Cheap credit fails economic acid test

Financial market types love a good metaphor, and the most popular ones lately have been all about investors' dependence. On cheap money, that is.

Financial market types love a good metaphor, and the most popular ones lately have been all about investors' dependence. On cheap money, that is.

US Federal Reserve chairman Ben Bernanke's plan to curb stimulus measures was equal to cutting back a drug addict's supply, some said. Sharemarket investors were said to be having a "dummy spit", like a toddler who had been given a firm "no" by a parent.

It's all pretty gloomy, and economists have been trying hard to inject some perspective. Quite rightly, they've pointed out that what may be bad for share prices isn't bad for the economy. After all, less need for stimulus in the world's biggest economy is actually a good thing.

But a new report from the influential Bank for International Settlements argues convincingly that there are uncomfortable questions facing the world economy as the era of cheap money draws to a close.

These challenges go beyond the fallout from the Fed slowing its $US85 billion-a-month bond-buying program. Economic powerhouses such as Japan, Europe and Britain are also facing tough questions after taking extraordinary measures to keep credit cheap.

The problem is that global markets are not the only ones that have become hooked on cheap money and must soon go through the painful withdrawal process. According to the BIS, overseas governments, households and businesses are also in this unenviable position.

The BIS annual report, published today, argues that after taking extreme steps to keep credit cheap for several years, overseas central banks (not Australia's) should plan "exit strategies".

To understand why this is important, it's worth reflecting on just how much has been asked of monetary policy - the setting of interest rates - in recent years.

Traditionally, central banks' goals were to keep inflation within a target range (2 to 3 per cent in Australia), and maintain healthy employment. In the global financial crisis, this brief expanded to doing "whatever it takes" to prevent collapse.

First, central banks in the US, Europe and Britain cut rates to virtually zero. Japan's rate was already near this level since the 1990s. When it was clear low rates were not enough, key central banks took to buying their governments' bonds. This was to ensure long-term borrowing costs remained low.

The sheer scale of this exercise has been astounding. Central bank balance sheets have nearly doubled from $US10.4 trillion in 2007 to a whopping $US20.5 trillion today. This is about 30 per cent of the entire global economy.

These measures achieved their primary goal of preventing the GFC of 2008 from becoming a full-blown global depression. But five years on, the BIS reckons pumping cheap credit into the world's financial arteries is "less and less likely" to get growth back on track.

"What central banks have done during the recovery is to borrow time - time for balance sheet repair, time for fiscal consolidation and time for reforms to restore productivity growth," it says.

So how did the world use this time? Not too well. Many countries haven't managed to go through these painful changes, because borrowing time also leads to delays.

"Cheap money makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change," the BIS says.

Its criticism is clearly aimed at governments in Europe, rather than Australia. But these difficulties being experienced in big developed economies are still relevant to us.

First, the world is growing more slowly because big developed economies are still stuck in a rut. Rich countries grew by an average of just 1.3 per cent between 2010 and 2012, half their average pace of 2.7 per cent over the previous 30 years. Even though Australia's big export markets are in Asia, this kind of weakness still affects us because it drags down the entire world economy.

Second, and more acutely, the extraordinary measures taken overseas had big international "spillover" effects on smaller countries. By pushing down their interest rates to record lows, central banks encouraged investors to shift money into assets in faster-growing economies. The result has been uncomfortably high exchange rates in countries like Australia, notwithstanding the dollar's recent plunge.

The Reserve Bank, unlike many overseas, still has the option to cut interest rates further, if necessary.

But the experience overseas holds important lessons about slashing interest rates. The fact is, near-zero interest rates and the extraordinary measures by central banks have not delivered as much as hoped.

The BIS is known as the "central banker's bank", so these guys have plenty of faith in the power of monetary policy. Yet they concede: "Despite having succeeded in containing the crisis, monetary policy has fallen short of original expectations."

We all know sharemarkets dislike any hint of stimulus being withdrawn - that's why there was such a violent reaction to Bernanke's comments last week. But as well as being a "dummy spit", recent volatility may also be a realisation of the steep challenges facing some of the biggest economies.

Ross Gittins is on leave.

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