hoover to liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate to purge the rottenness out of the system.

Yet it is worth asking whether decreasing rather than increasing the quantity of money, and increasing rather than decreasing the rate of interest, would have the catastrophic effects predictedand what price economies pay for the current approach. After all, it is fallacious to believe that increases in the quantity of money alone can in the long run increase the wealth of nations. Inflation and deflation alike are purely monetary phenomena. Both distribute their punishments and rewards arbitrarily. In an inflation, the prices of goods and services rise, offering windfall profits to producers and distributors. The real value of debt is reduced, rewarding borrowers. It is those who have saved, or who live on fixed incomes, who are punished by inflation. Deflation has the opposite of these effects. Prices of goods and services fall but so do the costs of producers, so they can still turn a profit. Those on fixed incomes enjoy an increase in their standard of living. When prices deflate, it is those with excessive borrowings that are hurt the most, because they are not able to service or redeem debts whose value has increased in real terms. They find selling assets at fire-sale prices only worsens their predicament.

Inflation is a jubilee, in which all debts are forgiven. Deflation is a fast, a period of self-denial by which right living is restored. The one is the obverse of the other: The victims of deflation are the beneficiaries of inflation, and vice-versa. Is that such a deplorable outcome? Morally speaking, inflation rewards the vicious, who have spent and borrowed too much. Deflation rewards the virtuous, who have savings and no borrowings. Economically speaking, deflation purges the system of uneconomic investments built up during the preceding boom, such as houses with mortgages their occupants cannot afford, commercial buildings with unrealistic rental expectations, over-leveraged private equity portfolios, holdings of Greek government bonds, the so-called toxic assets of banks and any number of industrial and commercial projects whose viability was based on an error of optimism. These assets then become available to the prudent at prices close to their real value, enabling the new owners to manage them to redemption or sale profitably. True, this is tantamount to a zero-sum redistribution of wealth. But that is an outcome deflation shares with inflation, with the difference that it is visible and just. Redistribution of assets is also a normal feature of a properly functioning market economy. Businesses constantly misjudge consumer demands, or technological change. They over-invest, or under-invest. So they get over-taken (or taken over) by competitors. This is the creative destruction of which Schumpeter wrote, and which is at the heart of the successful adaptation of a capitalist economy.

The purpose of the present policy is to obstructindeed, preventthat process of adaptation. This is because the volume of lending and investment errors that accumulated during the period of excessively loose monetary conditions was so great that it threatened to overwhelm the global banking system. Rescuing the imprudent from their folly may be the least-worst outcome for the global economy as a whole, but it is not without costs that stretch far beyond the immediate. It amounts to a refusal to acknowledge that the structures of credit and indebtedness created in the boom were unsustainable. Governments cut expenditure enough to refinance their debts or monetize what cannot be repaid. Central banks loosen their collateral eligibility criteria to fund assets that no other financier will touch. Where money is tight, central banks print more. Doing the minimum necessary or bending the rules or manufacturing money or monetizing debts in order to avert the crystallization of the cost of imprudent expenditures or investments solves nothing. It is merely a means of continuing to finance problems into a future where others can pay the price. It has all of the moral status of a mortgage sold not on the basis of the sum borrowed, but of the size of the monthly payments. Yet a sovereign state, Greece, now being refloated on large lines of official credit and a default-that-is-not-a-default, is embarked on exactly this course.

Making a problem financeable alters reality in one way only. It guarantees the persistence through each turn of the economic cycle of all of the errors of the previous cycle. The refusal of the financial markets to respond vigorously to unprecedented levels of stimulation reflects the deadweight of the misallocations of capital and mispriced assets of every previous turn of the credit cycle. This is why it is taking ever-lower rates of interest, and ever-larger doses of quantitative easing, to precipitate the asset price inflation in stock and housing markets (and the upsurges in debt-financed consumer spending) that are mistaken for recovery, but which in reality reward only the authors of the crisis and their profligate clientele. The economy of Japan, which is often portrayed as a warning of the horrors of deflationist policies, may in fact be a portent of the future that awaits Europe and the United States. In the 1990s, the Japanese government refused repeatedly to own up to the true number of bad loans the Japanese banks had contracted. By the early years of the 21st century, it was reduced to adopting what were then regarded as extreme measureszero rates of interest and quantitative easingin an effort to bring the economy back to life. The Japanese experience suggests that inflation of the money supply need not manifest itself even in rising asset or consumer prices, let alone a revival of real economic activity. Instead, it becomes the lifeblood of a zombie economy. It is one capable of being jerked into life by an external stimulus but, unconscious of the value of savings and of the value of the rate of interest in arbitrating between claims upon savings, it is incapable of sustained or self-generating growth, or of any but the shortest bursts of enthusiasm for the borrowing of money or the buying of stocks. The only way to put an end to zombie economics is to stop printing money, and put up the rate of interest.