Without structural reform, the next economic crisis is just around the corner

Stephen Roach says policymakers must bite the bullet to redress destabilising imbalances

PUBLISHED : Tuesday, 05 May, 2015, 1:38pm
UPDATED : Tuesday, 05 May, 2015, 1:38pm

The world economy is in the grips of a dangerous delusion. As the great boom that began in the 1990s gave way to an even greater bust, policymakers resorted to the time-worn tricks of financial engineering in an effort to recapture the magic. In doing so, they turned an unbalanced global economy into the Petri dish of the greatest experiment in the modern history of economic policy. They were convinced that it was a controlled experiment. Nothing could be further from the truth.

The rise and fall of post-second-world-war Japan heralded what was to come. The growth miracle of an ascendant Japanese economy was premised on an unsustainable suppression of the yen. When Europe and the US challenged this mercantilist approach with the 1985 Plaza Accord, the Bank of Japan countered with aggressive monetary easing that fuelled massive asset and credit bubbles.

The rest is history. The bubbles burst, quickly bringing down Japan's unbalanced economy. With productivity having deteriorated considerably, Japan was unable to engineer a meaningful recovery. In fact, it still struggles with imbalances today.

Despite the abject failure of Japan's approach, the rest of the world remains committed to using monetary policy to cure structural ailments. The die was cast in the form of a seminal 2002 paper by US Federal Reserve staff economists, which became the blueprint for America's macroeconomic stabilisation policy under US Federal Reserve chairs Alan Greenspan and Ben Bernanke.

The paper's central premise was that Japan's monetary and fiscal authorities had erred mainly by acting too timidly. Bubbles and structural imbalances were not seen as the problem. Instead, the paper's authors argued that Japan's "lost decades" of anaemic growth and deflation could have been avoided had policymakers shifted to stimulus more quickly and with far greater force.

If only it were that simple. In fact, the focus on speed and force has prompted an insidious mutation of the Japanese disease. The liquidity injections of quantitative easing (QE) have shifted monetary-policy transmission channels away from interest rates to asset and currency markets.

But fear not, claim advocates of unconventional monetary policy. What central banks cannot achieve with traditional tools can now be accomplished through the circuitous channels of wealth effects in asset markets or with the competitive edge gained from currency depreciation.

This is where delusion arises. Not only have wealth and currency effects failed to spur meaningful recovery in post-crisis economies; they have also spawned new destabilising imbalances that threaten to keep the global economy trapped in a continuous series of crises.

Consider the US - the poster child of the new prescription for recovery. Although the Fed expanded its balance sheet from less than US$1 trillion in late 2008 to US$4.5 trillion by the autumn of 2014, nominal GDP increased by only US$2.7 trillion. The remaining US$900 billion spilled over into financial markets, helping to spur a trebling of the US equity market. Meanwhile, the real economy eked out a decidedly subpar recovery.

Indeed, notwithstanding the Fed's massive liquidity injection, the American consumer has not recovered. Real personal consumption expenditures have grown at just 1.4 per cent annually over the past seven years. Unsurprisingly, the wealth effects of monetary easing worked largely for the wealthy, among whom the bulk of equity holdings are concentrated.

America's subpar performance has not stopped others from emulating its policies. On the contrary, Europe has now rushed to initiate QE. Even Japan has embraced a new and intensive form of it.

But, beyond the impact that this approach is having on individual economies are broader systemic risks that arise from surging equities and weaker currencies. As the baton of excessive liquidity injections is passed from one central bank to another, the dangers of global asset bubbles and competitive currency devaluations intensify. Politicians are lulled into a false sense of complacency that undermines their incentive to confront structural challenges.

What will it take to break this daisy chain? As Chinese Premier Li Keqiang stressed in a recent interview, the answer is a commitment to structural reform - a strategic focus of China's that, he noted, is not shared by others.

Policy debates in the US and elsewhere have been turned inside out since the crisis - with potentially devastating consequences. Relying on financial engineering, while avoiding the heavy lifting of structural change, is not a recipe for healthy recovery. On the contrary, it promises more asset bubbles, financial crises and Japanese-style secular stagnation.

Stephen S. Roach, a faculty member at Yale University and former chairman of Morgan Stanley Asia, is the author of a new book Unbalanced: The Codependency of America and China. Copyright: Project Syndicate