An Alternative to the Untested Monetary Model?

The sceptre of uncertainty hangs. In 2008 when the financial crash hit, with plummeting growth rates causing financial meltdown, America, the UK and Japan responded with an untried-untested monetary model. It is said that Quantitative Easing (QE) was responsible for stabilising economies in the midst of crisis, propping up inflation and providing growth stimulus to ease those in recession. Martin Weale of the Monetary Policy Committee claimed in a paper that QE had added 3% to UK GDP. This legacy prompted the European Central Bank (ECB) to announce its own Quantitative Easing programme. The problem is, experts aren’t certain it will work.

Every government strives for that “Goldilocks economy”, a locomotive with a balanced trade off between inflation and growth. Seven years after the US and UK’s introduction of QE, the ECB set out its own plan, buying $60bn of assets monthly – amounting to roughly 7% of Eurozone GDP. At first glance the stimulus package appears a perfect medicine. Inflation is desperately sought after in Europe and the evidence shows that QE has induced inflation for the UK in every round of stimulus. Subject to diminishing returns, growth was also a feature in the first and second rounds, with the effects of the third remaining disputed. Doubts however have overshadowed much of the optimism previously held. Many consider the ECB as lackluster, believing this call was long overdue. Andrew Sentence, an economic adviser at PricewaterhouseCoopers, points out that the experience of Japan in the 1990s and 2000s suggests that inside policy lags cause deeper financial problems. This would require a more aggressive stimulus package, but the ECB’s scale of purchase is modest in relation to the size of the Eurozone. The UK’s bond purchases for example amounted to 20% of GDP, suggesting that the ECB’s proposal may not be up for the job in its current state.

Speculation over whether the QE plan will really be effective is rife. Japan has continued to pump money into its economy and has seen only a few upticks amongst a general theme of stagnation. In the Eurozone, QE operates via the banking system, flooding banks with liquidity. This is unlikely to solve the core issue; banks are suffering a short fall in demand for loans, not an inability to supply them. Those in support of QE would say that this aside, one key benefit is that falling interest rates will reduce business costs and aid those at the bottom via a trickle down effect. Unfortunately, the trickle down effect has been questioned, and leading economist Paul Krugman believes that it has failed us.

Eurozone QE is just one chapter in a wider story of what Stephen King labelled the ‘monetary tug-of-war’.

Now that the stimulus has begun, investors are left with a choice; take on riskier assets or suffer poorer yields. The real question is: are investors ready? Markets typically respond well to announcements of stimulus. Last October though, it was shown that a dissonance between what the market shows and how investors feel still remains. Slow growth in Europe, the Ebola outbreak and an intensifying conflict in the Middle East and Ukraine wounded investor sentiment. Bloomberg reported that leveraged money had spurred mass sell offs when the market hit a brief downturn. QE had encouraged investors to move to riskier, less liquid assets, in search of higher yields and their real insecurity came to light when markets turned the other way. The release highlighted that “when markets are buckling and volatility is signaling a crisis, you sell what you can, not what you want”. It showed that the longer-term consequences of QE are still unknown and prospects for European investors may be one of panicked rather than prudent selling.

A particular concern is that Eurozone QE is just one chapter in a wider story of what Stephen King labelled the ‘monetary tug-of-war’. The sterling surge in 2004 taught us that when two major economies share contrasting monetary policies there is a possibility for major currency shifts. Now with the current outlook, it is important that we re-learn that lesson. QE has a tendency to depreciate the real exchange rate, as fixed income investors go in search of higher yields and inflation erodes away at real value. Only one week after stimulus introduction, the Euro had already fallen to a 12 year low against the dollar. At the same time, Janet Yellon is poised to raise interest rates on the other side of the pond and Mark Carney, under forward guidance, has similar ideas further on in the horizon. In other words, we have the same loosening-tightening basis for a 2004-style upheaval. The potential for strong appreciation in the pound and dollar concurrently with a depreciating euro may de-stabilise the West’s economic future.

Strong voices are emerging that question whether a return to Keynesianism may be more sensible

Externalities from Eurozone QE pose a secondary risk for the US economy. With more attractive European goods it would be wise to consider the risk of Europe exporting their deflation to the US, inflating the now-forgotten fiscal cliff, and stifling the US economy in greater debt. The imbalance is one reason why credit easing should have been avoided. The West does not want to find itself in a “who’s looser” competition, yet in light of the ECB’s announcement there is talk of US QE4 if the impact on real debt and trade is too large.

Some have recognised this risk. As the ECB embarks on its monetarist strategy, strong voices are emerging that question whether a return to Keynesianism may be more sensible. Research from HSBC suggests that many of the impediments to European economies are structural, which monetary stimulus cannot address. Firms state skill shortages as dissuasion from investment. A ‘new deal-esque’ spending programme targeted at labour market rigidities and the development of skills would add flexibility to the labour market. Fiscal stimulus would tailor itself well to those European economies mired in high unemployment – such as Spain (23%) and Greece (25%) – whilst avoiding the troubles of ‘monetary war’. The problem is that fiscal stimulus would undermine attempts at the austerity or budget reform that has been pushed politically across Europe, particularly by Angela Merkel over the past year.

So, we find ourselves stuck in a rut. The outcome of this latest venture is uncertain and the attempts at an alternative are politically constrained. The mismatch in monetary policies has made balance in the global economy unlikely if we continue on the same route. So if the Goldilocks ideal is to be achieved it might rely on governments looking beyond their bond buying gluttony and austere fiscal fantasies.