Monday, August 12, 2013

Financial market snapshot

Economic policy in the fix
Antony Mueller
The international financial system is in intensive care. The system is kept alive through massive transfusions of liquidity. Central banks in the United States, Europe and Japan have opened the floodgates of financial liquidity in order to keep the system alive in its state of emergency. How long can it go on? For years by now, interest rates have been at zero bound. Since the early 1990s, Japan has tried to stimulate its economy through easy money and public spending. At the inception of the current crisis, the United States have joined and more recently Europe, too, has begun to slash interest rates down close to zero. Yet like in Japan, in the United States and in Europe, the prime instruments of monetary and fiscal policy no longer work. What has been going on?

One main reason why the traditional instruments of monetary and fiscal policy no longer work is the fact that public debt has reached levels that are unsustainable. The more governments fight against stagnation, the more they produce the very obstacle against growth because of rising debt. In the meantime monetary policy has brought down interest rates to zero bound. While this seems to be fine for financial market, it also means that there is no longer room for expectations of a further decline of interest rates.

Where do we go from here? Central banks try as hard as they can to keep interest rates low. Any significant rise of the real interest rate would bring governments closer to default. There is no room left for central banks to lower nominal interest rates. There is only one way out of this dilemma in the perspective of the major central banks: price inflation. Nevertheless, inflation rates remain stubbornly low in the major economies. Central banks still face a nightmare: deflation with the consequence of sharply rising real interest rates which would not only bring many companies down and lead to higher unemployment, deflation would also mean that governments themselves are threatened by default.