Are asset bubbles the only way for central banks to boost demand?
Leading economists are starting to wonder. And both the pundits and central bankers are clearly tilting in favor of keeping asset prices frothy if that’s the only way to keep the economy ticking over.
This will undoubtedly prove a mistake, though given the constraints under which central bankers operate, it’s a mistake they may well feel they have no choice but to make.
That suggests equity markets will keep vaulting from one milestone—the DJIA broke 16,000 and the S&P 500 hit 1800 on Monday—to another.
The debate, which has been percolating during the past few years, recently hit top billing thanks to Larry Summers, a former U.S. Treasury Secretary, following his speech at an IMF Research Conference earlier in November.
He made two key observations.
First, notwithstanding the widespread view that central banks had held interest rates too low and had encouraged asset bubbles, there weren’t signs of economic overheating in the years before the financial crisis in countries like the U.S.. Unemployment wasn’t at extreme lows and inflation was well behaved.
Second, output shortfalls caused by the financial crisis and subsequent sharp global downturn haven’t been recovered by a substantial rebound in growth as might have been expected.
It could be that economies, including the U.S.’s, have slipped into “secular stagnation”, as Mr. Summers put it. In other words, these economies have turned Japanese. Because of excess global savings and technological change, their “natural” short term interest rate–i.e. the rate consistent with full employment–has long been negative 2% or 3%. But because there’s a zero lower bound on rates, policy has effectively been too tight rather than too loose.
Since the crisis, to combat the zero lower bound central banks have been left with unorthodox policy. Especially central bank purchases of bonds and other assets known as quantitative easing, which, in part boosts demand by generating positive wealth effects through rising asset prices.
Central bankers think that if only they can kick-start demand to a certain level, it will become self-sustaining. Output goes up, capital investment rises, supply expands, labor productivity increases and, eventually, employment grows too until excess capacity is absorbed. At the same time, investment boosts potential growth rates, in other words, it ratchets the recent disappointing trajectory higher.
If the primary mechanism to generate this initial growth is through wealth effects, then perforce central banks will tend to inflate asset bubbles.
That’s because wealth is unequally distributed. Because a small minority of people own a large majority of assets and because there are limits to how much anyone can possibly consume (a lot of what rich people buy is actually investment rather than consumption), to get the wealth effect flowing into general increase in demand you need to create very, very substantial increases in asset prices.
And here’s where the problems kick in.
Most ordinary people then either borrow or eat into their liquid savings or sell some of their assets to achieve the newer, higher rates of consumption–the sort of demand that will achieve escape velocity. Selling assets concentrates them in the hands of the rich. Liquid savings have already been drawn down. And as we saw during the last cycle, borrowing against inflated assets to consume is dangerous, though central banks are doing everything they can to encourage credit growth.
At some point, either wages and incomes have to rise to where those inflated asset prices are justified or those asset prices will fall.
During the last cycle, asset prices fell, triggering the financial crisis. Central bankers don’t see asset bubbles emerging now because, they argue, current asset prices are justified by expectations of future growth levels and those growth levels are well within the economy’s potential.
If they’re wrong and they’ve overestimated future growth, the result will be too much inflation down the line. But inflation will erode the value of outstanding debts and thus justify current asset prices.
And maybe central bankers think the balance of risk is worth it, too much inflation later is less bad than too little growth now. In the absence of sufficiently aggressive fiscal policy to make up the slack in demand, central bankers might well feel these are risks they are forced to take.
But all this hinges on central bankers’ ability to sustain very high asset prices in the absence of sustained and strong rates of growth. Here, Japan is instructive. For twenty years, Japanese equity and property prices were on a downward trajectory despite massive amounts of fiscal and monetary stimulus. Sure, there were frequent and relatively long-lived rallies along the way. But the overall trend was down.
Before the crisis, central bankers were filled with hubris over creating the Great Moderation, an economic period of stable and low inflation and solid growth. They were proved wrong. Will they be as wrong about being able to generate real economic effects by creating illusory asset prices?