Stimulus addiction may be driving the global economy towards a cliff edge

Central bankers seem to have little choice other than to offer more stimulus, risking more financial instability later. Debt forgiveness may be the only way out – but therein lie other troubles

Anthony Rowley

Published: 1:30am, 21 Dec 2020

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Increasingly, it feels like we are heading over a cliff yet dare not turn back because of the demons pursuing us. This is the stuff of nightmares but also an apt metaphor for the fate that could await a global economy being driven towards disaster by an addiction to monetary and fiscal stimulus.

Financial counsellor and director of the International Monetary Fund’s monetary and capital markets department Tobias Adrian used more nuanced terms to describe the dilemma in a paper he presented to a high-level financial gathering in Washington recently. But the meaning was much the same.

Central banks, he said, have done a good job in preventing a “catastrophic downturn” in the global economy, and more of the same will be needed. But he also cautioned, “it is critical that policymakers weigh the pros of providing more stimulus today against the potential cons of higher financial stability risks down the road.”

It may seem hard to take such warnings seriously, and not just because the pandemic has pushed all thoughts of financial crisis out of most people’s minds. Do we not, after all, live in a world where money flows like milk and honey, and where debt no longer matters?

Is this not a brave new world where interest rates stay “lower for longer” (maybe forever), where authorities are committed to doing “all it takes” to avert economic and financial collapse, and where modern monetary theory teaches that (rich country) governments can go on printing money forever?

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Has not the threat of inflation been banished to the distant future? Is this not a time when stock prices can ignore economic fundamentals (even horrors such as Covid-19) and continue charging bullishly into the future? Have we not discovered the pot of gold at the end of the rainbow?

Are we not justified in believing that, come the era of mass vaccinations on the near horizon, all will be well again and that we can get back to pre-pandemic normal and norms amid recovering confidence, rising output and increasing investment?

Yet, if this is so, why are some leading economists feeling more than just a frisson of concern? The answer is that a lot can go wrong and the concerns among thinking people could translate into real-world problems.

Colossal monetary creation in recent times (some US$15 trillion in fiscal stimulus backed by central banks) is feeding inflation expectations, and rising inflation expectations drive bond prices lower.

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This is where things begin to unwind. The “wealth effect” created by record-high stock prices goes into reverse and consumption begins to suffer, as do prices of physical assets such as property. An economic downturn ensues and with it, the risk of financial system distress rises.

The biggest time bomb is debt. As the Institute of International Finance notes: “Spurred by a sharp rise in government and corporate borrowing as the Covid-19 pandemic wears on, the global debt load increased by US$15 trillion in the first three quarters of 2020 and now stands above US$272 trillion”.

Rising bond yields generate rising debt costs and the legions of zombie companies kept afloat by official stimulus to preserve employment and confidence face debt distress and bankruptcy. The only way out is more official purchases of corporate debt, which is precisely what is happening.

The US Federal Reserve has pledged to keep buying at least US$120 billion of public and private debt per month until “substantial further progress has been made” in the US economic recovery, and to keep interest rates close to zero until at least the end of 2023. The cliff edge looms, but so do the demons.

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As Adrian observed: “The Covid-19 crisis has greatly intensified these challenges. Employment has collapsed, threatening a major humanitarian crisis in many economies, and inflation has been further depressed by weak activity and falling commodity prices. Policy [interest] rates have already been pushed to zero or below, and very low yields on long-term government bonds limit the scope to provide stimulus through purchases of these instruments.”

Policymakers seem at a loss as to how to get around the ‘can’t stop, can’t go back and can’t go forward’ dilemma

So, where do we go from here? The Fed has hinted that it may allow inflation in the US to run hotter and higher for a limited period, creating more optimism and fuelling a stronger recovery. Meanwhile, central banks are generally exploring how policies already in use can be employed more aggressively. In other words, more of the same.

Policymakers seem at a loss as to how to get around the “can’t stop, can’t go back and can’t go forward’’ dilemma. They can only consider “the trade-off between boosting inflation and output in the near term and increasing financial stability risks down the road”, said Adrian.

Another way to express this is that they’re damned if they do and damned if they don’t. At the end of the day, wholesale debt forgiveness (not just relief) may be the only way out but therein lie other troubles. Let us enjoy Christmas at least.

Anthony Rowley is a veteran journalist specialising in Asian economic and financial affairs