The central bankers of Japan have announced that they are going to increase the money supply in that country by roughly 1.4 trillion dollars. In reasponse, the Japanese stock market soared and the yen got clobbered on the foreign exchange markets. Meanwhile, in the USA, the Federal Reserve continues to pump about $85 billion per month into the money supply through the latest manifestation of quantitative easing. In the UK, the government has modified the constraints on the Bank of England in order to facilitate moves towards increasing the money supply there as well. So far, however, the Bank of England has not changed its policy, but there are indications that this will occur in short order. What does it all mean?
The strangest thing about all of these moves to pump money into the economic systems around the world is that none of them are likely to work as intended. That is because the item most responsive to the growth of the money supply is interest rates and they are essentially at zero already. The current rate on Japanese 10 year bonds is 0.45% while the comparable rates in the USA and the UK are 1.78% and 1.75% respectively. For two year notes the rates are Japan 0.07%, USA 0.23% and UK 0.20%. Short term rates are even less. So there is nowhere for the rates to go. The conceptual basis for monetary policy normally is that the as the money supply is increased, interest rates will fall and this will make long term investment in the economy less expensive. The resulting higher investment will then result in higher economic growth. But here, when the interest rates cannot fall in a meaningful fashion, there will not be a resulting boost in economic growth.
Keeping interest rates low will have one beneficial effect for the economy. It will allow companies of all sizes to refinance their debt so as to reduce their interest costs. Over time, this will increase corporate profits and could lead to growth. On the other side of the ledger, however, people and companies with cash balances will no longer receive much, if anything at all, in the way of interest on their savings. This will reduce consumer income and corporate profits as well. As a result, the positive impetus for economic growth is likely to be slight from these combined effects.
Sadly, however, the increase in the money supply does bring with it negative consequences. First of all, the simplest point is that all of the new money has to go somewhere. It does not just get stuffed under mattresses. When it first appears, the money mostly goes into the bank accounts. Eventually, however, when we reach a point where it seems that the economy is stable enough to allow for safe investment, a big chunk of the additional money will be put somewhere that is likely to pay a return. When the day comes for investment of the new money supply, the big question is where will it go? The hope, of course, is that the investment would go into increasing economic growth through construction of new plants, offices and other facilities that would need to be populated by workers. With the economies of most of the world either stagnant or declining, however, those investments are not forthcoming. Instead, the cash is making its way into commodities like gold, oil, copper, and the like. If you consider why gold has risen by so much since the crash in 2008, the answer is that the extra money supply has pumped up the price of the metal. But even these price increases end at some point; the bubble bursts.
Even worse than commodity price bubbles, however, is what comes if the economy starts to recover and grow. At that point, all of the extra money that got pumped into the system will start to be spent. Think of it this way: as the economy picks up steam, millions of consumers who held off for years buying cars and other items will rejoin the market. This will lead to a major increase in demand that will be facilitated by the huge size of the money supply. Indeed, excess demand will quickly lead to price increases for the items being purchased. Home prices will soar, for example. It is the traditional recipe for high and increasing inflation. The inflation will then have to be stopped or the economies will again crumble to dust. And we all know how to stop inflation: the central banks will need to slow the economy.
This description is, of course, a simplistic one. There are many other factors at play. The main point, however, is one with which there can be no argument. Monetary easing is unlikely to help economic growth much, if at all, but it brings with it the distinct possibility of further long term economic damage. It is as if the central bankers feel that they must do something, so they take these actions which logically they must know will not work.
The strangest thing about all of these moves to pump money into the economic systems around the world is that none of them are likely to work as intended. That is because the item most responsive to the growth of the money supply is interest rates and they are essentially at zero already. The current rate on Japanese 10 year bonds is 0.45% while the comparable rates in the USA and the UK are 1.78% and 1.75% respectively. For two year notes the rates are Japan 0.07%, USA 0.23% and UK 0.20%. Short term rates are even less. So there is nowhere for the rates to go. The conceptual basis for monetary policy normally is that the as the money supply is increased, interest rates will fall and this will make long term investment in the economy less expensive. The resulting higher investment will then result in higher economic growth. But here, when the interest rates cannot fall in a meaningful fashion, there will not be a resulting boost in economic growth.
Keeping interest rates low will have one beneficial effect for the economy. It will allow companies of all sizes to refinance their debt so as to reduce their interest costs. Over time, this will increase corporate profits and could lead to growth. On the other side of the ledger, however, people and companies with cash balances will no longer receive much, if anything at all, in the way of interest on their savings. This will reduce consumer income and corporate profits as well. As a result, the positive impetus for economic growth is likely to be slight from these combined effects.
Sadly, however, the increase in the money supply does bring with it negative consequences. First of all, the simplest point is that all of the new money has to go somewhere. It does not just get stuffed under mattresses. When it first appears, the money mostly goes into the bank accounts. Eventually, however, when we reach a point where it seems that the economy is stable enough to allow for safe investment, a big chunk of the additional money will be put somewhere that is likely to pay a return. When the day comes for investment of the new money supply, the big question is where will it go? The hope, of course, is that the investment would go into increasing economic growth through construction of new plants, offices and other facilities that would need to be populated by workers. With the economies of most of the world either stagnant or declining, however, those investments are not forthcoming. Instead, the cash is making its way into commodities like gold, oil, copper, and the like. If you consider why gold has risen by so much since the crash in 2008, the answer is that the extra money supply has pumped up the price of the metal. But even these price increases end at some point; the bubble bursts.
Even worse than commodity price bubbles, however, is what comes if the economy starts to recover and grow. At that point, all of the extra money that got pumped into the system will start to be spent. Think of it this way: as the economy picks up steam, millions of consumers who held off for years buying cars and other items will rejoin the market. This will lead to a major increase in demand that will be facilitated by the huge size of the money supply. Indeed, excess demand will quickly lead to price increases for the items being purchased. Home prices will soar, for example. It is the traditional recipe for high and increasing inflation. The inflation will then have to be stopped or the economies will again crumble to dust. And we all know how to stop inflation: the central banks will need to slow the economy.
This description is, of course, a simplistic one. There are many other factors at play. The main point, however, is one with which there can be no argument. Monetary easing is unlikely to help economic growth much, if at all, but it brings with it the distinct possibility of further long term economic damage. It is as if the central bankers feel that they must do something, so they take these actions which logically they must know will not work.
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