Bubble masks economic weakness

This is my Perspective column for this week’s issue of Fund Strategy.

Those who manage the world economy are evidently following the wishing well theory of economics. They seem to believe that if they close their eyes, throw some money around and make a wish, the biggest challenges will magically disappear of their own accord.

Such an approach fails to recognise that the most intractable problems will not go away without concerted political leadership.

At the time of writing there were many apparently positive indicators that the naïve optimists could highlight to make their case. The most superficial were the stockmarket indices, which were trending upwards. American equities in particular had regained the losses made in the ugly days of the financial crisis of 2008 and 2009. European markets were also buoyed by the apparent return of calm to the continent.

But anyone who follows equity markets closely should be aware that the long-term studies suggest they are not correlated with economic growth. Equity prices reveal as much about economic health as the price of cheese says about next week’s weather.

However, there were more fundamental measures, which appeared to be pointing in the right direction. Probably the biggest positive for Europeans was the apparent stabilisation of the eurozone. After months of turmoil the agreement of a swap deal for Greek debt seemed to have settled nerves.

On a global level there was positive news on America too. In particular the jobs numbers were better than expected and stress tests by the Federal Reserve seemed to indicate that bank balance sheets were strengthening. The world’s largest economy seemed to be enjoying a steady, if slow, recovery.

The most negative indicators related to China. It recorded a large trade deficit in February and economic growth was expected to slow. But given that the new official growth of 7.5%, was still strong by normal standards this hardly signaled a disaster.

China’s growth simply seemed to have dipped from superfast to merely rapid. Perhaps not good for the Chinese people but, so the argument went, not too bad for the global economy.

So far so good but keen observers will recognise that an important part of the story is missing. Global leaders have only managed to stabilise the world economy thanks to the injections of vast amounts of credit worldwide.

All the main western central banks have kept official interest rates close to zero while also using unconventional means, such as quantitative easing (QE), to pump even more credit in the economy. That is leaving aside the reality that, despite all the talk of cuts, public spending generally remains high.

Although the terminology and exact techniques of monetary easing vary the principle is uniform. Central banks are inflating a credit boom while they wait for a hoped for recovery. Once the cycle turns and confidence re-emerges the assumption is it will be possible to go back to a more normal monetary policy.

In Britain’s case, for example, interest rates have remained at 0.5% since March 2009. Over the same period the Bank of England has pumped £325 billion of credit into the economy in its asset repurchase programme. At the same time the government is trying to promote directly a much smaller credit easing programme which involves underwriting bank lending to small and medium-sized businesses.

If any central bank is the odd one out it is the European Central Bank (ECB) because its rules prohibit it from directly purchasing newly issued debt. Its solution is to circumvent the spirit of the law by participating in long-term refinancing operations (LTROs) in which it has injected over €1 trillion (£832 billion) onto the balance sheets of commercial banks.

In America the scale of easing is greatest of all. In two rounds of QE from 2008 to 2011 the Fed injected $2.3 billion into the economy.

Essentially the authorities are continuing in a more extreme form the policies they have pursued since the 1980s. Rather than attempt to encourage economic restructuring they have simply tried to kick-start economic activity by maintaining easy credit. This is as true in Britain as other countries despite the government’s weary mantra that it is not possible to deal with a debt problem by creating more debt.

No doubt ministers would circumvent such criticism by saying monetary policy is the remit of the Bank rather than government. But such arguments are disingenuous as both fiscal and monetary elements are central to economic policy.

The main criticism of this policy, which usually comes from free marketeers, is that this approach is likely to, sooner or later, lead to hyperinflation. Pumping up the money supply, they argue, will after a time push prices upwards.

In the event consumer prices have yet to bear out this prediction. Britain’s relatively high inflation rate seems to have been a result of specific national factors and in any case has started to fall. ??It should also be remembered that the monetary boom is a phenomenon across the developed world rather than peculiar to Britain. However, there is a strong case that the recent rebound in equity prices is a result of such monetary largesse.

The main problem with this rapid expansion of credit is not that it might lead to higher inflation at some point. As Phil Mullan, an economist, has argued in a recent essay on spiked, an online publication, high levels of debt should not be understood in their own terms. On the contrary, they are an expression of a more fundamental economic malaise in the productive economy.

Extending credit in a fundamentally sluggish economy only postpones the need to tackle economic challenges. Typically it means that problems simply reassert themselves in a more virulent form at a later date. Without economic restructuring the apparent recovery is likely to prove illusory.