Fresh QE won't stop global recession
I have to apologise because this article will not be easy to read. I will try my best to explain things in the simplest way possible. However, global financial issues are difficult and complex in nature. If you feel that you do not want to be bothered with the complexity of the issue, I will give the conclusions of today's article now.
The first conclusion is that new efforts to save the world economy from recession will fail, because central banks are no longer as powerful as before. A global recession is unavoidable.
The second conclusion is that there will be a wave of capital inflows into Thailand, which will push the Thai baht up even higher. A rate of 28 baht per US dollar is possible.
The final conclusion is that the financial world is at risk of another crisis. This time, it will be called a "derivatives crisis", and it will make the subprime mortgage crisis of 2008 look like a walk in the park.
Now that I have your attention, do you wish continue reading the article?
Recently, we saw another round of global quantitative easing (QE) implemented to prevent the world economy from falling into recession. The US central bank -- the Federal Reserve (the Fed) -- has cut its reference interest rate twice this year, causing the Fed Funds Rate to come down from 2.5% to 2.0%.
Prior to the Fed's action, the European Central Bank (ECB) already cut its deposit rate to minus 0.5%. Negative interest rates simply mean that when banks deposit money at the ECB, they have to pay interest -- not the (usual) other way around. The ECB is not alone --the Bank of Japan (BOJ) has been offering a negative interest rate of 0.1% since early 2016.
The global interest rate cut is meant to do two things. First, central banks want to force savers to spend, as savings will earn them low, or even negative yields. Second, central banks want to force commercial banks to lend more, as keeping money in banks will earn them low, or even negative yields. When money is spent, the economy expands.
This is quite true for the first round of QE after the subprime mortgage crisis in late 2008. Before the crisis, the world economy was expanding admirably at 4.2% in 2007. But after the crisis, world economic growth plummeted to -1.7% in 2009. The crisis triggered fears of a repeat of the Great Depression.
To avoid a recession, major central banks blindly decided to cut interest rates and pump incredible amounts of money into their respective economies. The rate cuts were spear-headed by the Fed, which cut its rate from 5.0% to zero -- an unprecedented 5% cut. In the process, the Fed injected about US$1 trillion (30.5 trillion baht) into the economy.
And the result was indeed, a success. World economic growth quickly returned to its positive trajectory. In 2010, GDP growth stood at 4.2% and has remained in the range of 2.5-3.5% ever since.
Sound like a happy ending?
Not so fast. Massive injections of money through QE do have negative side-effects. The first victim of QE was Greece. Remember the 2009 Greek sovereign debt crisis? Greece was soon followed by Spain, and then Italy.
Bailouts saved their economies. However, the effects of QE were short-lived and Europe was soon threatened with recession again, only half a decade later.
The situation is not much better in Japan. That is why the ECB and the BoJ pushed their interest rates into negative territory. With clearer signs of a weakening economy, the Fed has recently chopped its own interest rate. US President Donald Trump strongly criticised the Fed, saying the move is "too late, too little". He then suggested the US Fed Fund Rate should be cut to -0.5%, just like in the EU. Therefore, one could expect more rate cuts from the Fed.
QE worked before. Will it work again this time? I am afraid not, for two reasons.
First, central banks do not have much room to cut rates. Take the case of the US -- the Fed cut interest rate by 5% in 2009 in order to save the American economy. But the Fed Funds Rate is now at 2.0%. The maximum possible cut will only by 2%, which experts agree is not enough. The ECB and BoJ are in much worse positions as their interest rates are already negative. In other words, central banks are now powerless to stave off recession.
Second, even if central banks manage to pump more money into the economies, who will be spending the money, given the current situation? Interest rates have already been negative in Europe and Japan for years and people there are not responding. Economists call this situation a "liquidity trap", as liquidity becomes worthless. The answer is clear -- this new round of QE will likely be ineffective.
Even though QE will likely not work, it will create havoc in smaller countries like Thailand. Increases in global liquidity will cause large capital inflows into certain countries. Last week alone, the Fed injected $120 billion into the US money market in order to drive down interest rates. The ECB announced it will inject €20 billion (about 672 billion baht) a month to keep interest rates negative, while the BoJ said it will continue its monthly 250-550 billion yen (between 71.2 to 156.6 billion baht) bond-buying programme. Do you want to guess where all the excess liquidity will go? Internationally. The new round of capital inflows will result in a much stronger baht and a boom in the stock market.
The situation indicates that there is too much money in the global financial system. When money is not being funnelled into production and/or consumption, it goes into speculation. An early indicator of this phenomena is price bubbles, for example in real estate and stock markets.
The Great Depression was caused by stock markets crashing. Something similar is under way, but this time the object is not stocks. Instead, it is an investment instrument called "derivatives". Let me frighten you with numbers. Common stocks in the whole world are now worth $68.2 trillion, but global derivative investments are valued at $542.4 trillion. If the collapse of stock markets caused a worldwide depression, imagine what the collapse of a system that is eight times bigger could do.
I hope you all have a good day.
Chartchai Parasuk, PhD, is a freelance economist.
Chartchai Parasuk, PhD, is a freelance economist.