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Business Economics

National Association for Business Economics

Ultra-Easy Money: Digging the Hole Deeper?


The global situation we face today is arguably more conscious of both the importance of the awarding
fraught with danger than was the case when the crisis body and the distinguished list of previous recipients.
first began. By encouraging still more credit and debt Perhaps even more important, I recognize that my
expansion, monetary policy has dug the hole deeper. policy views diverge significantly from what has, at
The fundamental analytical mistake has been to model least to date, been mainstream thinking about mon-
the economy as an understandable and controllable etary policy. I thank you for your open mindedness
machine rather than as a complex, adaptive system. and the opportunity to bring these views to a wider
This mistake also implies that the suggestion that audience. There should be no monopoly on truth in
central banks should necessarily reduce the financial this crucially important area, particularly given how
rate of interest, in response to a presumed fall in the frequently and radically views about the conduct of
natural rate, is overly simplistic. In practice, ultra- monetary policy have changed over the last fifty years
easy policy has not stimulated aggregate demand to the or so.1
degree expected but has had other unexpected conse- It is broadly agreed that the decline in U.S. house
quences. Not least, it poses a threat to financial sta- prices late in 2005 was the initial phase of the sub-
bility and to potential growth going forward. Further, sequent economic and financial crisis in the United
exit threatens to be delayed in many countries, States. Since then all parts of the world economy have
underlining the dangerous fact that the global economy come to bear its imprint, with many harboring fears
has no nominal anchor. Much better would be policies, that the Second Great Contraction2 is by no means
introduced by other arms of government, that would over. The duration, scope, and magnitude of what has
recognize that the fundamental problem is not inade- happened cannot be explained by a process of con-
quate liquidity but excessive debt and possible insol- tagion. Rather, there were credit driven imbalances
vencies. The policy stakes are now very high. accumulating in the complex, adaptive system we
Business Economics (2016). know as the global economy. The collapse of the
doi:10.1057/s11369-016-0012-2 subprime mortgage market in the United States, and
the complex financial instruments based on such
Keywords: monetary policy, debt, financial markets, mortgages, was simply the trigger that revealed a
exit strategy prevailing systemic fragility.
In this presentation I will try to trace the origins of
the crisis, and the particular contribution made by
expansionary monetary policies before (unnaturally
1. Introduction easy) and after (ultra-easy) the crisis broke. I will

For a record of these changes, which have affected all
et me begin by saying that it is a great honor to aspects of the conduct of monetary policy, see White [2013].
have been awarded the Adam Smith prize. I am This was the term used by Ken Rogoff in his Adam Smith
presentation to NABE in 2011. See Rogoff [2011].

Delivered as the Adam Smith Lecture at NABEs Annual Meeting on September 11, 2016. The views expressed are solely those of
the author, and are not necessarily shared by any institution to which he is currently, or has in the past, been associated.
*William R. White is currently chairman of the Economic and Development Review Committee (EDRC) at the OECD in Paris. The
EDRC carries on regular evaluations of the policies of both member countries and large non-member countries. For part of his tenure, he
was also a member of the Issing Committee advising the German chancellor on G20 issues. Previously, from 1994 to 2008, he was the
Economic Adviser and Head of the Monetary and Economic Department at the Bank for International Settlements (BIS) in Basel. In that
capacity, he had responsibility for the departments output of research, data and information services, for the organization of meetings for
central bank governors and their staff around the world, and for the BIS Annual Report. He came to the BIS from the Bank of Canada,
where he advanced over a period of 22 years to the position of Deputy Governor (International). He received his Ph.D. from the
University of Manchester in 1969 with the support of a Commonwealth Scholarship. He then began his career at the Bank of England.
William R. White

contend that the situation we face in late 2016, both in Looking at the individual regions in the global
the advanced market economies (AMEs) and the economic system also reveals potential weaknesses.
emerging market economies (EMEs), is arguably The United States is furthest ahead in the recovery but
more fraught with danger than was the case when the faces declining labor participation rates and (like
crisis first began. By encouraging still more credit and others) weak capital investment. With potential
debt expansion, monetary policy has dug the hole still lower, the risks of inflation are higher. Europe faces
deeper. Accordingly, I will finish by suggesting some its own idiosyncratic problems, not least a still weak
government policies that might be more effective in banking system and potential fallout from the vote on
restoring the strong, sustainable and balanced Brexit. Japan is conducting an unprecedented experi-
growth desired by the leaders of the G20. ment with Abenomics, but inadequate results to
I am aware that the current consensus is that date suggest even greater experimentation going for-
global economic prospects are likely to improve next ward. China must make a transition to a different
year. I would remind you, however, that actual out- growth model, based on internal consumption, but all
turns have generally been weaker than predicted (as of transitions are difficult and carry significant risks.
the previous spring) in each of the last seven years. Moreover, in our increasingly integrated global
This is not surprising since the models underlying economy, problems anywhere will quickly become
most forecasts (including those of the Fed, OECD and problems everywhere. As an example, think of the
IMF) do not adequately recognize the vital impor- implications of Chinas slowdown for other emerging
tance of credit and the financial system. The funda- markets and beyond, particularly for commodity
mental ontological error has been to model the producers. Note too that the EMEs have expanded
economy as a relatively simple machine, whose rapidly in size in recent decades and developments
properties can thus be known and controlled by its there are now likely to have a big effect on AMEs. In
policy operator. In reality, it is an evolving system, sum, there are valid reasons for concern about the
too complex to be either well understood or closely prospects for the global economy.
controlled. Moreover, it is a system in which stocks
and imbalances build up over time in response to
monetary stimulus. This reality makes future pro- 2. The Run Up to the Crisis of 2007
spects totally path dependent, and we are on a bad
How did we get into this mess? I want to suggest that
monetary policy, guided by flawed theory, has played
For the same reason, it is also overly simplistic to
a big role even if other agents also contributed
suggest that central banks should reduce the financial
materially.4 The flawed theory is, essentially, that
rate of interest in response to a presumed fall in the
growth and job creation deemed to be inadequate are
natural rate of interest (the expected rate of return
solely due to inadequate demand and that this can
on capital) since the crisis started.3 If expected profits
always be remedied with expansionary monetary
have collapsed as a side effect of monetary policies
policy. Moreover, it is assumed that such policies do
followed in the past, this hardly seems a justification
not have significant undesirable side effects. They are,
for maintaining such policies. A simple, single period
therefore, the proverbial free lunch.5
model, stripped of all policy side effects except near-
This theory was first tested in the early 1960s,
term inflation, is simply not adequate to deal with
when people still believed there was a long-run
such dynamic processes. It will be argued below that
tradeoff between unemployment and inflation. How-
other side effects, particularly those affecting supply
ever, one significant side effect of monetary stimulus
potential and financial instability, demand much
soon revealed itself. The expected slight increase in
greater attention.
inflation turned into the massive inflationary pressures
of the 1970s, as predicted by the theoretical insights of
The underlying model is that of Wicksell [1936]. He drew Friedman [1968] and Phelps [1968]. The Volcker
the distinction between the natural rate of interest and the 4
financial rate of interest. The former is related to the expected As discussed briefly below, a wide variety of economic
rate of return on investments and the latter is a longer-term rate of agents, both private and public, held false beliefs that led them
interest set by the financial system under the influence of the to act imprudently. While this paper focusses on central banks,
central bank. The latter is observable while the former is not. this should not be interpreted as indicating a wish to downplay the
When the natural rate is below the financial rate, the result will be important role played by other agents.
a decline in the price level and vice versa. In this model, a change My initial disagreements with this view were expressed
in the price level is the only indicator of disequilibrium in the many years ago. See Borio and White [2003] and White
system. [2006, 2012].

regime of the early 1980s dealt with this problem, but The easing of AME monetary policy in 2001, in
the tendency to turn to easy money as a cure-all response to slowing growth and the stock market
soon reasserted itself. crash, was of unprecedented speed and magnitude.
The Greenspan put that followed the stock Taylor [2007] contends that, in the U.S., at least it far
market crash of 1987 was followed by similar epi- exceeded the requirements of a Taylor rule. Moreover,
sodes of sharp monetary easing in 1991, 1998, and rates were also kept down much longer than such a
2001. Moreover, periods of monetary easing were rule would have suggested. This led to a whole host of
never matched by symmetric restraint when the imbalances, both real and financial, in many AMEs. In
economy was recovering. As a result, nominal interest the English-speaking countries, household saving
rates ratcheted downwards over the years and debt rates fell to unprecedented levels and there was a
levels, both public and private, ratcheted up.6 These further buildup of household debt. As the price of
monetary policies were made possible by the persis- houses rose, investment in the housing stock also took
tent downward pressure on global inflation arising off. Similar developments were occurring in periph-
from the process of globalization and the return to the eral Europe as sovereign credit spreads over German
market economy of China, the countries of Central Bunds collapsed.
and Eastern Europe and many others. Financial institutions dramatically increased
The principal analytical mistake made by leverage as they increased loans, and the price of
domestic policymakers in the AMEs was failing to financial assets also rose to unprecedented highs.
recognize the importance of these positive, global Given that increases in policy rates were being clearly
supply side shocks.7 Disinflationary pressures ought telegraphed in advance, and Sharpe ratios raised
not to have been interpreted as indicating the need for accordingly, speculation on further increases was
ever increasing domestic credit expansion. On the one strongly encouraged. Finally, via the mechanism of
hand, this outcome was a byproduct of excessive fears semi-fixed exchange rates (to which I will return), the
about the negative effects of deflation.8 On the other EMEs actively contributed to an explosion of global
hand, it reflected an underestimation of the costs liquidity and imbalances in their own economies. In
associated with easy money, in particular the buildup short, by 2007 the global economy was an accident
of a host of other imbalances in the domestic econ- waiting to happen and the policy makers all failed to
omy. In the successive cycles noted above, monetary see it coming. How could this have happened?
easing generated rational exuberance which then I would contend that all the relevant policy
slowly and inconspicuously transformed itself into makers were seduced into inaction by a set of com-
irrational exuberance; a boom and bust process.9 forting beliefs, all of which we now see were false.
This set the scene for the next downturn, the perceived Central bankers believed that, if inflation was under
need for still more monetary easing, and the genera- control, all was well. As a corollary, in the unlikely
tion of still more imbalances. These imbalances are case that problems were to emerge, monetary policy
perhaps best treated by looking in more detail at the could quickly clean up afterwards. Regulators
years just preceding the crisis. believed that, if single institutions were all healthy,
the system as a whole would stay healthy. Nor was the
private sector without fault. Bankers and other lenders
believed their large profits were due to talent (alpha)
It should be noted that fiscal policies in most AMEs erred in
the same asymmetric way. Thus, government debt stocks ratch-
rather than risk-taking (beta), and so became ever
eted up, cycle after cycle, to essentially unsustainable levels in more exuberant. Borrowers believed house prices and
many countries. the prices of other financial assets were a one-way bet.
There was a vigorous debate about such supply side issues Even governments were seduced. Buoyant tax rev-
in the pre-War period. See Selgin [1997]. enues were believed to be structural rather than
Careful historical analysis indicates that the Great Depres- cyclical and were quickly spent.
sion was essentially unique in there being an association between
falling prices (CPI) and a shrinking economy. See Atkeson and
Kehoe [2004] and Borio and others [2015].
There is now a huge literature documenting earlier crises in 3. Crisis in the AMEs and the Policy
which both the real and financial sectors have been affected.
Common themes are some early piece of good news that justifies
optimism, associated financial innovation, and a significant When the crisis hit, policymakers in the AMEs ini-
expansion of credit and debt. In addition to the classic reference,
which is Kindelberger and Aliber [2005], also see Reinhart and tially pulled out all the stops. They used a variety of
Rogoff [2009], as well as Schularik and Taylor [2012]. polices to stabilize the situation and in a fundamental
William R. White

sense succeeded. However, each of these policies policy rates would stay low for long, was also used
shared a major shortcoming. Their positive short-run to lower the yields on medium term government
effects were offset by negative longer-term effects. securities. In addition, central banks massively
For example, most AMEs allowed their fiscal deficits increased the size of their balance sheets, generally in
to expand rapidly in 2009. However, this quickly led an effort to lower longer-term rates, while often
to a rapid increase in debt ratios and, in some cases altering their composition as well in order to affect
(e.g., peripheral Europe), market pressure to reverse credit spreads.
these developments soon developed. These policies were first directed to restarting
Similarly, measures to support the financial sys- financial markets that seized up early in the crisis.
tem were needed and were initially successful. How- With time, however, the focus of AME central banks
ever, with the U.S. arguably an exception,10 they did shifted to emphasizing the need to stimulate aggregate
not address the underlying problems of an over-ex- demand.12 The policy essentially succeeded in
tended financial sector and the need for debt write- achieving the first objective, in that markets quickly
offs. In effect, most AMEs have chosen the Japanese began to operate more normally. Credit and term
path rather than the Nordic path to restoring the spreads also fell sharply from previously high levels,
financial system to good health. Finally, as the with over ten trillion dollars of government bonds
weakness of the economy became ever more apparent, carrying a negative interest rate by mid-2016. Some
the appetite for structural reforms to the real economy alternative hypotheses about the sustainability of these
also faded. developments are addressed below.
In short, in the aftermath of the crisis, ultra-easy However, the second objective of stimulating
monetary policy soon became the only game in spending has been much harder to achieve, particu-
town. Unfortunately, monetary policy shares the larly in continental Europe and Japan. Inflation and
shortcoming of all the other policies. Its effectiveness inflationary expectations have also remained stub-
decreases over time, while its negative side effects bornly below desired levels almost everywhere,13
increase over time. Let me treat these two phenomena although the U.S. is somewhat of an exception.14
in turn. I will distinguish, however, between the While many central bankers seem to have been sur-
undesired side effects in AMEs and those in EMEs. prised by the lack of response of spending to date,
Finally in this section, I will make a few comments both economic history and the history of economic
about global liquidity. The bottom line is that coun- thought should have given ample warning.
tries are increasingly interdependent but, sadly, we In previous downturns after a credit bubble, at
lack a global governance structure that recognizes this least in those cases where the financial sector itself
fact. had been weakened, history records that recovery can
take a decade or longer [Reinhart and Reinhart
(2010)]. Moreover, losses to the level of potential are
Why ultra-easy monetary policy might not commonly large and permanent. Evidently, to the
stimulate demand extent that monetary policy contributed to the finan-
cial boom and the subsequent bust, this conflicts
Central banks have resorted to unprecedented policies
with the conventional belief in the long-run neutrality
in response to the crisis. However, they have some-
of money.
times differed in their peculiarities, attesting to the
highly experimental nature of these policies.11 First,
policy rates in most countries were lowered very The Federal Reserve was the first and most enthusiastic
quickly to almost the Zero Lower Bound. Subse- advocate of such policies. The European Central Bank was much
more reluctant, but eventually also subscribed. The Bank of Japan,
quently, a number of countries even introduced neg- under Governor Shirakawa, was also reluctant but, under the
ative rates on reserves held by financial institutions at subsequently appointed Governor Kuroda, things changed dra-
central banks. Forward guidance, mostly implying matically. Abenomics subsequently included a massive
increase in the size of the Bank of Japans balance sheet as one
However, in both the U.S. and the U.K. there was a marked of its three arrows.
increase in concentration in the banking system. Otherwise put, A large part of this is due to weak prices for commodities,
the too big to fail problem got worse. For an explicit energy in particular. However, other measures of inflation and
recognition that this problem has not yet been adequately dealt inflationary expectations have also been weak.
with, see Financial Stability Board [2016]. 14
Core inflation in the US is not much below 2 percent, and
For a description of the many differences between the most estimates indicate the output gap is now quite small.
policies of the Fed and the European Central Bank, see Fahr and Nevertheless, both market and survey based measures of
others [2011]. inflationary expectations continue to decline.

Turning to this particular crisis, a number of several slips between the cup and the lip. This con-
reasons can be suggested for the lack of monetary clusion marked a sharp change from the policy
traction. It clearly has less to do with the signal not changes he had recommended in the Treatise on
getting through (since yields and spreads fell and asset Money [1930]. Hayek [1933, p. 21] went even further
prices rose sharply) than with there being an unusually in suggesting that monetary easing would actually
muted spending response.15 Profound uncertainty hold recovery back. To combat the depression by a
about the future, not least the future stance of mone- forced credit expansion is to attempt to cure the evil
tary and fiscal policies, might have suppressed ani- by the very means which brought it about.
mal spirits. The experimental nature of current
policies, suggesting panic to some, might also have
worked in the same direction. It is particularly wor- Undesired side effects in AMEs
risome that corporate investment has been falling
There is a rich historical literature on this topic, only
sharply, with the proceeds of record bond issues rather
one strand of which might be described as main-
being used to buy back stock (or increase dividends)
stream. That strand began with Wicksell [1936] who
and/or hoarded as cash. I return to the supply-side
warned that setting the financial rate of interest below
implications of this below.
the natural rate of interest would culminate in infla-
Perhaps most importantly, a lower discount rate
tion. There has not thus far been any indication of
works primarily by bringing spending forward from
rising inflation in AMEs, though I will suggest a little
the future to today. In this process, debts are accu-
later that there are still some grounds for concern.
mulated which constitute claims reducing future
Other strands of thought that are decidedly not
spending. As time passes, and the future becomes the
mainstream would include: the concerns of Hayek
present, the weight of these claims grows ever greater.
[1933] about real resource misallocations; Minskys
Some part of the weakness of current investment
[1986] suggestion that financial stability breeds
might be due to corporations recognizing the impor-
instability; Koos [2003], observations about balance
tance of such headwinds, particularly the overhang
sheet recessions; and insights from economists at the
of consumer debt. Why increase productive potential
BIS who have identified imbalances of various kinds
when future demand is likely to be constrained? In
that are spread internationally via global capital
short, easy monetary policies are likely to lose their
markets. It seems possible, even likely, that all of
effectiveness over timeand eight years seem rather
these undesired effects of ultra-easy money have been
a long time by anyones standards.
building up under the surface.
These are not just theoretical considerations. The
There are clearly grounds for believing that mone-
BIS Annual Report of 2014 sounded the alarm when it
tary policy, both before and since the crisis, has con-
noted that the level of debt in the AMEs (sum of
tributed to a reduction in the level of potential or even
corporate, household, and governments) was then
its growth rate. In fact, both seem to have declined
significantly higher than it had been in 2007. More-
sharply in AMEs in recent years.17 As Schumpeter
over, it has since risen further, to over 260 percent of
might have put it, without destruction there can be no
GDP. This increase has prompted the question
creation. It is a fact that in many countries, the entry of
Deleveraging? What deleveraging?16 This suggests
new firms and the exit of old ones has been on a
that, by following polices that have actively discour-
declining trend. Worse, if easy money actually lowers
aged deleveraging, we may instead have set ourselves
potential growth, and this induces still more easy
up for an even more serious crisis in the future.
money, the possibility of a vicious downward spiral is
As for the history of economic thought, Keynes
clear. In the end, rising inflation would bring this pro-
himself said in Chapter 13 of the General Theory
cess to a halt, but a great deal of real economic damage
[1936] that monetary stimulus was likely to be inef-
might have been done in the interim.
fective; If, however, we are tempted to assert that
As for the mechanisms, unnaturally easy mone-
money is the drink that stimulates the system to
tary policy before the crisis contributed to the
activity, we must remind ourselves that there may be
expansion of low productivity industries; in particular,
construction, retail and banking.18 As well, the
For a fuller description of the various ways in which ultra-
easy monetary policy might actually decrease consumption and For a general discussion of these issues, see Bank for
investment, see White [2012]. international Settlements [2016]. Also Borio and others [2015].
16 18
See Buttiglione and others [2014]. For a similar analysis, See Cecchetti and Kharroubi [2015] for a discussion of the
see McKinsey Global Institute [2015]. effects on real growth of the expansion of the financial sector.
William R. White

interaction of easy financing conditions and manage- worse since the crisis began. With monetary policy
ment compensation (in some countries, including the (especially that of the Fed) seen to be the crucial
U.S.) significantly reduced the incentives to invest.19 factor driving all markets, there has been a marked
Since the crisis, these problems have become locked increase in the correlation of returns within and across
in and others added.20 Very easy monetary conditions asset classes. Moreover, as perceptions changed as to
have encouraged banks to evergreen loans to zombie whether monetary policy would be effective or not,
companies, which in turn prey on the otherwise market reactions have bifurcated. When the mood is
healthy and lower their productivity. Furthermore, positive, financing flows (Risk On) to more risky
with banks preoccupied with managing old loans, the assets, and when the mood is negative the opposite
availability of credit to new firms (with innovative occurs (Risk Off). This focus of RORO investors,
ideas but no physical collateral) can become particu- essentially on tail risks, seriously reduces the longer-
larly constrained. This is a serious problem in Europe. run benefits of diversification and of value investing.
Another set of concerns has to do with an inad- A similar set of outcomes will be produced by the
vertent contribution of ultra-easy monetary policy to recent, massive shift of investors into Exchange Tra-
financial instability. One concern is that it has ded Funds (ETF).23 These financial market trends
reduced the viability of financial institutions by cannot be good for economic growth over time. As
severely squeezing term and credit spreads. Insur- well, the likelihood of sharp swings in the prices of
ance companies and pension funds have been com- financial assets would also seem enhanced.
plaining about this added threat to their business Against the background of these swings in senti-
models and even viability for some time.21 This is ment, the easy stance of monetary policy might also
not surprising since it comes on top of various other have contributed to financial market prices getting
problems, not least demographic challenges. What is well ahead of fundamentals. As occurred prior to
more surprising is how long it took for banks to the crisis, transparency might also have contributed
complain about the effects of monetary policy, and to this outcome by raising Sharpe ratios and encour-
thinner margins, on their overall profitability. Only aging speculation. As of mid-2016, we observed
quite recently, under the influence of the introduction record high equity prices, record low (even negative)
of a negative policy rate in Europe and Japan, have bond yields for riskless assets, high-yield spreads
they added monetary policy to regulatory policy as a back down from February levels, record low costs of
source of concern.22 cover (e.g.: the Vix), the return of cov-lite and Pay-
Another financial side effect is that the function- ment in Kind (PIK) financing, and a general lowering
ing of financial markets seems to have changed for the of lending standards. Broadly speaking, the levels of
prices in financial markets today look as stretched as
Andrew Smithers has repeatedly and convincingly made they did in 2007 just before the crisis erupted.
the following argument. For a manager whose bonuses are linked Granted, private sector leverage in AMEs has
to stock market performance, it pays to issue bonds at low rates to been generally less in evidence since 2007. Never-
either buy equity or increase dividends. Cutting investment frees
up more cash to the same end. In a similar vein, Mason [2015]
theless, in a number of countries (the Nordics,
provides empirical support for the argument that Whereas firms Canada, Australia, Israel and many others) where
once borrowed to invest and improve their long-term perfor- healthy banking systems allowed continued growth
mance, they now borrow to enrich their investors in the short run in mortgage credit, house prices and household debt
He attributes this change to the shareholder revolution of the
continue to make new highs. In the U.S., where
Borio and others[2015] provide estimates of the magnitude
household debt exposure has improved, media atten-
of these effects. They are not trivial, amounting to one-quarter of a tion has nevertheless focused recently on the marked
percentage point off growth (annually) in the upturn and double expansion of subprime car loans, student loans, credit
that in the subsequent downturn. card lending and Securities Based Loans. Each has the
For example, see Hoffman [2013]. Also the extensive potential for mischief. As noted already, U.S. corpo-
discussion of these issues in Eurofi [2016]. Of particular note, to
the extent that low interest rates push up the deficits of corporate
rate leverage has also increased as bond issues have
pension funds with defined benefits, the corporation must fill the
gap. This will be a direct charge on cash flow and profits. It is hard
to avoid the conclusion that this will discourage investment. 23
The insights of those managing active funds have been
The return on equity for institutions designated as overwhelmed by these correlations and they have systematically
Systemically Important Financial Institutions (SIFIs) has fallen underperformed ETFs. A recent survey indicates that passive
dramatically in recent years. The irony is that, if public sector funds now account for one-third of all fund assets in the U.S.
polices have rendered them unviable while leaving them still too Marriage [2016] and the associated FTfm special report on
big to fail, the taxpayer will once again be on the hook. Exchange Traded Funds outline the associated dangers.

been used to buy in equity, pay out dividends and to with certainty, is that we are in uncharted territory
finance M&As.24 when it comes to market functioning.26
Further, with innovation constantly occurring, And for the record, it should be noted that central
exposures to risk might have been growing in differ- bank policies might have had other downsides as well.
ent and less evident ways than before. Recall that the First, with income distribution already a source of
full implications of the growth of the shadow great concern (due mainly to changing technology and
banking system only became clear after the crisis globalization) the recent stance of monetary policy
began. There are signs of similar structural changes has likely made it worse. The rich own most of the
occurring today. In part, this is due to new regulatory risky financial assets whose prices have increased the
initiatives, which are inducing a migration out of the most. Conversely, the middle classes mainly hold the
regulated financial system. less risky interest-bearing assets whose yields are at
Perhaps most important has been a remarkable record lows. While central banks seem increasingly
increase in the size of the asset management industry, aware of these effects,27 what can be done about them
which has become much more concentrated as well. is another issue.
Could this increase the threat of overshooting prices Second, much of what central banks have done,
should losses begin to cumulate? Although it is not albeit largely in the pursuit of financial stability,
the asset management firm that takes the losses, they constitutes a significant threat to their indepen-
must be concerned to protect their customers since dence going forward. There can be no doubt that the
relative performance is important. A related issue is institutional relationships of central banks with their
the reaction of ultimate lenders who might be tempted governments and their internal governance will be
to withdraw their funds, exacerbating the likelihood of actively debated topics in the coming years.28 Many
fire sales. Finally, asset management companies and institutional changes have already been implemented,
other funding houses are moving strongly into direct often hastily, in the wake of the crisis. The wildly
lending (especially to EMEs) to clients whose credit divergent nature of these changes across countries
worthiness they might not be adequately equipped to shows how much serious thinking about these insti-
assess. tutional and governance matters still remains to be
The BIS Annual Report for 2016 also highlights a done.
number of persistent market anomalies.25 Not only do Finally, and perhaps most importantly, what the
they indicate price distortions and potential misallo- central banks have done has encouraged governments
cations but could also indicate underlying structural to believe that the central banks have the economic
developments whose full implications for market situation under control. Governments desperately
liquidity are not yet obvious. Recall the plight of want to believe this since it absolves them from
European banks in 2008 who had borrowed dollars having to pursue other, politically difficult, policies
from money market mutual funds in the U.S. When that might in fact lead to stronger and more sustain-
this source of funding dried up, the Federal Reserve able growth over time. I return to these alternative
was forced to reopen U.S. dollar swap lines that it had policies in the last part of this presentation.
closed only a few years earlier. All that can be said

See BCA Research [2016], which contends the corporate 26
releveraging cycle is far more advanced than widely believed At the end of July, the Bank of Japan announced an
and overall corporate health looks only mildly better excluding expansion of its US dollar funding facility for Japanese banks,
the troubled energy and materials sector. Also Authers [2016]. allowing them to roll over dollar loans for as long as four years.
25 Presumably this was done in recognition of potential dollar
See Box ll.C in Bank for International Settlements [2016].
funding problems and with the agreement of the Federal Reserve.
Perhaps the most remarkable anomaly has been the persistent and 27
significant violation of the Covered Interest Parity condition, for Der Nederlandische Bank organized a conference on this
euro/dollar and especially for yen/dollar. Against the backdrop of issue in Amsterdam in November 2015. The Council on Economic
an excess of dollar assets relative to on balance sheet liabilities, Policies, a Zurich think tank, has also cosponsored a number of
foreigners are finding that dollar financing has become increas- such conferences with central banks, including a number of
ingly difficult. Moreover, with strong pressure from the Japanese regional Feds. For a quantitative analysis of the magnitude of
government on Japanese financial institutions to raise returns by these effects, see Domanski and others [2016].
investing abroad, and the incentive provided by negative risk-free See the discussion in Group of Thirty (2015), for which I
rates in Japan, this problem can only get worse. Other anomalies was the project director and draftsman. More recently, the
are the growing gap between corporate bond spreads in the Institute for New Economic Thinking (INET) and the Official
Eurozone and CDS spreads, and the relative performance of the Monetary and Financial Institutions Forum (OMFIF) have pro-
Nikkei and Topix in Japan. Both clearly reflect central bank asset posed to work together to examine the roles, performance and
purchases. governance of central banks.
William R. White

Undesired side effects in EMEs growing evidence of over building in a number of

countries. Similarly, there was in many countries a
While again subject to swings in market sentiment
massive increase in the capacity to produce raw
(RORO behavior), EMEs generally saw their curren-
commodities as well as the intermediate products
cies strengthen post-crisis as monetary policy was
required to support the building and construction
eased in the AMEs. Such push me factors have
industries. This threatened overcapacity should
been in evidence for decades. However, Shin [2012],
demand weaken.29
Rey [2013], and others have described in more detail
Credit booms are commonly followed by an
the changes in the international transmission mecha-
economic bust and this has indeed been the case
nisms that have influenced how the spillover pro-
for a number of countries. There was a subsequent
cess currently works. The implication is that there is
marked deceleration in the growth rates of many of
clearly an element of truth in the accusation that
the larger EMEs, with actual declines in recent years
AMEs are engaged in currency wars. At the same
in Brazil, Russia, and South Africa. In China,
time, many EMEs also seemed to have desirable pull
growth decelerated only moderately under the
me characteristics that provided further support for
expansionary influence of still more credit creation.
their exchange rates. Not least, many EMEs benefited
Inflation for some EMEs fell to very low levels,
from significant gains in their terms of trade as
although sharp depreciations of EME currencies
commodity prices rose.
against the dollar after mid-2014 led to higher
The governments and central banks of EMEs
inflation in a number of others. Commodity prices
resisted this upward appreciation for a variety of
also fell sharply as did producer prices in many
reasons, some less justifiable than others. One concern
EMEs, indeed in China the latter fell for forty
was a prospective loss of competitiveness, of partic-
months in a row. Capital outflows accelerated and
ular political importance in countries with export-led
domestic asset prices fell accordingly.
growth strategies. This would seem less justifiable,
In recent months, however, signs of economic
particularly for countries (like China) with large cur-
stabilization in the EMEs have led to renewed capital
rent account surpluses. Another concern, perhaps
inflows. These flows have also been supported by the
more justifiable, is that currency appreciation might
perception that monetary policy in the U.S. might not
otherwise have become unreasonably large. It is now
tighten as quickly as earlier supposed. That said, many
generally accepted that the law of Uncovered Interest
downside risks remain. Supportive pull me factors
Parity only applies over very long periods, with
might yet reverse. Many EMEs are now seen to have
momentum trading and carry trades generally gaining
deeper structural problems than was earlier appreci-
lasting force prior to an eventual mean reversion.
ated, and opportunities for reform were missed. As
The resistance to exchange rate appreciation took
well, the buildup of debt levels in EMEs inherently
many forms. A few countries used capital controls
leads to strains, just as in the AMEs. At the same time,
while others turned to so called macro prudential
push me forces could also reverse. Stronger growth
policies with the same intent. More common was
in AMEs could eventually lead to higher interest rates
foreign exchange intervention, which was often
and provide such an incentive.30 However, weaker
reflected in a large expansion in the balance sheet of
growth in the AMEs could be even more disruptive. A
the central bank, and the pursuit of easier monetary
return to Risk-Off behavior could follow, at the same
policies than would otherwise have been the case. As
time as exports from EMEs to AMEs were threatened.
a result, the rate of credit expansion in many EMEs
Adding to concerns about prospective capital
shot up and the ratio of non-financial sector debt to
outflows from EMEs must be the nature of the pre-
GDP also expanded enormously. Further lending to
vious inflows. Whereas in earlier years they were
those with foreign debts was also encouraged by
mostly driven by cross border bank loans, the flows in
exchange rate increases which tended to flatter their
balance sheets.
The upshot of these policies was that inflation China is a leading example, with the government now
rose in a number of EMEs to uncomfortably high publically agreeing that there is significant overcapacity in many
industries including steel, aluminum, cement, glass etc. Distribu-
levels (between 5 and 10 percent for the BRIICS, as of tion networks, not least shipping, also suffer from overcapacity as
early 2014). As well, many of the imbalances previ- indicated by the recent filing for bankruptcy by Hanjin Shipping in
ously seem in the AMEs were imported, via semi- South Korea.
fixed exchange rates, into the EMEs as well. Not least, Recall the taper tantrum of June 2013 when Chairman
there was a sharp increase in property prices and Bernanke merely hinted at the possibility of a tapering of QE
purchases in September.

recent years have been dominated (especially in South of financial assets. This is very much to be welcomed.
East Asia and Latin America) by off-shore issues of It recognizes the changing reality of globalization.
EME corporate bonds purchased largely by asset Less welcome, however, is the new focus it pro-
management companies. Since most of these bonds vides on the governance mechanisms for this chang-
have been denominated in dollars and euros, in ing global reality. On the one hand, to the degree the
response to low interest rates,31 this raises the specter Fed still sets global monetary policy, there is a defi-
of currency mismatch problems of the sort seen in the ciency. The Feds policies must, by law, be set with
South Eastern Asia crisis of 1997. The fact that many only American interests in mind. Others must then
of the corporate borrowers have rather low credit protect themselves as best they can, perhaps by rolling
ratings also raises serious concerns,32 as does the back open markets through intrusive capital controls
maturity profile. About $340 billion of such debt and macroprudential policies. On the other hand,
matures between 2016 and 2018 [Tarashev and others given the increased degree to which global financial
(2016)]. conditions now depend on the collective behavior of a
number of monetary authorities, there is no mecha-
nism to control that behavior.
The problem of global liquidity We clearly need to revisit the issue of the inter-
national monetary system and the rules that might
The interactions between AMEs and EMEs through
govern it. We have no global anchor.34 Today, absent
financial markets have now grown profound. While
any rules but domestic self-interest, virtually all cen-
the influence of AMEs on the financial markets of
tral banks (and certainly all the major ones) have the
EMEs has been discussed above, the reverse effect of
monetary and credit spigots wide open in pursuit of
EMEs on AMEs is growing increasingly important.
their domestic interests. What this collective monetary
Not least, the reinvestment of foreign exchange
experiment might eventually imply at the global level
reserves and the assets of Sovereign Wealth Funds
still remains to be seen.
(when they were rising) eased general credit condi-
tions in AMEs as well. Beyond this, property prices in
large gateway cities in AMEs have been increas-
4. The Need for Exit and Possible End
ingly influenced by private purchasers from EMEs.
This implies that financial and property markets in
AMEs might well be affected by changes in circum- Simple uncertainty about the full effects (not only
stances in EMEs. On the one hand, capital outflows unexpected but potentially undesirable) of todays
from EMEs might result in a rundown of foreign radical monetary policies might, in itself, seem to
exchange reserves that could help raise bond rates in argue powerfully for their moderation What has been
AMEs. On the other hand, the capital outflows might done is totally unprecedented and totally experimen-
be directly invested in property, raising prices still tal.35 But there is another no less powerful argument
further. for eventual exit. If the effects on aggregate demand
Given these complex interactions, a whole new decline with time, while the undesired side effects
strand of literature is developing on the nature of cumulate with time, at some point these two functions
global liquidity and international credit bubbles.33 must intersect. At that point, monetary policy would
While it is still the case that the dollar, and the poli- have to be judged to be doing more harm than good.
cies of the Federal Reserve, remain at the heart of the At this due date, exit would then be warranted.
global financial system, there is an increased interest Finally, and more in keeping with the conventional
in global aggregates for credit, money and the prices wisdom, exit would be warranted if there signs of
emerging inflationary pressures. This danger seems
From 2009 to 2015 Q3, U.S. dollar denominated debt owed greater today in the U.S. than elsewhere.
by non-bank borrowers outside the U.S. rose about 50 percent to
$9.8 trillion. It doubled to non-bank borrowers in EMEs to $3.3 34
See White [2015] for a discussion of the many shortcom-
trillion. See Bank for International Settlements [2016, pp. 1213]. ings of the current non-system.
In August of 2016, the IMFs Article 4 review of China 35
Central banks have embarked, full speed ahead, upon what
gave a stark warning about the quality of credit in China. See also is the biggest, global macroeconomic experiment of all time.
Blundell-Wignal and Roulet [2014] who note that much of the Contrast this approach with that of scientists involved in genetic
EME borrowing has arisen in industrial sectors where the rate of research, in particular gene splicing. There, enormous importance
return on capital has been falling in recent years. is given to the need to protect against unintended conse-
For example, see Bank for International Settlements quences. Similarly, all new drugs in AMEs must be tested, not
[2011]. just for their effectiveness, but also their side effects.
William R. White

Why exit threatens to be delayed questionable even if rates were to rise less than to the
old normal. Some return to the post-war period of
Unfortunately, there are a whole host of reasons to
financial repression might then be expected. More-
expect exit to be delayed until well after its due
over, those currently speculating on lower for
date, even in the U.S., where a marginal increase in
longer will lobby vigorously to ensure this policy
the policy rate has already occurred. The first concern,
continues. Not least, they will emphasize the dire
reflecting the unprecedented character of the current
results of raising policy rates for zombie banks and
policy setting, is uncertainty concerning the use of the
companies with high levels of leverage and debt,
instruments of policy. The modalities of exit in the
respectively. Finally, pressure to keep rates down has
U.S. are still subject to debate. Moreover, the jury is
recently emerged from minority groups whose job
still out as to whether it is possible to raise policy rates
prospects remain uncertain.39 This predicament is
significantly while maintaining a swollen central bank
increasingly referred to as the debt trap. Raising
balance sheet? What side effects might follow new
rates is thought not to be an option, but leaving rates
procedures to make this possible? In principle, what
low only makes the underlying problem worse.
should be the order in which previous policies could
To all this, we must add that central bankers too
be reversed? Is full transparency about the policy-
are human. They will worry about the capital losses
makers intentions a good thing or a bad thing?
they might have to record when credit conditions
And to this uncertainty must be added the even
tighten. Losses could easily damage their reputation
greater uncertainty over the implications of tighten-
for competence. As well, the possibility of a pop-
ing. What happens if exit is too fast, say as in the
ular call for recapitalization, and the need to strike a
U.S. in 1937? Could sustainable growth also be
political deal with their respective Treasuries, would
threatened by exit being too slow, as in the U.S. in
be a further source of concern. Finally, if tightening
the early 1970s? In any event, what is the level of
did prove to be too fast and the economy then
post-crisis potential in the United States, and what
faltered, central banks are aware that the blame will
is the likely rate of growth of potential going for-
fall totally on their shoulders. For these reasons,
ward?36 Finally, to what extent, and through what
directly affecting the central banks own interests,
channels, might international developments abroad
plus all the indirect pressures noted above, the bias
feed back on U.S. inflation and unemployment?37 On
seems likely to be that of exiting too late. In effect,
all of these questions, reasonable people could easily
staying put will become the central banks default
propose different answers, with differences of views
on committees (like the FOMC) a recipe for inaction.
Exit will also be delayed due to pressure from
those benefiting from the status quo. As noted above,
Possible end games
debtors are gaining at the expense of creditors, and
governments are essentially the biggest debtors of Given the enormous, remaining uncertainty as to what
all.38 Indeed, the sustainability of sovereign debt should be done by central bankers (an analytical
service for some countries would be highly issue), what could be done (a legal and regulatory
issue) and what will be done (a political economy
A closely related question is whether recent developments issue), the best I can do is suggest certain scenarios. In
are caused by secular stagnation or are rather the product of
successive boom-bust cycles with the downside effects perhaps any event, one characteristic of complex systems is
exacerbated by the effects of easy monetary policies on the supply that precise forecasting is literally impossible. In the
side of the economy. scenarios I sketch out, polices other than monetary
Developments in China seemed to have exerted a signif- policy are taken as given. I proceed from the most
icant influence on the FOMCs decision in September 2015 not to optimistic to the least optimistic outcomes.
raise the policy rate. However, members of the FOMC at the time
emphasized that this was not done in Chinas interests, but due to A first scenario assumes a happy ending, though
the associated knock on effects (perhaps aggravated by associated even that is not guaranteed. Suppose that significantly
slowdowns elsewhere) on the United States itself. International faster growth does reemerge in the global economy,
concerns seemed off the table when the FOMC raised the policy
rate in December, but seemed to return around the time of the
Brexit vote in June of this year. Footnote 38 continued
Central banks are part of government. Therefore, when rate is now negative. Accordingly, exit from QE will increase gov-
central banks buy longer-term government debt with central bank ernment deficits. So too will raising policy rates.
liabilities, they are essentially replacing the governments longer- Representatives of Fed Up, an activist group, met with an
term, fixed rate obligations with short-term debt which tends to unprecedented number of senior Fed officials at Jackson Hole in
have a much lower rate of interest. Indeed, in some countries that late August.

and that bond markets react in an orderly way. (e.g., exchange traded derivatives) and to the expansion
Thus, monetary policy could begin to tighten and low of central bank balance sheets. Further, reflecting new
bond rates would move up only slowly. Ideally, they capital charges, dealers inventories of risky securities
would rise less than the increased nominal growth (corporate securities in particular) are now far below
rate, implying a gradual reduction in the burden of where they were prior to the crisis. Fourth, if what
debt over time. In this assumed world, current high happens in AMEs leads to capital outflows from EMEs,
equity prices and tight risk spreads might seem gen- sales from reserve managers would put still more
erously valued, but they would be fundamentally downward pressure on bond prices in AMEs.
justified by future growth prospects. In this case, sharply higher bond rates and asso-
For this optimistic scenario to be realized, it must ciated financial disruption could also abort the
also be assumed that central banks, in spite of the recovery in AMEs, even in the face of further central
exit bias referred to earlier, do not make any sig- bank easing to avoid this outcome. Capital outflows
nificant mistakes with respect to controlling inflation. from EMEs might lead to the same outcome in their
Were inflation and inflationary expectations to rise in case. Even assuming that inflation and inflationary
this faster growth scenario, a belated monetary expectations were not shocked upwards by ever more
response might lead to recession, as has been common aggressive monetary easing, we could again face the
in the post-war period. The risk of such a policy possibility of a global slowdown given these negative
mistake (exiting too late) is not insignificant. feedback effects.
Orphanides [2001] has documented how hard it is to If there are risks to the optimistic scenario, there are
calculate output gaps based on real time data. Borio even darker possibilities. The current, relatively slow
and others [2013] show that it is even harder in the pattern of global growth could continue or even weaken
wake of a financial boom that gives a falsely high further. The secular factors suggested by Gordon [2016]
reading for potential looking forward. could contribute to this, as could the accumulating
There is also a second threat to this optimistic headwinds of debt. In this case, both policy rates and
scenario of a return to faster global growth. Suppose longer-term risk-free rates would be expected to stay
bond markets react in a disorderly way. That is, very low. However, in this environment, current equity
long rates rise faster than the projected increased rate prices and narrow risk spreads will be increasingly seen
of growth in the nominal economy implying that debt as unrealistic. Resulting sharp declines in the prices of
service burdens worsen rather than ease. There are such financial assets are likely to catch out many
various reasons why this might be expected. speculators and could, potentially, do further harm to
First, if unconventional central bank actions had banking systems in countries already affected by the
been successful in holding bond rates down, as sug- crisis. Unaffected AMEs, where household debt and
gested above, then the reversal of such policies should property prices have continued to rise since 2007, might
reverse these results. Momentum could develop quickly be particularly badly hit. Banks everywhere will, in any
and overshoots in financial markets are common.40 event, be further weakened by slow growth that raises
Second, private sector investors have also been the number of non-performing loans. Both the demand
encouraged by central banks to be long risk and short for and the supply of credit will remain very subdued, as
volatility. A rush to the exits could have significant in Italy today.
effects on both. Third, trading of a stabilizing kind might In this scenario, the current low level of inflation
also be impeded by the lack of collateral,41 now tied up (in the AMEs) seems likely to decelerate further. As
in various ways due to both recent regulatory changes noted above, while falling prices would exacerbate the
real burden of debt service, the likelihood seems small
One reason people are prepared to buy sovereign bonds at that price decreases would be extrapolated into the
negative rates is that they expect even more negative rates, raising future and spending held back in anticipation. Nev-
the possibility of future sales and a short-term capital gain. ertheless, given the biases noted above (leading to
However, the moment that doubts arise as to the central banks
resolve to facilitate this, the appetite for bond purchases will
exit being delayed), still more aggressive use of
disappear. The unprecedented increase in JGB rates in a few days monetary policy would likely be the chosen option to
in early August might have been an example of such a respond to this slow growth, with central bank balance
phenomenon. The proximate cause was the BOJ announcing a sheets expanding still further.
bond buying program that was less generous than the market
Baranova and others [2016] suggest problems are less Footnote 41 continued
likely to arise from a shortage of collateral (in periods of stress) collateral may be unable to reach those that wish to use it. This
than from a reduction in dealer intermediation capacity. In effect, could result in fire sales and funding difficulties.
William R. White

On the one hand, further monetary expansion would be other policy measures which would begin by
might finally succeed in promoting more spending and recognizing that the fundamental problem is one of
the expansion of the real economy. Deflationary excessive debt and possible insolvency. Such prob-
expectations might then be avoided. Logically, the lems must be solved by governments, not central
possibility cannot be ruled out that the tepid response banks. Other policies, again in the realm of govern-
of spending to the monetary stimulus to date has been ments and not central banks, would also help mate-
simply due to the stimulus being too small. On the rially. To the extent, these alternative policies might
other hand, there is also the possibility that this pro- threaten inflationary pressures, then reversing the
cess might get out of hand. Still more monetary current ultra-easy monetary policies should be the first
expansion might cause inflationary expectations to line of defense as this would help minimize the
finally ratchet sharply upward, leading to a sudden fall imbalances problem as well.
in the demand for both base money and broader stocks First, debt restructuring and outright forgiveness
of money as well. While the demand for real assets must be used much more aggressively. As noted
would rise, the effects on current production of sig- earlier by Reinhart and Rogoff [2013] It is difficult
nificantly higher levels of inflation are harder to pre- to envision a resolution to the current five-year-old
dict but could well be negative. crisis that does not involve a greater role for explicit
A sudden speeding up of the inflationary process restructuring. A number of commentators have
would be more likely in countries where both gov- suggested debt for equity swaps, as a means of crisis
ernment deficits and debts were initially very large. resolution, and more use of risk sharing instruments to
Thus, governments would have to borrow but could help prevent future crises.44 Debt restructuring and
not get adequate private sector financing. This would forgiveness will in turn likely call for the recapital-
raise expectations of fiscal dominance further ization of banks and sometimes for the closure of
eroding the private sectors demand for government financial institutions. The legal framework must be
paper. Bernholz [2006] has pointed out that such made ready for this. Banks will also have to cut costs
processes, potentially leading to hyperinflation, are materially to ensure future profitability.
not uncommon in history. Such outcomes would also Second, structural reforms should be aggressively
be consistent with those described in the famous pursued to promote growth, and the capacity to ser-
article by Sargent and Wallace [1981]. At the vice debt, as well as to help resolve trade imbalances.
moment, Japan is clearly the country to watch in this Freeing up the services sector in many countries with
regard. Should the Bank of Japan opt for still more large trade surpluses would be particularly helpful in
monetary stimulus, this danger would obviously achieving both objectives. Raising retirement ages
increase.42 everywhere should be a crucial part of broader pen-
sion reform. This will boost both potential supply and
aggregate demand, and will take pressure off the fiscal
5. A Better Way Forward Than Digging the framework (pension obligations) going forward.45
Hole Deeper? Measures to raise wages and the wage share of factor
The above scenarios are stories, not forecasts. Nev-
ertheless, they indicate some of the profound risks we
Footnote 43 continued
face in relying totally on central banks to restore market anticipations of slower growth not faster growth. Similarly,
strong growth. If it succeeds, which is doubtful, it when the BOJ introduced negative policy rates in January of this year,
seems unlikely to be either balanced or sustainable. the Yen rose (Risk Off) rather than fall. As a further sign of
If it fails, the vaunted credibility of central banks decreasing confidence, in only one week in August, the Financial
Times had three major op ed pieces by respected observers (Amar
will be destroyed. Indeed there are worrisome signs Bhide, Bill Gross and Eric Lonergan) all expressing views similar to
that this process has already begun.43 Much better those contained in this paper.
For example, Buiter [2009].
In both Japan and the Eurozone, massive increases in the 45
Off-balance sheet sovereign obligations, implicit in current
base money provided by central banks have not led to significant legislation, are huge relative to traditional measures of public
increases in broad money. This is because the central bank debt. In a recent article, Miron [2016] calculates the size of the
purchases of debt have largely come out of the portfolios of banks. fiscal imbalance (FI) in a number of countries. By FI is meant
A tipping point for expectations could possibly arise when the present value of future expenses less the present value of
nonbanks begin to sell bonds in exchange for central bank money future revenues all expressed as a percentage of the present value
and measures of broad money do finally begin to increase. of projected future GDP. The FI for the U.S. is 5.4 percent
When the Fed raised rates in December, long rates did not (Table 1, p. 24) and for France and Germany is 14.6 and 13.9
rise but fell. This is more consistent with Risk-Off behavior and percent, respectively.

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