Since 2008, all major advanced economies have seized monetary policies to cope with challenging debt crises. The massive monetary expansion is deferring vital structural reforms in the advanced world and posing new risks to the emerging world.
Last Tuesday French President François Hollande complained that the euro should not be left fluctuating at the mercy of the “mood of markets.” The European Central Bank (ECB) should have a foreign exchange policy, Hollande argued. “Otherwise we are asking countries to make efforts on competitiveness that are annihilated by the value of the euro.”
When Spain and Italy were swept by market turmoil more than a year ago, the euro plunged to $1.20. Since then, the Eurozone currency has appreciated steadily and sharply, peaking at $1.36 recently. Analysts believe the currency could soar to $1.45 against the dollar and stay there for a while.
While the concern for the fluctuations of the euro may be valid, the proposed medication – mandating the ECB to run a foreign-exchange policy – is politically unviable and economically counter-productive. It would reinforce competitive devaluations rather than show a way out.
The current European currency debate is not exactly a new one, however.
Post-crisis currency wars 1.0
As the global crisis exhausted the traditional instruments of monetary policy, central banks have been opting for new rounds of quantitative easing (QE). And, with investors seeking higher returns, more QE has been driving ‘hot money’ (short-term portfolio flows) into high-yield emerging-market economies.
As these monetary policies remain in place, they are growing less effective, but continue to inflate potentially dangerous asset bubbles in Asia, Latin America, and elsewhere.
Initially, these policies were characterized as “extraordinary” but “temporary.” The goal, or so it was said, was to support the recovery and create foundations for solid growth.
But have these policies improved economic prospects, really?
Over-estimating strengths, under-estimating risks
In the early days of the global crisis, even the most informed observers were hopeful. The Fed chief Ben Bernanke saw “green shoots” in the U.S. economy as early as in spring 2009.
At the end of 2010, the annual growth of the advanced economies was 3 percent and projected to remain at 2.5 percent by 2012. In turn, emerging and developing economies were growing at 7.1 percent and their growth was expected to be 6.5 percent by 2012.
Nevertheless, the realities proved very different.
In the next two years, the expected growth of the advanced economies was almost halved to 1.3 percent, while that of the emerging and developing economies decreased by a fifth to 5.1 percent. Meanwhile, most major forecasts were significantly downgraded, from the largest investment banks to the International Monetary Fund.
Today, these forecasters expect advanced economies to grow by 2.2 percent and the emerging world by 5.9 percent in 2014. However, if you take a careful look at their most recent forecasts, you will find that these projections, too, have been downgraded, one quarter after another.
Such deviations are not irregularities or anomalies, but a pattern. During the past four years, the expected growth of the advanced economies has been hugely over-estimated and the impending risks vastly under-estimated.
It is the same patterns that have justified the systematic extension of supportive monetary policies in all major advanced economies.
Three monetary musketeers
In September 2012, the Fed expanded its holdings of long-term securities with open-ended purchases of $40 billion of mortgage debt a month. It seeks to hold the federal funds rate near zero until 2015. The goal was to boost growth and reduce unemployment.
In late summer 2012, the ECB chief Mario Draghi pledged to do “whatever it takes” to preserve the euro. The pledge was followed by the Open Monetary Transactions (OMT) program, to provide liquidity to sovereign debt markets. The goal was to reduce tensions and boost market recovery in the Eurozone.
Recently, the stimulus package of the new Japanese government, coupled with the anticipation of aggressive monetary easing and reforms, has driven Japanese stocks sharply higher and the yen significantly lower. That, in turn, could unleash a series of new currency rivalries.
During the past four years, the bloated balance sheets of these three central banks have doubled and then almost tripled to almost $10 trillion.
Monetary expansion, soaring unemployment
In the United States, the lingering stagnation has replaced solid growth and unemployment remains nearly 8 percent. Labor force participation has plunged and monthly job creation is significantly below what is needed for a solid recovery. Before the crisis, unemployment was below 5 percent. Now the target is 6.5 percent. Structural unemployment may have come to stay.
In the same time period, unemployment in the Eurozone has soared from 7 percent to 12 percent and the area is in recession, again. In the ailing Southern periphery, the unemployment rate is twice as high and youth unemployment more than 50 percent.
In Japan, the third lost decade has begun. The economy is near-stationary, and the worst days of population decline are still ahead.
Structural reforms can no longer be deferred in these major economies, which must soon cope with aging populations, rising health care costs and reduced growth. However, the awakening cannot occur until the era of highly accommodative monetary policies has eclipsed.
Bloated central banks in the West, shrinking growth in the East
In the advanced world, these monetary policies are not supporting growth and employment, but translate to de-leveraging, deflation and depreciation. In the emerging world, the same policies contribute to potential asset bubbles, inflation and appreciation.
In adverse scenarios, such challenges could either slow or disrupt the emergence of Asia as the global economic powerhouse.
While these monetary policies create a perception of stability, they also provide a pretext to defer structural reforms, which, in turn, creates a moral hazard. In Washington, this status quo has resulted in a prolonged fiscal cliff. In Brussels, muddling through has postponed change. In Tokyo, the standoff has discredited a generation of political leaders.
What’s worse, any perception of stability could prove elusive if the U.S. fiscal cliff fails to lead to a credible, bipartisan medium-term adjustment plan, if the Eurozone is swept by new turmoil, or if markets would lose faith in Japan’s huge debt.
Bloated central bank balance sheets in the advanced world have become a part of the problem.
The author is research director of international business at India China and America Institute (USA) and visiting fellow at Shanghai Institutes for International Studies (China) and EU Center (Singapore)
Slightly modified version of “Printing Self-Illusions,” China Daily, February 6, 2013