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September 2012 will surely go down in history as the month in which the world’s top central bankers set the seal on the greatest monetary experiment of all time. Mario Draghi of the European Central Bank committed to buying eurozone sovereign debt without limit. Federal Reserve chairman Ben Bernanke announced an open-ended asset purchase programme aimed specifically at a weak US labour market. Then at the Bank of Japan Masaaki Shirakawa announced an aggressive expansion of monetary easing, increasing the size of asset purchases and extending the deadline for the purchasing programme.
Market lore has it that it never pays to fight central bank policy. This tends to be true of the Fed and it has been true more widely for much of this year as central banks continue to expand their balance sheets. Admittedly the ECB’s twists and turns, together with political vacillation in the eurozone, have occasionally provided opportunities for lucrative bets against the central bank. But from July Mr Draghi’s hints that unlimited central bank firepower was in the offing put an end to the short sellers’ party.
That said, renewed anxiety in recent days suggests that markets may once again be losing confidence in central banks’ unconventional measures – as well they might on a longer view. As I have remarked here before, the nature of this experiment is about buying time. And as central bankers themselves have emphasised, there is a limit to what they can do to ensure that time is well used. The requisite policies have to address both deficient demand and supply side reform, while bringing down a huge overhang of debt. A judicious mixture, in other words, of Maynard Keynes and Friedrich Hayek. Yet the mere act of expanding central bank balance sheets risks creating a false sense of security among politicians in over-indebted countries as to the scale of the challenge.
Stephen Cecchetti and colleagues at the Bank for International Settlements have calculated that the primary fiscal surplus as a percentage of gross domestic product must swing over 10 years by 15 percentage points in the UK, 14 per cent in Japan, 11 per cent in the US and 9 per cent in France just to stabilise public debt at the pre-crisis level. How likely are their governments to pull off this awesome trick?
Between now and Christmas there will be fraught negotiations in the US to prevent a plunge over the fiscal cliff into big automatic federal budget cuts. Last year’s debacle over the debt ceiling increase suggests that many on Capitol Hill complacently feel that all problems can be left to Mr Bernanke to solve. This does not inspire confidence in the ability of the US to avoid a recession. In Japan the government is addressing debt sustainability by doubling the rate of value-added tax. It is politically courageous, but falls short economically of what is required to fix the highest public sector debt in the developed world. The UK and France, meantime, are struggling to achieve deficit and debt targets as their economies fall back into recession.
In the eurozone, debtor countries, most notably Spain, are having second thoughts since the Draghi initiative about submitting to tough conditionality in exchange for rescue money. Austerity is already causing their economies to shrink, tax revenues to erode and debt to go on rising regardless. This is reverse Keynesianism with Hayekian add-ons – structural reforms to raise underlying growth rates – that will take years to have beneficial effects.
A further cause of concern is that with all the monetary stops now out, the exit from unconventional policy will be all the more challenging, especially in relation to central bank independence. In effect, central banks have been weakening their balance sheets both in terms of the declining quality of the assets they buy and the collateral they accept. The extreme case is Japan, where the central bank has extended its buying programme from government paper to commercial paper, corporate bonds, exchange traded funds and J-Reits. The quality of the sovereign paper acquired by the ECB also leaves a great deal to be desired.
If markets start to worry about central bank balance sheets, they may have to be recapitalised. At that point the politicians may demand more control over institutions that are clearly encroaching on fiscal policy, just when inflation may be about to return as a serious threat. Having distorted the markets to such a high degree, the central bankers will also be flying blind because the capacity of markets to send useful signals about inflationary pressure will be seriously impaired.
Throughout history monetary experiments have shown a nasty tendency to blow up. I repeat: this experiment is vast. It must not breed complacency.
The writer is an FT columnist
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