Neverending stimulus is not only ineffective, writes Philip Cross, it’s sowing the seeds of the next big financial crash.
By Philip Cross, Dec. 1, 2016
It has been eight years since massive monetary and fiscal stimulus was adopted throughout the G7 to tame the global financial and economic crisis. However, these nations, including Canada, remain mired in slow growth despite sustaining and even expanding this stimulus. Why these policies failed to restore faster growth is the main question for economists today. It’s one I explore in a paper just released by the Macdonald-Laurier Institute.
Years of extraordinary monetary and fiscal stimulus have not jump-started a strong recovery. For the advanced economies, real GDP growth averaged nearly three per cent before the crisis. Since then, it has averaged 0.9 per cent, including 1.7 per cent for the last four years. The eurozone has been particularly anaemic, with growth averaging 0.3 per cent since 2010. Japan has adopted 15 fiscal stimulus packages since 1990, maintained zero-interest-rate policies for 15 years, and implemented nine rounds of quantitative easing, all without lasting benefit.
Why has unprecedented monetary and fiscal stimulus not produced the desired results? Partly because it is being asked to do something it is incapable of: boosting growth over the long term. Some analysts go further, arguing that the very policies designed to boost growth in the short term subtract from it in the long term. Stimulus partly works by shifting demand from the future to the present via more borrowing and risk-taking, which clearly dampens spending in the future. At a deeper level, emergency levels of monetary and fiscal stimulus were never intended to be sustained for a long period because of the distortions they introduce into a wide range of decisions about saving, investing and borrowing that lower long-term potential growth. As the Bank for International Settlements stressed in its 2016 annual report, “tomorrow eventually becomes today.” We are living in the future we distorted and borrowed from to avoid a worse recession several years ago.
Years of extraordinary monetary and fiscal stimulus have not jump-started a strong recovery.
The long term is more than the sum of a series of short terms. In the words of Yale University’s Robert Shiller (who won a Nobel prize for spotting both the stock market and housing bubbles in the U.S.), “We must therefore consider the short run and the long run separately, and the policy responses to the two are very different.” Long-term growth policies encourage a better allocation of resources and enhanced technological change. Easy monetary policies instead divert resources to low-productivity sectors that benefit from low interest rates, notably housing and government; allow inefficient firms to survive; weaken financial institutions; and encourage risky behaviours with low payoffs.
More worrisome is that history shows that recessions and financial crises have their origins in policies undertaken to tame a previous slump or crisis. The 1987 market crash led to emergency interest rate cuts that sparked higher inflation, resulting in the 1990 recession. The low interest rates designed to fight that recession induced investors to seek out higher returns in Asia, leading to 1997’s Asian financial crisis. The Fed slashed interest rates in response to that, triggering the dot-com bubble that burst in 2001. The ensuing regime of suppressed interest rates helped fuel the U.S. housing bubble that collapsed in 2007. Given this pattern, one can only view with alarm the distortions introduced into a wide range of markets over the past eight years of unprecedented monetary stimulus to fix our current slump. To quote the novelist William Faulkner, “The past is never dead. It’s not even past.”
Canada is often perceived as having the healthiest public debt position of the G7 nations. This ignores the growing indebtedness of the provinces.
Meanwhile, government deficits in the G7 have soared, injecting uncertainty into the private sector about future tax hikes and limiting the ability of governments to respond to the inevitable next recession. Deficits have mounted throughout the western world as crude Keynesians argued for more spending while crude supply-siders advocated tax cuts. Neither put sufficient emphasis on the nefarious effects of the resulting increases in debt, now approaching levels that markets in the past have been reluctant to finance. Nevertheless, increased risk-taking in financial markets in response to ultra-low interest rates raises the probability of another crisis that governments are unprepared to face.
Canada is often perceived as having the healthiest public debt position of the G7 nations. This ignores the growing indebtedness of the provinces. While the ratio of federal debt to GDP is low for a G7 nation, the ratio of all government debt to GDP in Canada is only 10 to 13 percentage points below levels in the U.S., the U.K., and the euro area. As noted by Olivier Blanchard, the former IMF chief economist, one of the lessons of the last crisis was that “What appeared to be safe levels of public debt before the crisis were in fact not so safe.”
The economics profession has not communicated that its understanding of the macroeconomy is embryonic and primitive, not encyclopedic and sophisticated. Even if it did prevent the 2008 crisis from becoming a depression, this appears to be at the expense of chronically slow growth. Economists have not clarified that policies designed to stimulate growth in the short term, like lower interest rates and more government debt, are the opposite of policies that boost long-term potential growth. Finally, since economists cannot reliably forecast the arrival of crises, this implies a need to keep a reserve of potential monetary and fiscal responses. Governments in the advanced economies haven’t done so, leaving them unusually vulnerable to another shock. That shock will probably originate in the distortions introduced by the past decade of extraordinary monetary and fiscal stimulus.