LESS than two years has passed since massive interventions from central banks and governments to arrest a crisis of confidence in financial markets. With trillions spent on shoring up the banking sector and rushing forth stimulus spending, many countries are now left with sovereign debt problems as economic activity begins to ebb.
The biggest conundrum now facing policymakers around the world is whether to embark on European-style austerity measures to arrest deficits and bring debt back in line with traditional ratios or whether to further inflate and hope that activity will be self-sustaining. The line of responsibility between government and central bank has blurred dangerously.
Having taken the Fed funds rate quickly to zero, the US Federal Reserve then embarked on quantitative easing, the dubious practice of buying government and private debt instruments aimed at inflating the money supply and driving longer-term rates lower for the benefit of borrowers.
Economists generally warn of the risk of high or hyper-inflation as a larger money supply means dilution of purchasing power. The Fed's balance sheet now stands at a staggering $US2.3 trillion ($A2.6 trillion) after the purchase of about $US1 trillion in mortgage-backed securities. We now know that quantitative easing has backfired, with banks and corporations simply shifting those securities from their balance sheets and hoarding the cash proceeds.
Exposure to leverage and a lack of liquidity saw the collapse of many US and European banks in the financial crisis, and it seems the private sector at least is not going to make that mistake again. This is at the expense of small business, which accounts for much of an economy's hiring. It is not surprising, therefore, that US unemployment is sitting at 9.5 per cent even after a strong initial recovery. The longer-term consequences of such a large Fed balance sheet containing many credit-risky investments are unknown. It seems clear it has little potency outside of monetary policy.
Only Kansas City Fed president Thomas Hoenig has had the foresight to speak out and vote against the Fed's zero-rate policy. Retirement savings now attract little or no interest. The Fed kept rates far too low for too long from 2002 to 2005, which perhaps prompted much of the US housing bubble.
Hoenig argues for a return of the Fed funds rate to 1-2 per cent. Clearly, the issue at hand is the availability of credit flowing through the economy, not the price of it, and many central banks have fallen into the trap of employing emergency settings permanently. Many economists believe rates will not rise in the US and Europe until 2012 at the earliest. By contrast, the Reserve Bank used the recovery of 2009-10 to move rates back within norms and the economy coped just fine.
Global bond yields are at postwar lows and many market commentators claim this signals the onset of deflation. At the same time, gold, a traditional hedge against inflation, is at record highs, so it is more likely we are seeing investors looking for safe asset classes to store wealth during this period of uncertainty. It is ironic that monetary authorities are being allowed to fund huge budget deficits at historically low yields due to the perception that government bonds are one of the few risk-free investments, yet the cost of servicing alone will create severe budget problems as rates rise if issuance is not scaled back. This is the concern of those seeking fiscal austerity.
Deflation should not be a big concern for Western economies, and financial markets are mispricing this risk. Perhaps a period of disinflation might occur, when prices temporarily fall in response to slower growth. But in a world of growing population and limited natural commodities, rising consumption and resource prices should prevent a long-term deflationary spiral.
Japan has suffered deflation for nearly 20 years as banks were crippled due to non-performing loans and regulation failed in compelling them to realise losses and provision for bad debts. Japan is facing a crisis as an ageing population and zero-migration policy will have severe implications for consumption and growth. To compare the plight of the US to Japan, therefore, is simplistic and unfounded.
During the Australian election campaign all parties were preoccupied with when and to what extent the budget should return to surplus, with the assumption surpluses are good and deficits bad. People should question this logic and ask if taxation is too high or public spending on infrastructure and services such as health and education is too low.
The next two years will give academics answers about the effectiveness of central banks and the consequence of their actions. The interaction of responsibilities between government and central bank will continue to evolve as we emerge from the GFC. Many have chided the excesses of capitalism, yet that system, with some further regulation, still seems best to rebuild that which it helped destroy.
Australia was spared the fate of Europe and the US not so much by skilled government action during the GFC, but rather an economy extremely responsive to China's expansion. A sensible level of skilled immigration has kept demand for housing and services firm, which has helped sustain employment and business expansion.
The RBA is a central bank without peer. The past few years have shown policy management to be somewhat of an art, yet the RBA has held its course and resisted much of the emotional hip-shooting seen elsewhere.
Neale Muston is the former managing director of fixed income at Morgan Stanley Australia. He runs a global markets trading business in Sydney.
