No more quantitative easing, please

Greg Nash

As global financial markets melt down, one has to hope that the Federal Reserve and the world's other major central banks are drawing the right lessons from their past policy mistakes, since those mistakes created the very conditions for the current asset price meltdown. More importantly, one has to hope that the Federal Reserve is not planning to respond to this meltdown by yet another round of quantitative easing. While another round of such easing would very much please its Wall Street proponents, it will only make the final day of reckoning for Main Street even worse in the not-too-distant future.

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Over the past seven years, the distinguishing feature of monetary policy in the industrialized economies has been the massive resort to their central banks' printing presses. This has seen the size of the Federal Reserve's balance sheet expand by more than fivefold, from $800 billion in 2008 to around $4.25 trillion at present. Further adding to global liquidity have been the parallel massive expansions in the balance sheets of the Bank of England, the Bank of Japan and the European Central Bank.

Sadly, as had to be expected, the unprecedented wave of money printing by the world's major central banks gave rise to asset price inflation and to the severe mispricing of financial market assets across the globe. It did so as investors were encouraged to stretch for yield by the maintenance of artificially low interest rates. This mispricing was particularly evident in a super boom in international commodity prices, in global equity prices becoming detached from underlying earnings prospects, and in high-yield interest rates dropping to levels that did not reflect the underlying default risk of the issuing companies.

The flood of global liquidity also caused capital to flow into the emerging market countries at unprecedented rates. It did so despite the very shaky underlying economic fundamentals of those countries. That, in turn, gave rise to excessive currency appreciations and to macroeconomic imbalances in those countries. Of particular concern is the fact that those flows spawned a binge in emerging market corporate borrowing, which is bound to strain the industrialized countries' financial institutions as many of those corporations default. According to International Monetary Fund estimates, emerging market corporate debt outstanding ballooned from around $10 trillion in 2009 to around $25 trillion at present.

In the same way that the world's major central banks spawned asset price bubbles, so too has the Federal Reserve helped to prick those bubbles. It did so first in September 2014 by announcing an end to its third and open-ended quantitative easing program. More forcefully yet, it did so by announcing on Dec. 16 the first Federal Reserve hike in seven years and by intimating that between three and four further interest rate hikes would be made in 2016.

If the past is any guide, now that global asset price bubbles have burst, thereby raising possible risks to the global economic recovery and to the global financial system, the Federal Reserve can be expected to again be tempted by another round of extraordinary monetary policy easing. After all, that is what Alan Greenspan's Fed did in 2001 in response to the bursting of the NASDAQ bubble. It is also what Ben Bernanke's Fed did in an even more spectacular fashion in 2008 in response to the bursting of the U.S. housing and credit market bubbles.

Hopefully, the Federal Reserve will resist that temptation and recognize that such a course will only spawn yet more asset price inflation. Instead, one must hope that the Fed will now throw its weight behind a program of serious structural economic reform that might spur a meaningful supply-side driven pick-up in economic activity and investment. Alternately, if the Fed feels compelled to engage in monetary policy experimentation, it should be of the helicopter approach that Milton Friedman propounded some three decades ago that would not again lead to asset price inflation. If not, we should brace ourselves for even bigger asset price booms and busts down the road.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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