There’s no free lunch for central banks either

Milton Friedman never tired of reminding us that there is no such thing as a free lunch. If ever this adage has to be true, it is of the extraordinarily unorthodox monetary policies of the world’s main central banks over the past several years.

To be sure, over the past nine years, those policies might have prevented an economic depression and might have produced a global synchronized recovery from the worst world economic recession in the post-war period. However, they did so at a considerable cost.

{mosads}First, they have substantially compromised the central banks’ balance sheets. Second, and very much more importantly, they have all too likely set us up for the next global boom-bust cycle by having created global asset price bubbles and by having seriously distorted credit markets around the world.

A distinguishing characteristic of the world central banks’ monetary policies over the past decade has been their aggressive resort to so called “quantitative easing” in their attempt to get their respective economies moving.

This policy involved the massive purchase of government and other high-grade bonds with the express purpose of reducing long-term interest rates and of encouraging markets to take on more risk.

One measure of the tremendous scale of these operations can be gauged by looking at the expansion of the Federal Reserve’s balance sheet. From a level of $800 billion in 2008, the Fed’s balance sheet exploded to around $4.5 trillion by 2016.

Another measure of the extraordinary scope of recent monetary policy can be gauged by looking at the combined balance sheets of the Federal Reserve, the Bank of Japan, the Bank of England and the European Central Bank.

Over the past nine years, these central banks’ combined balance sheet has increased by more than a staggering $10 trillion. This is equivalent to around 15 percent of the world’s GDP.

With interest rates now beginning to rise as the central banks start normalizing their policies, it is becoming very clear that these banks face very large potential losses on their bond purchase operations. Having bought these bonds at very high prices, their potential losses could be enormous.

They could be so as interest rates rise to more normal levels causing bond prices to fall. Indeed, already if the central banks were forced to mark their bond holdings to market, as private companies are required to do, their entire capital would be wiped out many times over.

The central banks maintain the fiction of being solvent by not marking their book to market. Instead, they take the position that they intend to hold these bonds to maturity. They justify this position by arguing that they plan to reduce the size of their bloated balance sheets not by selling their bonds but rather by allowing these bonds to run off at maturity.

The more serious cost of the central banks’ unorthodox policies is likely to flow from their having massively distorted global financial markets. It is not simply that they have created equity and housing-price bubbles around the world. It is that they have caused the widespread mispricing of risk in many credit markets.

Sadly, it is all too likely now that as the central banks are forced to raise interest rates to keep inflation in check, asset price bubbles around the world will burst and credit markets will reprice.

That in turn is all too likely to cause severe strains in financial markets in general and in the world’s shadow-banking sector in particular. In so doing, it is also likely to set the stage for the next global economic recession within a year or two.

Before pointing a finger at the world’s central banks for having conducted irresponsible policies, we might want to consider that too much of the burden for getting the global economy moving again might have been placed on their shoulders.

With governments around the world unwilling or unable to resort to fiscal stimulus as the global economy risked getting into a deflationary spiral, the world’s central banks had little option but to resort to aggressive quantitative easing to address the deflation threat.

Hopefully, policymakers will have learned something from the latest world boom-bust economic cycle. Instead of placing all of the burden of getting a recovery going on the world’s central banks, they might want to engage in a large central-bank-financed tax cut along the lines of Milton Friedman’s proposed use of “helicopter” money.

Maybe then we can hope to have weaned ourselves from the boom-bust cycles of the past two decades and from further compromising the central banks’ balance sheets. 

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.