The Limits of Central Bank Policy

Equity markets worldwide have fallen hard in the wake of the Federal Reserve’s latest stimulus attempt.
It could be that investors were disappointed with the size of Operation Twist, or with the lack of something more aggressive, like unsterilized purchases of Treasury bonds. Though that might just be a matter of perceptions and semantics.

Goldman Sachs economists figure what the Fed was doing was, in fact, QE3–$400 billion of long-dated bond purchases while swapping an equivalent amount of short-dated bonds for bank reserves sitting idle and generating about the same sort of yield as the debt.

Or it could be that the sovereign debt crisis in Europe is overwhelming central bankers’ efforts.
I think it’s because investors are starting to realize that central banks are at the limits of policy. Governments need to take over with fiscal stimulus–with a catch. Governments first need to allow markets to clear.

The most significant problem right now with global economies, and this increasingly includes developing markets, is that investors can’t trust asset prices. After waking up out of the mass delusion fed by the two decade long debt binge that culminated in the 2008 financial crisis, investors realize that economies have to live off their real productive potentials, not some fantasy.

These productive potentials ought to be reflected in asset prices. But they’re not. Central banks and governments have done all they can to prevent markets from clearing, because this would mean falling asset prices and falling asset prices against a backdrop of mountains of debt means wholesale default and misery.

But until asset prices are at a level where people are comfortable making investment decisions, they’ll keep sitting on their cash. Eventually, inflation and a slow erosion of asset prices–Tokyo shares have been falling for 20 years and may not have bottomed yet–leave economies in a zombie-like state.

But were governments to allow asset prices to adjust, they’d also need to do some pretty heavy lifting as well. Debts would have to be written off, banks would have to be recapitalized, ideally by their bond and equity investors, but governments might have to help too, and the social safety net would have to be reinforced to catch those poor unfortunates who suffer because of others’–and their own–poor past decisions.

In other words, governments have to unleash the harshest ravages of capitalism and at the same time mitigate these with Scandinavian-style socialism. At the end of it, people will feel less well off than they did at the height of the boom, especially the very rich who have benefited to an unconscionable degree from both the debt bubble and from the rescue afterwards. But they will feel less hopeless, more inclined to invest in their businesses and their futures and thus more able to lift themselves out of this financial disaster.

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