Four years on from the great crash of 2008, world governments and central banks have managed to prevent a 1930s-style debt deflation. They’re still shovelling, but so far so good. However the question still hangs there: has deflation just been postponed, or will we end up with the opposite – inflation?
The actions of governments, now exhausted due to lack of money, and central banks, still printing, have led to sovereign debt levels that are way beyond serviceable and central bank balance sheets that are, to put it politely, experimental.
The European Central Bank is focused on shielding governments from the debt markets to buy time while a more durable fiscal and banking union can be cobbled together.
To appease the Germans the ECB must not only neutralise the monetary effect of bond purchases but also impose strict conditions on governments whose bonds it buys. The effect of that is simultaneously to weaken its own balance sheet, since it’s selling good bonds while buying bad ones, and to make it virtually impossible for the supplicant nations to break out of their deflationary spirals.
It is obvious that austerity does not work and none of the actions by the ECB deal with the fundamental problems of the eurozone: namely the crushing debt and the fact that Spain, Italy, Greece, Portugal and Ireland – the PIIGS – need deep micro-economic reform and deregulation to become competitive against the northern eurozone members.
But with unemployment of up to 25 per cent there is no political capital to do anything meaningful.
Most importantly private capital is staying away in droves; or rather it is being mobilised to run away from the PIIGS. And now 'conditionality' on the ECB’s bond purchases leaves open the prospect of devaluation. The ECB is NOT doing "whatever it takes”, as promised, because a country that fails to meet the conditions will not be supported, which means it will have to leave the euro.
So those five countries can reform their labour markets and deregulate all they like, but unless they can attract capital to invest it will be in vain. And capital will not invest if there is a material prospect that devaluation will wipe out half of it.
In the United States the Federal Reserve appears to be delivering on "whatever it takes” by announcing an open-ended bond and mortgage securities buying program at $US40 billion a month, for as long as necessary.
At that rate it will take 15 months for QE3 to equal QE2’s $600 billion, and that didn’t work even though it came all at once, so you’ve got to wonder about the benefit of spreading it out over a year and a quarter.
But at least there’s no sign of deflation and the economy is not spinning into recession again as Europe appears to be.
As in Europe, the problem is a lack of productive investment, as opposed to speculation. American corporations are sitting on a cash pile of about $US2 trillion, even though the interest on that money is tiny, and banks are likewise sitting on the money they are getting from the Fed in return for selling bonds and mortgages, or else they are using it to speculate.
To work, capitalism requires long-term, illiquid bets to be made: someone has to build a factory or dig a mine or tie up money in a software start-up.
But these days the world has gone short. Cash is king and derivatives are its queen. Even on the stock exchange most of the turnover is now high frequency computer traders who start and finish each day owning nothing.
And why would anyone lock up their money in a factory or a mine? Money is being debased so that when it comes out of the prison of productive investment it will be worth much less, either because there has been a devaluation or because of inflation, or both.
QE3 is more likely to lead to an M&A boom than productive capital expenditure.
In Australia, investors are pulling back from long-term commitments as fast as they can, with resources projects being abandoned where possible or scaled back where it’s not. The fear in this country is not devaluation, but the opposite – as the US and Europe debauch their currencies ours goes up, ruining our export industries.
Somehow capital needs to be persuaded to go long again, to commit to taking risk in the expectation of gain in ten years rather than ten minutes.
In the meantime all the money printing will probably inflate the prices of assets, as well as commodities, so the short-termers may have another ride for a while, and forget about the debt for a while.
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