CHAPTER 2

Central Banks Don’t Print Growth

“It’s true, you can do anything you want to do”

—Phil Lynott

A liquidity trap is a situation when expansionary monetary policies, such as the increase in money supply, fail to stimulate economic growth because economic agents prefer to hold on to cash at any given rate, even with negative real interest rates. This happens because of the fear of more adverse events and the lack of attractive opportunities to deploy funds.

If there is a clear example of what a liquidity trap is, we can find it in the European Union.

Since the launch of QE in January 2015, until the end of 2016, the ECB has expanded its balance sheet by more than €2 trillion to reach 35 percent of the eurozone GDP.¹ While growth and inflation expectations have been revised down, the excess liquidity has soared to €1.1 trillion.

In terms of monetary aggregates, the increase in M3² was lower than 4 percent (annualized in 2016). Loans to the nonfinancial sectors grew a meager 2 percent.³ All this with the greatest monetary stimulus seen since 2008.

What about inflation? It increased from 0.4 percent in September 2016 to 0.6 percent in December 2016. But this was fundamentally because of the cost of energy. Draghi himself recalled that “there are no convincing signs of recovery of underlying inflation” (January, 19 2017 ECB conference)—that which excludes energy and food.

The velocity of money (nominal GDP/M2)—which measures economic activity—is at multiyear lows and more liquidity and low rates do not help improve it.

Quantitative easing is disinflationary for prices because it sinks interest margins of banks by artificially lowering bond yields and makes economic agents behave with more caution—not rush to spend or to borrow—due to the perception that the cost and the quantity of money are artificial. But it is very inflationary in financial assets.

What these figures tell us is that growth is still very poor and the huge amount of monetary stimulus created from the central bank does not have the effect that its defenders promised. The ECB’s balance sheet soared to €3.58 trillion, more than €400 billion above its 2012 high, and the accumulation of risks is more than evident, even if many decide to ignore them.

At the end of 2016, the ECB owns almost 10 percent of all the eurozone government bond market and 9 percent of the corporate debt, and that figure could double in one year.⁴

However, owning all those bonds has done nothing to improve economic conditions. Credit growth has remained subdued, broad money supply has stalled, which means that credit is not growing, and investment in the real economy has continued to decrease.⁵

As Fitch Ratings notes, investment in the economy in the eurozone remains 8 percent below 2007 levels and they cite “the crisis” as a reason but “pessimism about the medium-term growth outlook for the eurozone may also have played a part.”⁶ Fitch also notes that the outlook for business investment remained uncertain after two years of massive monetary stimulus. Investors polled in Fitch’s annual senior investor survey stated they were “increasingly downbeat on companies’ capital investment plans” and only 2 percent of those polled expected corporates to focus significantly on capex.⁷

As such, investors did not take more risk because liquidity was soaring and corporates did not invest more—because it was not needed. These economic agents decided to save more, to focus on strengthening the balance sheet and, in the case of investors, hoard negative-yielding bonds.

Why is it that families and companies do not decide to take on more debt and increase investment if rates are ultralow and liquidity is plentiful?

Because the central bank ignores the problem of overcapacity, which remains above 20 percent in the eurozone,⁸ and the public perception that despite artificially low rates and manipulated money supply, economic conditions remain difficult. But also because the middle class suffers as real wages stall and labor market conditions become more uncertain. Therefore, solvent credit demand does not increase.

This is an important factor. It is not that the eurozone is not investing or that there is no demand for credit, rather the contrary—it simply is not as much as the central bank assumes it should be.

Why?

The central bank estimates that the rate of savings to investment is “too low” and therefore it must lower interest rates and help free the balance sheet of banks by purchasing their government bonds. However, the main problem is that the ratio of savings to investment is considered “low” only because the policy makers are comparing it to the bubble period⁹—the excessive accumulation of debt and poor allocation of capital from 2001 to 2007 that led to the crisis.¹⁰ If one assumes a normalized credit decision process, we can perfectly understand that the deleveraging process of the real economy is not only healthy but also essential to avoid another crisis.

But all this would be fine if the liquidity trap would not simultaneously generate very negative consequences.

What Negative Consequences?

Government bond yields in the eurozone have fallen to all-time lows with the purchasing program of the ECB. The inflow of capital into risky assets soars¹¹ and risk premiums collapse, while financial asset valuations rise.¹²

As such, even if there is excess liquidity, yields are low, and the “risks” have been contained, the central bank cannot stop its purchase program or adjust it per the new reality because of the fear of a market crash. The central bank did not function as a transmission mechanism to improve the real economy, but as a perpetuator and instigator of yet another financial asset bubble.

The financial bubble is such that if the ECB decided to cut its purchase program to absorb the excess liquidity in the system, it could cause a market collapse because investors, who have been hoarding government bonds at unsustainably low rates and equities unsupported by fundamentals, would immediately trigger a sell-off.

If we make an analysis of the eurozone crisis, there was never a liquidity problem. The ECB had €120 billion in excess liquidity when the QE program was launched. Spain and other peripheral countries were already regaining strength and growing above the EU average. There was a problem of confidence in the survival of the eurozone and a large problem in the banking system, which at the peak of the crisis had total assets exceeding 320 percent of the eurozone GDP and nonperforming loans of more than €200 billion.¹³

These problems could have been contained with the same words—and no asset purchases—that Mario Draghi famously pronounced, “We will do whatever it takes and it will be enough,”¹⁴ and with a series of targeted liquidity programs (TLTRO)¹⁵ specifically designed to act as support for banks to reduce their imbalances and improve balance sheet while preventing the perverse incentive of perpetuating those same imbalances. A Europe-wide Troubled Asset Relief Program (TARP) program focused on return via dividends—a loan that has to be repaid and at the same time includes monitoring of actions—would have been equally effective without the liquidity trap risks. This system would have served as an effective tool to recover credit to SMEs and the real economy while providing effective penalties for the wrong use of the funds.

The ECB, I must say, has implemented its monetary policy because it was a clamor coming from the overindebted governments, not so much because the chairman and the committee believed liquidity measures were urgent. Proof of that is that asset classes and markets stabilized rapidly months before the ECB purchased a single bond, after the commitment to the euro was categorically affirmed by Mr. Draghi.

At least Mr. Draghi takes every available occasion to remind nations that they must implement structural reforms to make the central bank policy work. The ECB has also applied several measures to avoid excess risk-taking or incorrect use of funds, such as costs for holding unutilized liquidity and adding holdings of government bonds to increase margins through carry trades. But they are timid, and have not prevented the massive bubble.

Ask yourselves one question. Does anyone really believe that many peripheral European countries’ government bond yields should be below the U.S. 10-year bond? Granted that some of those countries saw those bond yields soar to unjustified levels when doubts about the survival of the euro flooded the market, but since those fears were eradicated, bond yields in countries such as Portugal, Spain, and Italy have fallen to the lowest level on record because the ECB buys as much as it can from any issuance. In many cases, the ECB absorbed entire new issuances from sovereign bonds.

At the pace of purchases of government bonds seen in 2015 and 2016, the ECB would own the entire debt of the eurozone in 11 years.¹⁶

But This Is a Good Thing, Right?

If the central bank owns all the debt, governments will be able to spend freely without the constraints of market volatility and investor confidence. Think again. In 2017 alone, the eurozone needs to refinance €1.1 trillion of debt and, even with outstanding monetary stimulus, it has €125 billion of interest payments.¹⁷ Japan, which we will discuss in a separate chapter, spends 22 percent of its budget in interest payments despite having close-to-zero interest rates for 19 years.

Deficit spending is not free even if central banks monetize all the debt. It has a very steep cost, via either economic stagnation, or stagflation.¹⁸

Draghi cannot be criticized for his work, which has been exemplary when it comes to highlighting challenges and risks. When he analyzed the eurozone’s macroeconomic and monetary situation in 2016, he confirmed a very fragile environment and disappointing figures.

The European economy will grow by 1.7 percent each year in 2016 and 2017 and by 1.6 percent each year in 2018 and 2019. Despite flooding the system with liquidity, expectations have not increased. And we must note that the ECB has revised down its estimates of growth and inflation every year since 2011.

The Risks

The eurozone accumulates more than €4.2 trillion in bonds with zero or negative rates, according to Bloomberg.¹⁹ See Figure 2.1.

The “inflation” that the media tells us does not exist, lies in the huge bubble of bonds and ultralow bond yields. This accumulation of risk is exactly as dangerous as that between 2006 and 2008 but potentially more difficult to contain. This is because economic agents—particularly governments, which are much more indebted—are not in a better position of solvency and repayment capacity today than they were in that period. This leads to inefficient and heavily indebted governments falling into the trap of thinking that cheap money will always exist and deciding to increase their imbalances, which adds to deficits and increases the risk of a debt shock when rates rise.

Figure 2.1 Negative-yielding bonds worldwide

Source: Fitch Ratings, Bloomberg.

If EU countries get used to ultralow rates, the risk of multibillion nominal and real losses in bond portfolios and pension funds is enormous, because the tiniest tilt in inflation will make the house of cards collapse. Goldman Sachs estimates losses of $2.5 trillion worldwide from a 1 percent rise in inflation.²⁰ It is so relevant that if interest rates raised a stunted 1 percent in the European Union, it would lead to massive budget cuts to maintain current deficits.

Of course, Draghi does not stop repeating that this period of excessive liquidity must serve to correct imbalances and implement structural reforms. But no one seems to listen. Cheap money calls for cheap action. More “fiscal stimulus” and more spending.

The problem is that the structural challenges of the European economy—demography and overcapacity—are not solved by perpetuating imbalances, because governments and economic agents simply get used to seemingly temporary measures as if they were eternal.

What is troubling is that most European countries are not prepared for the end of QE. They are geared to its extension.

The Fallacy of the “Wealth Effect”

At this stage, I believe it is important to make a differentiation between the placebo effect of quantitative easing and real stabilization.

In 2012, Reuters’s Pedro Costa asked Ben Bernanke, chairman of the Federal Reserve, the following question:

Speaking to people on the sidelines of the Jackson Hole conference, the concern about the remarks that you made is that they could clearly see the effect on rates and they could see the effect on the stock market, but they couldn’t see how that had helped the economy. So, I think there’s a fear that, over time, this has been a policy that’s helping Wall Street but not doing that much for Main Street. So, could you describe, in some detail, how does it really differ from trickle-down economics?²¹

The answer is revealing:

This is a Main Street policy, because what we’re about here is trying to get jobs going. We are trying to create more employment, we are trying to meet our maximum employment mandate, so that’s the objective. The tools we have involve affecting financial asset prices, and those are the tools of monetary policy. There are a number of different channels—mortgage rates, interest rates, corporate bond rates, but also the prices of various assets, like, for example, the prices of homes. To the extent that home prices begin to rise, consumers will feel wealthier; they’ll feel more disposed to spend. If house prices are rising, people may be more willing to buy homes because they think that they’ll make a better return on that purchase. So house prices is one vehicle. Stock prices—many people own stocks directly or indirectly. The issue here is whether or not improving asset prices generally will make people more willing to spend. One of the main concerns that firms have is there is not enough demand, there’s not enough people coming and demanding their products. And if people feel that their financial situation is better because their 401(k) looks better or, for whatever reason, their house is worth more, they are more willing to go out and spend, and that’s going to provide the demand that firms need in order to be willing to hire and to invest.

This looks interesting, but it does not work.

Financial repression inflates the price of financial assets but at the same time destroys the purchasing power of the currency, and devalues the wealth accumulated in deposits.²²

Over 81 percent of stock wealth is held by the top 10 percent of the population. In fact, over 80 percent of U.S. citizens have 9.9 percent or less of their wealth in stocks.²³ (In the European Union or in Japan it is even lower.)²⁴ That same overwhelming majority of U.S. citizens have most of their wealth in deposits, which got completely obliterated with the policy of devaluing the currency.²⁵ Meanwhile, real salaries decline²⁶ and the ability of the middle class to pay debts and mortgages shrinks.

At the same time, rising house prices do not create a “wealth effect” to borrowers with a mortgage, and they certainly make it more difficult for nonowners to get into the so-called property ladder. It is no surprise that throughout the housing recovery in the United States the number of homes bought without any mortgage rose dramatically.²⁷ Quantitative easing benefits most those who have access to the rising financial assets and to leverage. That is, the super-rich. It is no surprise that the left media complains about rising inequality. Quantitative easing is basically supporting the wealthier at the expense of the savers. The problem with the media is that they see inequality and demand even more so-called “expansionary” measures as the solution.

The idea that rising stock markets, lower bond yields, and higher house prices benefit main street is simply ridiculous. And the rise of populist alternatives like Bernie Sanders and the victory of Donald Trump in the 2016 elections are further proof that the “economic miracle” simply did not reach the middle classes.

At least trickle-down economics²⁸ has some merit and reality to it. During the Thatcher mandate in the United Kingdom, real income per capita rose by over 34 percent, including for the poorest segments—this, with two recessions, a war, and 11 percent unemployment. Thatcher lowered taxes (from the top marginal rate of 83 percent to 40 percent) but kept tax revenues at 40 percent of GDP. Under Reagan real per capita disposable income increased by 18 percent from 1982 to 1989, meaning the American standard of living increased by almost 20 percent in just seven years. The poverty rate declined every year from 1984 to 1989, dropping by one-sixth from its peak.²⁹

Good idea. Instead of printing money so that governments and speculators get wealthier, let us create money for “the people.”

The Disaster of “People’s QE” and Modern Monetary Theory (MMT)

“Money is the general medium of exchange, the thing that all other goods and services are traded for, the final payment for such goods and services in the market”

—Murray N. Rothbard

The apparent failure of expansive monetary policies created a “new” school. I say new with irony because it is the oldest school in history, to create money out of nothing to finance “the people.” And “the people” being, of course, the government.

It is called the modern monetary theory but it is just the same thing that has been done many times in history from the French Assignats, to the policies of Allende in Chile,³⁰ Kicillof in Argentina,³¹ or Maduro in Venezuela.³² And with the same results—massive inflation, destruction of currencies, then blaming “speculators” for the stagflation, and finally, bankruptcy.

Because there is nothing “social” about mass inflationary policies. From Allende to Kirchner and Maduro, printing and inflating is not a social policy; it is theft.

The indiscriminate creation of money not supported by savings is always behind the greatest crises, and there is always someone willing to justify it as both a problem and its solution.

We must understand what money is and why “creating it” artificially without support destroys more than it apparently improves.

Money is a means of exchange and payment that must be widely accepted. If citizens lose confidence in its value due to manipulation, it disappears as a means of exchange, a store of value, and unit of account. That confidence is not dictated by a committee or a government by decree.

Money in its function as a means of exchange facilitates trade, preventing barter. When its value is questioned, when it loses its place as a reserve, the economy is destroyed, going from crisis to crisis, which are becoming faster and more violent.³³

There are very evident examples of currency crisis generated by reckless increase in money supply with no respect for the warning signs of inflation and devaluation. Maduro’s Venezuela (Figure 2.3), Zimbabwe (see Figure 2.2), Kirchner’s Argentina, the Assignats disaster in the French revolution, the Weimar Republic—all those examples generated mass poverty, scarcity, out of control inflation, and widespread loss of confidence in the currency.

Figures 2.2 Evidence of the impact of reckless money printing on inflation

Source: Dallas Fed, IMF.

Figure 2.3 Evidence of the impact of reckless money printing on inflation

Source: Dallas Fed, IMF.

Inflation is always a monetary effect. It is the symptom of a clear imbalance.

Money Versus Inflation

Money, when created from the expansion of artificial credit is also destroyed—a serious financial crisis, defaults, falling real assets—based on unjustified expectations.

Whether that artificial money creation is through credit to governments, people, or companies, the outcome is the same. The distortion generated by inefficient allocation of capital has the same effect.

Modern monetary policy advocates using the expansion of the central banks’ balance sheet for helicopter money, that is, to give newly created money directly to the people—and for financing government spending. It is the same mistake as QE but it shifts the imbalance from financial markets to the average citizen.

It sounds promising. The central bank “creates” new money and gives it to every citizen, so they can spend. This boosts consumption and improves the economy. Except, it doesn’t. The currency devalues and imports, goods, and services become more expensive. The economy does not receive the boost that the media and inflationist economists estimate because the negative effect of rising prices lowers the assumed impact on consumption and also because some citizens will decide to save that money. Even in contained environments like the cities in Europe that have created local currencies to boost regional consumption, there is no evidence of any improvement in either the economy or its ability to endure crises.³⁴

Consider the example of Argentina, which has seen an inflation of 350 percent since 2008 from what the government called an “inclusive” policy of creating money to pay “employment and public investment,” increasing money supply by 30 percent per year.

But the desire to think that making money out of nothing “creates wealth” and has no consequences is simply a pseudo-religious prejudice, not a reality. Any analysis of the creation of money and inflation shows that the effect is evident and that it always ends with a financial crisis, higher inflation, and greater unemployment. The “placebo effect,” the illusion of growth that is created shortterm, erupts with a major crisis in a short period of time.

What the socialist inflationists of the MMT school forget is the effect of saturation of debt and the impact of the continuous creation of money on money velocity, which measures the economic activity.

Creating money to subsidize hypertrophied states or to perpetuate the misallocation of capital of private agents are the same. An additional unit of indebtedness does not generate enough nominal GDP growth to reduce debt accumulation, even if the stock is monetized; it fuels the next shock with greater virulence.

The relationship between money creation and inflation since 1960 is direct as can be seen in “Inflation versus M2 Money Supply from 1960.”³⁵ See Figure 2.4 with more recent data.

The saturation effect and the manipulation of capital allocation in the economy favoring specific sectors designated by the government plunge economic activity, as financial repression and the tax burden on families and companies increase. Input costs soar, tax burden increases, expansion cycles are shorter, and margins are weaker.

But the theory is based on the idea that if “the government spends, economic activity increases and there is a multiplier effect.” Public spending multiplier has been proven to be inexistent, even negative, in many studies. In the experience of more than 44 countries it is shown that the multiplier effect is nonexistent in open and highly indebted economies.³⁶

Figure 2.4 International data on inflation and money growth (N. Gregory Mankiw)

The accumulated deficit means higher taxes later. Consumer preferences, given financial repression, do not improve because the government spends. Government spending only generates more overcapacity and consumers spend less knowing taxes will rise. The new monetarists forget that their recommendation is precisely what led Brazil and China to industrial overcapacity of 27 percent and 38 percent respectively.³⁷ And these are not populations with demographic problems.

Growth is not poor due to lack of public spending, which, globally, is at its highest in 50 years. It is poor because of the attack on the consumer through taxes³⁸ to pay for said expense and the assault on the saver through financial repression by means of devaluation and lowering of rates.

Other examples of the disaster that “creating money for the people” were seen in Chile with Allende, Zimbabwe, and Venezuela. The perpetrators of this disaster always call it “economic warfare”—accusing businessmen or speculators of the consequences of monetary irresponsibility.

To flood the public sector with “new” money without any sterilization,³⁹ monetizing everything, which is called “Popular QE,” is the same madness and has the same effects.

It assumes that the central bank loses its already-questioned independence and directly becomes a government agency that prints money when the government wants, but that increase of money supply does not become part of the transmission mechanism that reaches all parts of the economy; the new money is only for the government to finance a “Public Investment Bank.”

The mistake of the socialist monetarists of the popular QE is that their theory starts from the correct argument that monetary expansion as we know it today does not work. However, instead of understanding that printing currency is simply an unjust transfer of wealth from savers to the inefficient and the indebted, they do not see monetary expansion as the problem, but the distribution mechanism. So, they want to avoid any transmission mechanism and create money directly for governments.

The first problem is obvious. The central bank would create money without any backing, which is the equivalent of a bank lending without any assets. And that money would be used for white elephants—massive public spend projects without any evident economic return because if there was one it would have been invested in the past. The public investment bank would provide unlimited funding, generating elevated risks of irresponsibility in spending. And it is an obvious displacement of incentives to waste money. But it would also generate disproportionate negative effects on the private sector as unfair competition would mean that the only sectors that would survive would be the ones attached to governments (what we know as cronyism).

The second problem is that this public bank’s mounting nonperforming loans from lending to projects without profitability will be covered with taxes to citizens and the private sector.

The third problem is that inflation created by these projects is a burden on the disposable income and purchasing power of the citizen who does not benefit from this expansion of “unlimited” spending. Taxes rise, cost of living soars and, above all, a large part of the business fabric gets destroyed, because the government has unlimited privileged credit. To think that this inflation leads to higher salaries is a fallacy that is demonstrated by history. It has always proven that real wages fall to historic lows.

This policy, as we have said, has been implemented many times in the past, and every time with disastrous consequences. It is the model that sank the French revolution with the Assignats⁴⁰ and the Argentina of Cristina Fernández de Kirchner and her minister Axel Kicillof.⁴¹ It is a model that has only created massive inflation and recession, or, stagflation.

To think that the government can decide the amount of money it needs and spend it on what it wants without dramatic negative consequences is simply science fiction.

Aristocrats of public spending, who have never created a company or hired anyone with their savings and effort, always think that intervening in the creation of money and in the economy will save everything.

Do they know? Of course, they do. They do not care, because for them the State is infallible and the objective of political dominance of the economy excuses every other mistake. “Socialism has a history of failures so brutal that only a group of pseudo-intellectuals can ignore it and say that they will make it different.”⁴²

Increasing money supply more than the historical growth of nominal GDP always creates huge imbalances that lead to a great crisis.

The MMT is not new. It is the same old search for unlimited economic government control at all costs financed at the expense of all others.

Ecuador Avoids Depression by Not Printing Money

Gabriela Calderón de Burgos explained how Ecuador, unable to print “money for the people,” avoided depression by having its currency pegged to the U.S. dollar, and, in turn, escaped the monstrous inflation and monetary disaster of Venezuela and Argentina.⁴³

Government officials repeated that they had managed the economic recession even being tied up for not having their own currency.

What would have happened if, from the beginning of the problems in 2014, instead of having been dollarized Ecuador would have had a national currency and followed the monetary policy of its ideological partners Venezuela and Argentina?

Politicians would have tried to combat the economic cycle, spending more, printing money while foreign currency inflows collapsed, and trying to monetize the expense, leading to a massive depreciation of the currency.

The Ecuadorians would have reacted by rejecting such a currency that loses value every day, as Argentinians and Venezuelan citizens have, in search of another that maintains value. This would have led, like in the countries mentioned, to massive withdrawals of the Sucre—the Ecuadorian currency—from banks to buy U.S. dollars, gold, or any other value reserve option.

This is not counterfactual. It happened in the late 1990s, when the Central Bank of Ecuador (BCE), seeing the fall of the Sucre against the dollar, intervened in the foreign exchange market to try to stop its decline, spending all its foreign currency reserve in the process and fuelling depression and massive inflation.

Seeing reserves fall, people become even more nervous and withdrawals accelerate. When this happened in Ecuador, the central bank sought to curb capital flight and withdrawals of deposits by raising the interest rate. It did not stop the stagflation process.

How much did they issue? In 1996 money supply registered an annual increase of 51.2 percent; in 1997 it was 28.2 percent; in 1998, 38.6 percent; and in 1999, 149 percent. Along with this orgy of money creation came the galloping inflation, which went from 24 percent in 1996 to 52 percent in 1999 and to 96 percent in 2000.

It should be noted that the huge increase in money supply created such a depreciation of the currency that it triggered a bank run and massive capital flights. The central bank lent the banks so they could pay their customers, who desperately wanted to convert their Sucres to dollars. The currency, economic, and financial crises were halted in January 2000 when dollarization was adopted.

From 2014, when the government budget reached its peak and the fall in oil prices began, Ecuador’s funding gap rose considerably. Spending cuts ensued but they were not enough, avoiding inevitable and deeper structural adjustments.

In its stubbornness, the Ecuador government replaced high oil revenues with an aggressive increase in public debt at high rates. Money is never enough, and it is easy to assume that if, for example, during 2015 to 2017 the Ecuador government had counted with its own currency, much of the financing gap would have been covered by a significant increase in money issuance and a spiral of aggravating phenomena similar to or worse than the ones seen in 1999.

Despite the increase in debt, which stands at 33 percent of GDP, still below that of other countries in the area, dollarization has allowed Ecuador to pass the rout of oil prices with moderate inflation and much less economic pain than faced by Venezuela or Argentina, and without destroying the country’s finances. Far from complaining about dollarization, government officials should recognize that it was the best economic reform introduced in the country.⁴⁴

What Next?

Monetary and fiscal stimuli have been implemented with the objectives of spurring growth and reducing imbalances caused in the previous crisis, and to help reduce debt.

However, at the end of 2016 global debt exceeds $217 trillion or 327 percent of GDP, and in the first nine months of 2016, global debt increased by $11 trillion, $5.3 trillion of which was from governments. Global debt has increased by more than $67 trillion in the eight years of the stimulus and deficit spending bonanza.⁴⁵

The monetary laughing gas machine has not delivered, and its consequences are felt all over the world, as seen in emerging markets: currencies collapsing, commodities at multiyear lows, stagflation, and so on. Years of cheap dollars flooding the markets and long-term investments financed with short-term, QE-driven liquidity created overcapacity, distortions, and bubbles bursting in slow motion in front of our eyes ahead of a rate hike of ... 0.25 percentage points!

One of the biggest difficulties that the OECD faces is that it has launched massive stimulus plans that have ballooned the balance sheets of central banks, and price inflation has not been created, while growth remains more than disappointing. This is what I call the three Ls: “low interest rates, low growth, low inflation.”

In the stimulus period the G7 countries alone have added almost $18 trillion in debt to a record $140 trillion, with nearly $5 trillion from the expansion of the balance sheets of their central banks, to produce only $1 trillion of nominal GDP. That is, in five years, to generate $1 of growth the G7 have “spent” $18, with 30 percent coming from central banks.⁴⁶

To try to tackle the “crisis,” the central bank prints money—expands credit—to buy bonds from the financial system and private sectors in order to “alleviate” the balance sheet of the banks and help credit flow to the real economy.

However, by perpetuating this, the central bank has made the mistake of becoming the largest single purchaser, thus sustaining “bubble” valuations.

First mistake: The central bank buys bonds with a valuation that is significantly higher to fundamentals. Therefore, although these asset purchases generate a return—the central bank receives coupons of those bonds—the market price of the principal is justified only by the fact that the central bank buys most of the supply.

Imagine you have a market and one single buyer acquires all the products irrespective of demand. Prices go through the roof because this “superbuyer” inflates them. Then, when it stops acquiring those products, what happens in the market? Exactly! Prices fall too aggressively. So the superbuyer needs to keep buying to avoid a massive collapse in prices that he himself inflated.

Second mistake: thinking that the previous valuation was unjustified. By extending monetary policy and asset buybacks for years the central bank goes from buying “bargains” that actually traded at an unjustified discount, to purchase “whatever” is available. And it generates a bubble in bonds. It creates its own trap as the possible capital loss of buying overvalued assets is “fixed” by the central bank itself, fuelling the bubble.

Third mistake: The risk curve shifts and markets increasingly pay less yield for greater risk. Thus, each new program of monetary expansion generates two perverse effects: Banks and investors still prefer bonds and liquid assets, and invest less in the real economy; and, the central bank is forced to perpetuate the asset purchase program in order to avoid another financial crisis. That is why money velocity collapses.

After all, excessive risk-taking, be it by the financial sector or by the central bank, is the same. The imbalances that are generated are similar. However, if the financial system creates an asset bubble, it is spread among a large number of entities with different risk exposures. If the central bank feeds the bubble, especially in sovereign bonds, it creates more financial repression, printing more for longer at the expense of taxpayers and savers, whether through a lower value of the currency, more inflation, or through higher taxes.

That is why the words of Mario Draghi are so important: “Monetary policy cannot replace reforms. It is crucial to have cooperation between economic policy and structural reforms.”⁴⁷

Central banks cannot print growth. They may buy some time, but the effect, like monetary laughing gas, is short-lived.

One of the most dangerous statements we usually hear is that “fundamentals have not changed.” They have—a lot.

If we analyze the global growth expectations of international organizations, the first thing that should concern us is the speed and intensity of downward revisions. In the United States, for example, we had an expectation of growth of 3.5 percent revised to 2 percent in less than six months in 2015. If we looked at the revision of the estimates for the fourth quarter of 2015 of the major economies of the world, they were downgraded by 40 percent in less than 20 days.⁴⁸

Not surprisingly, the IMF and the OECD cut their expectations almost every three months. Can they be wrong? Yes, but if we look at history, they have mostly been optimistic, not cautious.

This downgrade process is not over.

China is one of the key reasons. The global economy has geared itself to justify huge investments to serve the expected Chinese growth, ignoring its fragility. China, with an overcapacity of nearly 60 percent and total debt already exceeding 250 percent of GDP,⁴⁹ has a financial problem that will be dealt only with large devaluations and lower growth. That landing will not be short. An excess of more than a decade is not resolved in a year. This exports disinflation to the world, as China devalues and tries to export more, and when the “engine of the world” slows down because it ends an unsustainable model, the world is left with the excess in global installed capacity created for that growth mirage. Commodities fall and mining- and energy-dependent countries suffer.

Consensus economists have consistently overestimated the positive effects of monetary policy and expansionary fiscal measures, and ignored the risks. Emergency measures have become perpetual, and the global economy, after years of expansionary policies shows three signs which increase fragility.

Excess liquidity and low interest rates have led to increase in total debt by more than $67 trillion, led by growth in public debt of 9 percent per annum, according to the World Bank.⁵⁰

Second, industrial overcapacity has been perpetuated by the refinancing of inefficient and indebted sectors. Governments do not understand the cumulative effect of this overcapacity because they always attribute it to lack of demand, not misallocation of capital.

In 2008, there was an overcapacity problem mainly in developed countries. With the huge expansion plans in emerging markets, overcapacity has accumulated and has been transferred to two-thirds of the global economy. Brazil, China, the OPEC countries, and Southeast Asia join the developed nations in suffering the consequences of investment in huge white elephant projects of questionable profitability “to boost GDP.”

Financial repression has not led to the acceleration of activity from economic agents. Currency wars and manipulation of the amount and price of money make the velocity of money slow down. Because the perception of risk is higher, and solvent credit does not grow, as the average cost of capital⁵¹ is still greater than expected returns, causing debt repayment capacity to shrink despite lower rates, according to Fitch and Moody’s.

A balance-sheet recession is not solved with more liquidity and incentives to borrow. And it will not be solved with large infrastructure spending and wider deficits spending.

Offsetting the slowdown from China and emerging markets with public spending is fiscally impossible.

Most economies have exceeded the threshold of debt saturation, when an additional unit of debt does not generate a nominal GDP increase.

The global need for infrastructure and education is about $855 billion annually, per the World Bank.⁵² All that extra expense, if carried out, does not make up for even half of the impact of China slowing down to a sustainable growth level, even if we assume fiscal multipliers that are more than discredited by reality.⁵³

China’s share in global GDP is about 16 percent;⁵⁴ its slowdown to sustainable growth cannot be compensated with white elephants elsewhere. This is not pessimism; it is mathematics.

Monetary laughing gas only buys time and gives the illusion of growth, but ignores the imbalances it generates. Financial repression encourages reckless short-term borrowing, attacks disposable income, and is accompanied by tax increases that affect consumption.

The capital misallocation created by excess liquidity and zero rates has led to a credit bubble in high-yield and sovereign bonds, masking their true ability to repay. Looking at the figure globally, maturities of corporate and sovereign bonds to 2020 are nearly $20 trillion. Up to 14 percent of those are considered “nonperforming.”⁵⁵

With all these elements of fragility, it is normal to assume we face an environment of low growth, but there are reasons to doubt a global recession.

The Chinese problem is mostly in local currency and within its financial sector, reducing the risk of contagion to the global financial system.

Dollar reserves in emerging countries only fell modestly and remain at record levels after a 50 percent collapse in commodity prices.

Although default risks in emerging markets, mining, and commodities rose, the combined total failed to reach a fraction of the extent of the real estate bubble risk in 2008.

Consumption continues to increase due to the growth in the global middle class and the effect of technology, which provides efficiency and good disinflation.

This is a slowdown from oversupply, not a credit crunch led by financial risk, and as such it puts in question the possibility of a global recession. But increased consumption will not compensate for the saturation of the obsolete indebted industrial growth model.

The global economy faces a long period of weak growth, but we should not confuse it with a global recession. Repeating the mistakes of the past will not change the landscape—it will perpetuate it.

Negative real rates will not stimulate investment. They slow lending to the real economy and encourage short-term speculation.

The exit from a balance-sheet recession is not going to come from the same mistake of increasing public spending and adding debt. It will only be solved when increasing disposable income of households, not attack it with financial repression, becomes the main policy objective.

But this is the great mistake—to think that, because “nothing has happened” so far, it will not happen again. Economist Alan Taylor shows how credit booms lead to both financial crises and longer and deeper recessions than normal.⁵⁶ Financial crises were common in the nineteenth and early twentieth centuries, happening about every 15 to 20 years, and following the end of the Bretton Woods System, the world has seen twice the number of financial crises, although—and this is important—they have become more frequent and less severe.⁵⁷ So, yes, the reader does not have to be a rocket scientist or a top economist to predict that, at some point in the next five years, there will be a major financial crisis. The difficulty is to predict when.

Bubbles are not difficult to see. The challenge is to understand when they will be pricked.

The main lesson from this chapter is that monetary policy may have some effect when panic and contagion risk are unjustified, like in the breakup of the euro, but can soon become a trap by providing perverse incentives to prolong imbalances.

The fact that those perverse incentives exist with the transmission mechanism of commercial banks does not make the same policy without such mechanism any more effective. It creates different, and equally dangerous, negative incentives.

For investors, the main lesson from the European experience with QE is that “Buy the Dip” mentality does not work if fundamentals don’t improve.

The European QE experience yielded strong returns for bond investors but resulted in a value trap for equity investors. The main reason was that, while in the United States financial repression was used by companies to boost share buybacks and dividends, and banks rapidly strengthened to return the loans received and escape from intervention, in Europe companies simply continued to act as if nothing had happened and banks fell into the trap of QE thinking it would be positive for earnings. And it wasn’t.

¹ ECB official data.

² Broad money supply.

³ Mario Draghi’s statement on the eurozone economy December 2016.

⁴ ECB, Reuters.

⁵ Capex in the eurozone has fallen to 2007 levels according to Morgan Stanley and Deutsche Bank.

⁶ Fitch Ratings, European Corporate Funding, October 2016.

⁷ Fitch Ratings, European Investor Survey 2Q 2016.

⁸ Capacity utilization has been below 80 percent since the crisis, and low interest rates have actually perpetuated such overcapacity as nonperforming loans were refinanced.

⁹ Even some rating agencies make their analysis comparing their data to that of 2007, when this year was the peak of excess.

¹⁰ Private debt soared to 200 percent of GDP in many European countries, and family indebtedness doubled to 1.65 times the income of a household.

¹¹ Capital inflow into bonds led to more than €4.7 trillion of negative-yielding bonds in the eurozone in 2016.

¹² The Euro Stoxx 500 Price to Earnings ratio in 2016 is at almost 18x despite five consecutive years of zero earnings growth.

¹³ European Banking Association.

¹⁴ July 26, 2012 at UK Trade & Investment’s Global Investment Conference.

¹⁵ Targeted Long-Term Refinancing Operations.

¹⁶ Assuming €80 billion of purchases per month and the eurozone maintaining its net refinancing needs.

¹⁷ Bloomberg.

¹⁸ Weak growth with significantly higher inflation.

¹⁹ December 2016.

²⁰ Goldman Sachs, Implications of Rising Inflation Expectations on Bonds, December 2016.

²¹ September 13, 2012 Transcript of Chairman Bernanke’s Press Conference.

²² Ultra-Easy Monetary Policy and the Law of Unintended Consequences. William White. Working Paper no 126. Federal Reserve Bank of Dallas, Globalization and Monetary Policy Institute.

²³ Gallup.

²⁴ Less than 6 to 7 percent according to Eurostat and the BOJ.

²⁵ The dollar devalued more than 33 percent against its currency basket throughout QE (www.forbes.com/sites/charleskadlec/2012/02/06/the-federal-reserves-explicit-goal-devalue-the-dollar-33/#5d13cbbb7865).

²⁶ Real salaries in the United States fell throughout QE and by 2016 have not recovered to 2008 levels. Meanwhile labor participation rate fell to the lowest since 1978 with more than 11 million workers leaving the labor force.

²⁷ www.doctorhousingbubble.com/americans-that-own-home-with-no-mort-gage-free-and-clear/

²⁸ Lowering taxes, cutting public spending, and letting real disposable income rise.

²⁹ Peter Ferrara, Reaganomics vs. Obamanomics. Facts and Figures. Forbes. May 5, 2011.

³⁰ The HyperInflation of Chile: Lessons for Us All, Economic Policy Journal, 2010.

³¹ Argentina: Close To Default...Again www.dlacalle.com/argentina-close-to-default-again/

³² Venezuela entered hyperinflation in 2016. It is only the seventh country in the history of Latin America to have that dubious distinction. Technically, hyperinflation occurs when month-on-month inflation tops 50 percent for 30 days straight.

³³ Loss of Confidence and Currency Crises. Willy Spanjers. Economics Discussion Papers from School of Economics. June 1998.

³⁴ Greek citizens who accepted the local system called TEM (in Volos, Greece) in 2010 have not seen any improvement in the economy or benefited relative to the rest of the country. The same is true for Bristol, UK.

³⁵ Consumer Inflation vs. Money Supply Growth 1960 to 2016 William G. Dewald, St Louis Fed.

³⁶ Ethan Ilzetzki, Enrique Mendoza, and Carlos Végh, “How Big (Small?) are Fiscal Mutlipliers?”

³⁷ 2016.

³⁸ OECD tax burden reached a historical record level in 2016.

³⁹ Sterilization: selling to the open market some of the bonds purchased by the central bank.

⁴⁰ Revolutionary France’s Road to Hyperinflation, Frank Hollenbeck, 2013.

⁴¹ A massive annual inflation of 40 percent and currency controls, printing money.

⁴² Thomas Sowell.

⁴³ El Instituto Independiente, January 2017.

⁴⁴ Gabriela Calderón writes for El Cato and El Universo.

⁴⁵ Institute of International Finance (IIF). Global Debt Monitor—January 2017.

⁴⁶ Deutsche Bank, Torsten Slok, IMF data.

⁴⁷ ECB minutes, 2016.

⁴⁸ Average annual downgrade of IMF and OEC estimates since 2001 is 20 percent from January to October, according to Bloomberg.

⁴⁹ Total debt, December 2016.

⁵⁰ World Bank 2016 Review.

⁵¹ Convertibility, currency controls and cots of capital, 1950–1999. Hans-Joachim Voth.

⁵² World Bank estimates of investment requirements, 2015.

⁵³ Ethan Ilzetzki, Enrique Mendoza, Carlos Végh, “How Big (Small?) are Fiscal Mutlipliers?” http://users.nber.org/~confer/2011/SI2011/IFM/Ilzetzki_Mendoza_Vegh.pdf

⁵⁴ 2016.

⁵⁵ Standard and Poor’s.

⁵⁶ Alan M. Taylor, “Credit, Financial Stability, and the Macroeconomy,” Annual Review of Economics. 2015.

⁵⁷ Michael Bordo, Barry Eichengreen, Daniela Klingebiel, Maria Soledad Martinez-Periaand, Andrew K. Rose, “Is the crisis problem growing more severe,” Economic Policy, Vol. 16. 2001.