Harry Geels: Five side effects of the monetary cornucopia

August 13, 2024

_{This column was originally written in Dutch. This is an English translation.}

By Harry Geels

During the last stock market downturn, investors were, as is often the case, hopeful of new monetary support. This raises the question of whether we can do without monetary abundance today. And do investors sufficiently understand the consequences of repeatedly deploying monetary abundance?

When the yen carry trades were partially reversed last week, the stock markets were suddenly on fire. But a recovery came when investors hoped for interest rate cuts from the main central banks (partly due to the Bank of Japan's promise that it would not raise interest rates for the time being, shocked as they were by the reaction on the stock markets). While some investors still had some doubts about whether US interest rates would be cut this year, they now appear to be expecting five cuts, starting in September.

Investors are no strangers to some opportunism. But what does that Pavlovian reaction that every fall in prices must be absorbed by (additional) interest rate cuts imply? Let's take a look at the consequences of a consistently supportive monetary policy.

1) Significantly increased financialization

First, that policy, characterized by increasingly lower interest rates, quantitative easing and increased liquidity, has contributed to the 'financialization' of the world since the 1980s. The value of financial assets is now more than five times greater than that of the real economy. Relatively more and more people have started working and investing in the financial world, at the expense of the real economy. Research shows that this has limited innovation and growth of the economy.

2) Increase in the use of debt

Second, loose monetary policy facilitates debt creation. Almost every year the mountain of debt (of consumers, companies and governments combined) increases. Investing with borrowed money, for example with carry trades, has also grown enormously. This is problematic because the system becomes more sensitive (read more volatile) if interest rates rise. There is also the ethical question: can we leave future generations with the debt obligations? Finally, the excess return (in terms of growth) for every dollar or euro of debt decreases.

3) Market efficiency is affected

A third consequence of the monetary policy of recent years is that market efficiency (which ensures correct and timely adjustment of rates based on new information) is affected. If central banks buy certain bonds as part of quantitative easing, without regard to the fundamentals, their prices are pushed up too high. This can, among other things, lead to incorrect allocation of capital, an unhealthy search for yield, and an increase in the number of investors (or even savers) who want to invest on a risky basis.

4) Increasing polarization

A fourth consequence concerns polarization. If monetary policy supports investors, it favors the 'haves' (owners of investments and houses) over the 'have-nots'. Furthermore, the current monetary policy has an inflation target (2% on average). Inflation further increases inequality, because investments usually provide inflation compensation, but the purchasing power of ordinary people does not always keep pace. Due to rising real estate prices (powered by the central banks), a house is now unaffordable for many.

5) Free market forces are affected

From a social-philosophical perspective, the constant intervention by central banks is problematic, because both private and public markets receive support or 'guidance' (or coordination) from a non-democratically elected entity. Central banks have had an increasing influence on the economy, including through the supervision of financial parties. Specifically for investors, the actions of central banks now seem more important than other economic variables. The 'invisible hand' has been replaced by the 'monetary hand'.

Way out

To be clear, I am not in favor of monetary doping during crises. Not even during the last unwinding of the carry trades. First, it only works in the short term, while it has negative long-term effects. Secondly, because we should not make ourselves dependent on a powerful financial-monetary institution that has to save our investors every time (and can potentially thwart government policy).

As an aside, a central bank has potentially useful tasks, such as that of 'lender of last resort' for banks and adjusting the (equilibrium) interest rate and money supply to economic conditions. Is there a way out? Unfortunately not in the short term (although it would be a good start if countries, for example, would adhere to the Maastricht Treaty). The government (via monetary financing) and investors (via monetary doping) like to feed on the cornucopia every time, in this case the monetary horn of plenty.

In the long term, consideration must be given to a different system in which policy, including the appointment of central bank directors, is rewritten. The monetary mandate should become smaller and more transparent. As for the policy interest rate, it could be determined relatively easily with a simple and objective algorithm, which should be slightly higher rather than lower, because that ensures less inflation, less debt, more productivity and more economic growth.

The key question is: where does the primacy lie, with the free market or with the central institutions?

This article contains a personal opinion from Harry Geels

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