Commentary

Monetary Stimulus Creates Only Pseudo Wealth

The European Central Bank’s decision to follow the Federal Reserve’s footsteps and embark on a massive program of quantitative easing to lower interest rates, encourage risk and inflate asset prices seems to be working for the moment.

New wealth appears to be created even though simple economic logic tells us that monetary stimulus cannot permanently increase a nation’s productive capacity or real income. Central bankers are engaged in pseudo, not true, wealth creation.

With ultra-low rates, savers have little incentive to postpone current consumption. There will be less saving, less capital accumulation and slower growth of real income.

The wealth effect of central bank “stimulus” will be short-lived. When rates return to normal, as they must, asset bubbles will burst, major losses will be incurred and the distortions in capital markets will become evident.

Economic freedom, not central bank intervention, is the driving force of wealth creation and widespread prosperity.

The Eurozone’s negative real interest rates are not natural; they are the result of government policy — in particular, the ECB’s unconventional monetary policy.

In a normally functioning market economy, with monetary equilibrium, nominal interest rates will be close to natural rates. However, when central banks cause an excess supply of money or an excess demand, monetary disequilibrium leads to a divergence between nominal and natural rates.

The Gold Era

In the market for loanable funds, the nominal rate of interest is determined by the demand for funds and the supply of funds. If there are no monetary disturbances, the supply of funds will depend on the time preferences of savers and the demand for funds will depend on the productivity of capital, technological progress, the security of property rights, and expected profits.

Ultimately, preferences, technology and resources determine real interest rates, not the central bank.

During the classical gold standard (1880-1914), the average level of money prices was relatively stable, as were interest rates. With a stable anchor for the price level, real rates reflected long-run productivity and time preferences.

Nominal and real rates cannot be negative as long as (1) borrowers and lenders expect long-run price stability, (2) consumers prefer current to future consumption and (3) productivity growth is positive.

The main factor today resulting in negative real rates (i.e., financial repression) is the failure of central banks to adhere to a monetary rule. We live in a world of pure discretionary government fiat monies, and a political environment in which the focus is short-term palliatives rather than long-run solutions.

The ultralow interest rates engineered by the Fed and other central banks were purposefully intended to shift investors into risky assets to stimulate the economy and lower unemployment. The risk of creating asset bubbles has been downplayed as have the high costs imposed on savers.

Alan S. Blinder, former vice chairman of the Federal Reserve, contends that keeping the federal funds target rate near zero for more than six years and engaging in three rounds of QE have not led to “financial hazards.” Hence, “patience is the right policy.”

His sanguine view, however, ignores the mounting risks of failing to normalize monetary policy and interest rates. The driving force behind high U.S. stock and bond prices has been the expectation of prolonged low rates — not robust economic growth.

Driving Prosperity

The longer the Fed waits to end its still strong asset purchases (its maturing securities are being rolled over even though officially QE has ended) and adjust its benchmark rate upward, the higher the risk of a severe recession when wealth bubbles evaporate.

The growth of leveraged loans to highly indebted firms and other questionable “investments,” plus a large government debt that will eventually have to be financed at higher rates, point to future financial hazards that are now being ignored.

Federal Reserve Bank Chairwoman Janet Yellen was successful in having the word “patient” removed from the March Federal Open Market Statement. But in her press conference she reassured financial markets by noting that “just because we removed the word patient from the statement doesn’t mean we are going to be impatient.”

U.S. markets have cheered the Fed’s unconventional monetary policies, as have economies closely linked to the dollar such as Hong Kong. European markets, likewise, are applauding European Central Bank President Mario Draghi’s announcement that the ECB will purchase 60 billion euros worth of bonds a month until September 2016.

German 10-year bonds now yield only 0.16% and two-year yields are negative. No wonder Germany’s stock market is booming.

It would be nice if monetary policy alone could create permanent real growth and wealth, but alas that is not possible. The impact of monetary stimulus may be positive in the short run, but sustainable long-run growth requires sound money and institutional changes that strengthen property rights, reduce high taxes on labor and capital, and limit the size and growth of government.

Economic freedom, not central bank intervention, is the driving force of wealth creation and widespread prosperity. Waiting a little longer with a hope that central banks know how to create wealth is a dangerous gambit. Wishing away the asset bubbles that are now so evident can only result in tears.

James A. Dorn is vice president for Monetary Studies and a Senior Fellow at the Cato Institute in Washington, D.C.