The Age of Monetary Excess: A Tough Lesson in Economic History
By Hans Hoogervorst, Skytop Contributor / January 15th, 2024
Hans is a distinguished Dutch former minister and public policy expert with a notable career in both the public and private sectors. He served as the Chairman of the International Accounting Standards Board (IASB) from 2011 to 2021, where he played a pivotal role in shaping global accounting standards. Prior to this, Hans held various significant positions in the Dutch government, including, Minister of Economic Affairs, and Minister of Health, Welfare, and Sport. His leadership extended to the Netherlands Authority for the Financial Markets (AFM) and the International Organization of Securities Commissions (IOSCO) Technical Committee, where he served as Chair, contributing to the regulation and oversight of financial markets.
Throughout his career, Hans has been recognized for his expertise in economics, finance, and governance. His work at the IASB was instrumental in promoting transparency and accountability in financial reporting worldwide. Hans's extensive experience and dedication to public service have made him a respected figure in the world of finance and accounting. Known for his strategic vision and commitment to high standards, he has left a lasting impact on the institutions he has led and the global financial community.
Our Age of Monetary Excess
I have no doubt that the first decades of this century will go down in economic history as the age of monetary excess. After the heroic inflation-fighter Paul Volcker (1927-2019) was succeeded as chairman of the Fed by Alan Greenspan in 1987, central banks around the world increasingly engaged in accommodating monetary policies.
Greenspan’s philosophy was that central banks should not try to prevent financial bubbles. Rather, they should mop up the mess once the bubbles burst by drowning the markets in liquidity. The financial markets started to count on the “Greenspan put,” the belief that the Fed would always step in with monetary stimulation if speculation went south.
After the outbreak of the Great Financial Crisis (GFC) in 2008, partly caused by the Greenspan legacy of excessive liquidity, central banks responded by doubling down on their stimulative monetary policies.
Around the world, central banks adopted a flexible definition of price stability of 2% inflation per year. Volcker drily commented in his memoirs that a yearly inflation of 2% could not possibly be called price stability since it results in a halving of the value of money in little over a generation. He also presciently warned that with inflation price increases of 2% could easily become 3% or 4% or even more and that bringing it down again would be extremely difficult and costly.
Record Low Level Interest Rates
In practice, inflation stayed below 2% for a very long time, mainly because of China flooding the global economy with cheaply produced consumer goods. Determined to lift annual price rises to their desired level, central banks resorted to policies that they called ‘unconventional’ but which could more appropriately be called extreme.
Interest rates were pushed down to extremely low levels, and Europe and Japan even experimented with negative interest rates.
Ultimately, central banks, led by Fed Chairman Ben Bernanke, even resorted to buying up enormous quantities of (mainly) government bonds to push down long-term interest rates and push up inflation. They called this Quantitative Easing (QE), a euphemism for debt monetization. Every traditional economic textbook warns against debt monetization as it is an open invitation to fiscal profligacy, but all classical economic principles went out of the window. In response to the COVID pandemic, QE was pushed to ever more extreme levels with central banks buying up more bonds than increasingly indebted governments could even supply.
Hangover from Monetary Excess
In 2021, the central banks finally achieved the surge in inflation that they had been so desperately trying to achieve, albeit rather more than they had bargained for.
In 2021-22, inflation exploded with price levels increasing by double digits in the Western world. Central banks were slow to react, deeming the surge in inflation to be transitory. But ultimately, they had to resort to more traditional policies, raising interest rates and putting a stop to QE. While they succeeded in bringing down inflation, it remains to be seen whether this success is durable. Moreover, the world is still grappling with a serious hangover from the prolonged monetary party of the past decades.
The hangover from monetary excess is visible in almost every aspect of the economy.
From Central Bank Losses to the Rise of Populism
First, the central banks themselves suffer the consequences of their unconventional policies. As a result of QE, the balance sheet of many central banks is filled to their brim with extremely low-yield bonds. The fair value of these bonds has tanked as a result of interest rates having reverted to more normal levels, and many central banks have incurred severe losses as a result.
Due to dodgy accounting (unlike normal companies, central banks can set their own accounting rules), these losses are not always clearly visible and as state monopolies, nothing prevents them from staying in business even with negative equity.
Nevertheless, it is deeply embarrassing for central banks to be in worse financial shape than the commercial banks that they supervise. Moreover, the taxpayer pays a price as central banks can no longer distribute their normally fat profits to the state. Finally, the deadweight of their bond portfolios gives central banks an unhealthy incentive to return to low interest rates more quickly than the fight against inflation would justify.
The prolonged period of artificially low interest rates has also produced an enormous inflation of asset prices. Stock and homeowners became a lot richer, but rising inequality and the young generation being increasingly cut off from home ownership led to a lot of resentment that has fed into the rise of populism.
Mortgaging the Global Economy
The financial markets have also become pervaded by moral hazard. A whole generation of investors has become accustomed to authorities bailing out the economy whenever the markets throw a tantrum.
The most perfidious effect of monetary excess has been the relentless rise of leverage in the global economy. All economic actors have been encouraged to pile up debt when money was practically free. The combined debt of consumers, companies, and the public sector had already reached a historic high of 200% of global GDP when the GFC hit in 2008. Since then, global debt has continued rising inexorably to about 240% of global GDP currently.
We have mortgaged the global economy more than two times and still we are not on a convincing path to deleveraging.
Governments and Their Money Trees
The most serious threat to financial stability is the relentless growth of government debt. When I was Minister of Finance of the Netherlands at the beginning of this century, I had a simple story to tell: the government does not own a money tree, higher government debt will inevitably lead to higher interest rates, and rising interest costs will crowd out much more useful public spending. However, this story no longer held up when central banks indeed started providing a free money tree to governments, allowing them to borrow at zero or negative interest rates. Predictably, fiscal discipline suffered almost everywhere.
In Japan, the first industrialized economy that started experimenting with QE, public debt is now more than 260% of GDP. Nobody knows if this humongous debt can stay manageable, with inflation and interest rates going up. In Europe, big economies like the UK, Italy, France, and Spain are all struggling with public debts of more (or far more) than 100% of GDP. These countries will struggle to service their debt while at the same time having to meet the costly challenges of their ageing societies and the bitter necessity of increasing military expenditures. Their exhausted public finances are one of the reasons why economic growth in Europe has practically come to a standstill.
From Free Money to a Tough Road Ahead
The only country that keeps on defying economic gravity is the United States.
Despite a public debt of Italian proportions, the American economy is still performing strongly. The stellar performance of the U.S. economy owes a lot to its incredibly flexible labor market, its entrepreneurial culture and the U.S. being a magnet for talent from around the world. But American growth is also artificially fired up by an outsize budget deficit of more than 6% of GDP.
While the dollar’s status as reserve currency allows the US to get away with less fiscal discipline than other countries, interest on its growing debt will become an increasing burden on the American economy.
The age of monetary excess lasted long, and we can expect its hangover to fester on for a long time too.
Monetary policy is exhausted, and it is increasingly clear that central banks may have been too quick in declaring victory over inflation. Public finances are exhausted too, and there are increasing signs that the bond markets are becoming less and less tolerant of fiscal profligacy.
Public authorities will have to face the hard choices that free money has allowed them to dodge for too long.