Albert Einstein defined insanity as “doing the same thing over and over again and expecting different results.” The world’s policymakers would do well to remember these words in the coming months as they ponder their next moves to battle the global economic malaise.
As economic indicators have worsened, central banks and governments have demonstrated an asymmetric reaction function: They have been more likely to react to — and act upon — deflationary influences than inflationary ones. There has been a growing recognition, even among central bankers, that a little inflation is better than deflation.
Central bankers turned to quantitative easing during the financial crisis to spur GDP growth. But that was never intended to be a precise instrument or part of bankers’ long-term policy tool kit. Although the mass buying of government bonds by the U.S. Federal Reserve and the Bank of England has probably driven down bond yields, it’s very hard to tell whether the actions have boosted lending.
The Bank of England’s latest Quarterly Bulletin ascribed a positive GDP effect to quantitative easing, but the analysis smacked a little of starting with the answer and working backward to the question. The bank must now ask itself: Would repeating the exercise of bond buying bring genuine economic benefits, or are yields so low that the power of quantitative easing is diminished?
Now that we have grown accustomed to quantitative easing and had time to reflect on its value, more-precise tools can be made available to boost growth. The dyed-in-the-wool monetarists among us are nervous about any unconventional stimulus. Boost the money supply without growth and inflation will surely follow, the logic goes. Yet this might be a risk that has to be taken. Generating nominal GDP growth on its own might be tricky, but creating a little inflation to accompany it might actually be a desirable outcome.
Such thinking, of course, flies in the face of nearly 30 years of accepted wisdom that lower inflation is always better. The slaying of the inflation dragon that crippled economies in the 1970s and early ’80s was necessary, and nobody suggests or desires a return to the double-digit inflation of that era. Nonetheless, a period of slightly elevated inflation would reduce the real value of debt and could have a positive effect on consumer confidence. Money illusion — the appearance of greater wealth when both incomes and prices have risen — is a powerful force.
So how can we target nominal GDP growth? One method would be direct lending to key growth-generating sectors, such as small and medium-size enterprises (SMEs). SMEs form a significant proportion of GDP in many countries and are hotbeds of innovation and entrepreneurialism. However, they are too small to access bond markets; without willing banks, they struggle to get funding.
Direct lending to SMEs could boost growth by breaking the credit logjam. Whether done directly by a government agency or by the government’s underwriting of loans by commercial banks, it’s a more direct way of encouraging innovation, investment and job growth.
The monetary effect of such lending could be offset by the sale of Treasury bills, or, if the authorities felt the risk of deflation was too great, money could effectively be printed to cover the loans. The program would blur the boundaries of fiscal and monetary policy. Lending is central bank territory; sectoral intervention is the preserve of governments.
For SME lending to be successful, getting buy-in from central bankers would be critical. Governments and central banks, though, are unlikely to ever admit to trying to generate inflation — even a little bit. As a result, it is at least as important to watch what policymakers do as to listen to what they say.
The upshot of such policy developments would be the superior performance of real assets and the underperformance of financial ones. The relative performance within real assets would vary according to the type of inflation generated. If prices rose because of an increase in genuine demand in the economy, riskier assets such as equities and property would probably perform well, but this scenario is hard to create. In more-uncertain economic circumstances, the preferred portfolio would be lighter in risky assets like equities than would normally be the case during a recovery.
The policy mind-set of the past 30 years has been vehemently anti-inflationary. That may need to change, at least to the extent that we recognize it is dangerous to get too close to the black hole of deflation. Getting sucked into that hole could result in a decade of moribund growth. But if the authorities get their policy prescription right, a respectable economic recovery is still quite feasible.
Jonathan Gibbs is head of real returns for Edinburgh, Scotland–based Standard Life Investments, which has $233 billion in assets under management.
