When patients do not respond to a particular type of medicine, or suffer from side effects, doctors usually stop administrating it and decide on a different course of action. But for central bankers, which are medics hired to fix ailing economies things are not that simple. The European Central Bank and the Bank of England initiated today programmes aimed to expand the availability of credit in an attempt to cure the economic sickness with the very thing that caused it: too low interest rates.
More easy money
In a widely expected move, the governor of the Bank of England, Sir Mervin King announced they would increase their bond buying programme by the tune of £50 billion of newly created money. The benchmark interest rate is already at the record low of 0.5%. The European Central Bank decided to cut the its lending rate at 0.75% and surprisingly, the People`s Bank of China announced that it would lower, for the second time in a month, its lending rate to 6%. This comes after the US Federal Reserve opted to expand the so called Operation Twist by a further $267 billion and the Bank of Japan increased its asset purchasing by $61 billion. Bold moves as they may be, they have not quenched the thirst of market participants for more quantitative easing: the ECB is expected to initiate a new LTRO and FED is believed to begin QE3 by the end of this year.
Despite being disguised under the pompous terminology of quantitative easing or long term refinancing operations, the purpose of all these measures is very clear: create inflation. Supposedly, inflation would help the process of deleveraging by decreasing the creditor`s burden of debt. So far they have done a good job at increasing the rate of inflation, but the economic benefits have failed to appear.
Credit in the world of finance is like sugar: it is a basic nutrient for the body and is very important as long as it is ingested in moderate quantities. If eaten in excessive quantities, the body becomes mildly addicted to its short term exhilarating effects and starts to accumulate it thereby causing negative aftereffects. Luckily, the human body signals early on when the consumption of sugar should be diminished, showing that the only way to cure the effects of an excess is by cutting the excess itself. It is only in the world of finance where an excess is though to be corrected by more excess.
The financial crisis of 2008 was indeed started by the widespread availability of cheap credit and the lack of basic regulatory framework to account for market failures such as moral hazard, free riders and asymmetric information. The sensible way to react to a crisis is to allow it to take its normal course and let the market decide upon the reallocation of resources from shareholders in failing companies to creditors.
By insisting in deploying inflation generating quantitative easing programmes and by artificially lowering the long term interest rates, the central banks are running into the so called liquidity trap (by which banks hoard additional liquidity for the fear of deflation or currency devaluation). The liquidity trap appears due to a combination of grim expectations and record level yields which make savers/investors think twice before putting their money on the market. Take the latest liquidity injection provided by the European Central Bank to European banks. It was hoped to boost the purchasing of European sovereign debt by incentivising banks to engage in a carry trade. The reality is that more than half of the money handed out during the two Long Term Refinancing Operations were sent back to the ECB as deposits. What good does it make if all the money boomerangs back to the central bank ?