Blowing another bubble

It is widely held that the devastating economic crisis of recent years was the result of the bursting of an economic bubble. Ironic then that the authorities seem intent on inflating another one.

One of Britain’s sharpest economic commentators concluded that the Bank of England will never unwind quantitative easing after hearing Mark Carney, the governor, testify before the Treasury select committee. Although central bankers never make such blatant statements outright it was implicit in what he said.

For those who remember back to the early days of QE in 2009 the statement was astonishing. What started as a temporary measure to head off a financial crisis has gradually become a permanent part of the economic landscape.

Admittedly the Bank is not pumping new money into the economy via QE. But it seems intent on holding on to its considerable existing holdings of gilts. It is also using Funding for Lending Scheme as an alternative way of shoring up economic activity.

Meanwhile, the Bank for International Settlements, essentially a central bank for central bankers, has issued a warning on the potential risks of forward guidance. Once again the language is cautious but one conclusion is that it could encourage excessive risk taking as it gives investors advance warning of any rise in interest rates.

To understand the significance of these two pronouncements it is necessary to take a step back. They only make proper sense if viewed from a longer-term perspective.

The financial bubble that burst in 2007-8 was not the result of reckless risk taking by greedy banks. On the contrary, it was one that the authorities played a key role in inflating.

Raghuram Rajan, recently installed as the governor of the Reserve Bank of India, outlined some of the key factors in relation to America in his book Fault Lines.

As I pointed out in a Fund Strategy review in 2011: “Rajan shows how the authorities helped a credit bubble in several ways including keeping interest rates low, encouraging wider home ownership from the early 1990s and relaxing lending standards. Government sponsored agencies known as Fannie and Freddie also played a role by providing backing for greater lending.”

However, there is a limitation in Rajan’s argument. He fails to see that the authorities encouraged easy credit as a way of shying away from dealing with the economy’s structural problems. The fundamental problem was a chronic lack of dynamism rather than temporary cyclical weakness.

Although easy money kept the economy moving in the short term it had damaging long-term consequences. Eventually the bubble burst with all the harmful fall-out with which we are now familiar.

However, several years on from the financial crisis it is clear that the authorities still feel more comfortable pumping credit into the economy than tackling fundamental challenges. Measures such as QE, the FFLS and forward guidance are essentially a continuation of the easy money policies that came before.

Unfortunately blowing bubbles into the economy does not make its weaknesses disappear. It only paves the way for more volatility in the future.

This blog post first appeared today on Fundweb.