William White: «Central banks cannot reverse»

«We are in totally unprecedented territory», says William White, former chief economist of the Bank for International Settlements (BIS) in Basel. Regarding unconventional monetary policy, the most dangerous side effect is the massive expansion of the balance sheets of central banks, according to White.

Mr. White, when will central Banks end their ultra-easy monetary policy?
The bias will be to keep easing, and to refrain from tightening. Monetary policy has been expansive for such a long period of time, there has to be a good reason for central banks to tighten. Otherwise it would be a repudiation of what they have done so far. There is a bias to keep easing in order to validate their previous policy.

Have central banks painted themselves into a corner?
There continues to be a lot of uncertainty about what the effects of a beginning to tighten might be. The fallback plan will be to continue to be expansive. Central banks can hardly reverse: They know that if they do tighten and everything falls apart, they are going to get all the blame – even if the underlying problems were caused by someone else, be it the government or the banks or others.

Is the economy too fragile for central banks to tighten?
Given the big expansion of debt that we have seen over the course of the last few years, particularly in emerging market countries and especially in China, but also of corporate debt in the US, the situation could be as dangerous as it was in 2007 and 2008. We simply don’t know. That is the reason why there is this enormous amount of caution about tightening. I fear that the expansionary policies that have been in place for such a long time might have encouraged imprudent behaviour to a point where even moderate degrees of tightening could cause problems.

Is it impossible to turn back?
It would be better everywhere, before the tightening starts, to do what governments should do: Fiscal expansion in the short term – where there is room – plus a credible plan to get the government deficit under control over time. Also, debt reduction in the private sector and recapitalization of banks need to be done. And in addition to that structural reforms. More attention ought to be paid to how we can reduce the fragility of the system. That means looking much more intensively at the balance sheets of banks, bad loans and so on.

Do you expect governments to play their part?
If the governments see the economy recovering, they say that they don’t need to do anything. And as long as governments think that the central banks have it under control, they are not going to do what is needed. The bias of central banks to keep easing provides encouragement for governments not to do what only governments can do.

Is there a ominous symbiosis between governments and central banks?
In most countries, government debt is very high. There will be a lot of pressure behind the scenes to keep interest rates down, in order to keep the debt service down. There are many reasons to believe that the fallback position will be more of the same.

How can central banks free themselves?
I wish that five years ago, if not longer, the central banks had said in a collective way to their governments: «You’re asking us to do something that we can’t do.» Essentially, there is an insolvency problem, an excessive debt problem. Central banks can’t handle that other than by stoking up enough inflation to reduce the real value of the debt. Central banks can deal with illiquidity problems, but not with insolvency problems. They should have said so years ago.

Is there no way out of this quandary?
In the course of the last few months I have sensed a change in the atmosphere. There is more of a willingness of everybody, both governments and central banks, to agree to what I have been saying since 2010: Easy money may not work in the way you want it to work in terms of stimulating demand. And it may have a lot of very unpleasant side effects. Recently there has been more of a willingness of governments to accept that central banks have been overburdened, and somehow we have to take that burden off them. I think this is a welcome development.

How could this take a turn for the better?
There might be a pickup in global growth that would turn out to be robust. In that case, central banks would raise short term interest rates. Long term interest rates would tend to go up as well. It is not impossible to envisage an orderly outcome, in the sense that the long rates in particular would rise in an orderly fashion.

Where are the risks in the optimistic scenario?
There are all sorts of assets that seem to me to be very richly priced at the moment, for example equities as well as corporate bond spreads. If people thought that the economic recovery was relatively robust, they would probably say that those prices got ahead of themselves but would be underpinned by faster expected growth, and therefore it was ok.

Would stronger economic growth solve all problems?
One of the risks is, that in many areas of the global economy we are not so far off full capacity already. There might be a more inflationary future. If those sorts of pressures were to emerge, the long rates could move in a rather more disorderly way. We know that when rates start to move, they often move in a momentum driven way, which means that the rate increase can be pretty sharpish. One should also know that there is a lot of concern in the financial markets because banks have withdrawn from market making, for example for corporate bonds. It’s not hard to tell a story – even in the optimistic case – of disorderly markets, that are feeding back on the expanding economy in a negative way. That could actually lead to the recovery aborting.

What would a pessimistic scenario look like?
Economic growth would continue to be weak, really as it has been for the last seven or eight years. The overhang of debt would persist. At some point, there could be a recession or a financial crisis. I hope that this would lead to governments facing up to the fact that they can’t kick the can down the road any further but have to face up to the problems.

What is the most likely end game?
Nobody really knows. We are in totally unprecedented territory.

What are the most influential measures that central banks have taken so far?
In the end, all measures are devised to lower credit spreads and to lower term spreads. The experimental character of their measures is underlined by the fact that different central banks have done different things.

What are the most important side effects of these experimental measures?
The most dangerous side effect is the massive expansion of the balance sheets of central banks. This worries me the most. It’s the most unconventional outcome. We’ve always had forward guidance of one form or another. And lowering interest rates to or below zero is unprecedented, but the idea of lowering rates is conventional.

Why are large central bank balance sheets worrying?
The problem is how this can be reversed, and what the implications might be. In May 2013 in the so called taper tantrum, interest rates increased fast and to a considerable extent, as people just started to think about the possibility of a reduction of the bond buying program, the quantitative easing. Ben Bernanke hadn’t even announced this, but only said that they should be thinking about it. And this was enough to set the bond markets off.

Is there a limit to increase central bank balance sheets?
There is no physical limit to it. A central bank can buy anything, even cars and cheese, and just pay for it, with a claim on its own balance sheet. Having said that, there are both theoretical and empirical reasons to think that there are limits.

What theory sees a limit to central bank balance sheet expansion?
The theoretical limit was discussed in a paper called «Some Unpleasant Monetarist Arithmetic» published by Thomas Sargent and Neil Wallace in 1981. Suppose a central bank is worried about rising inflation and decides to raise interest rates. But the government has a huge debt with a short maturity. By raising short term interest rates, the central bank raises the debt service burden for the government. At some point, people realise that the government can’t support the debt burden without going back to the central bank to print more money. This is a tipping point. And then you are in hyperinflation.

What evidence suggests that balance sheet expansion is limited?
Peter Bernholz from the University of Basel wrote a book called «Monetary Regimes and Inflation», where he describes a number of historic hyperinflations. As a matter of fact, they all have their roots in the theory from Sargent and Wallace. The government has got a really big deficit and a big debt, it needs to borrow. Initially, there is often a deflationary situation, where tax revenues go down and the government can’t cut the expenditures enough. If the stock of debt is too big, nobody will lend money to the government any more. And then they have to go to the central bank, to print money.

What would such an end game scenario look like?
Think Latin America, over and over again. At a certain point, people see the writing on the wall, that the situation is not sustainable. Then there is a big increase in inflation. The currency takes a hit, the demand for money plummets, and everybody is trying to get out.

Some critics argue that the ECB has not done enough and should expand its bond buying program, which would increase its balance sheet further.
A bond buying program or quantitative easing is financing the government indirectly by issuing liabilities with the shortest term possible, which is the overnight liabilities of the central bank. This is as close to money as you can get. And it strikes me as being dangerous and potentially even foolhardy.

Why is financing with short term debt so dangerous?
If debt is financed with short term money, this can go on for a long period of time without any problems. But when problems start to emerge, they exacerbate very quickly and are enormous. An Example would be Simbabwe. President Robert Mugabe printed money for almost 20 years, and nothing much happened. Then the whole thing exploded and ended in hyperinflation.

So in fact there is a limit to central bank balance sheet expansion, but we don’t know where it is?
When I say that there is no limit, in one sense this is true. But, at a certain point, if the government’s situation is bad enough, there can be some really bad side effects. I’ve been saying for quite some period of time that I’m worried about Japan.

What are the dangers for Japan?
The deficit is still around 5% of GDP and government debt is 230% of GDP. All they need is some little problem, not least of which is faster economic growth.

Why is economic growth bad for Japan?
Because it could unstick interest rates. If this happens, the debt service charges are going to skyrocket. The implications for debt service would overwhelm the increase in nominal economic growth and income. So all this is not just hypothetical, and such concerns are not unwarranted.

How close is Japan to such a scenario?
These are non-linear processes. The economy is not a machine, but it is a complex adaptive system. Almost all such systems are characterised by phase shifts. If you push it beyond a certain point, ice turns to water, and then to vapor. And this may be due to not just one cause – with water it could be either the temperature or the pressure. So with regard to inflationary pressures, you should not only look at the output gap, which is the capacity utilization of the economy, but also for example at the growth rate of debt that could indicate big problems down the road. One of the things that worries me about central banks, as I’ve grown to know them over the course of the years, is that they use models that are essentially linear. In their world, there are no phase shifts.

How much leeway do we have?
Anybody who says that there are no worries with regard to debt or central bank financing is not looking at history. There are many instances where there was an output gap but still very high inflation. I’m not saying that such an outcome is imminent. There may be a lot of room to push. And I don’t think that there is any kind of clear understanding about when you get to the point where the markets become unstuck. This is the problem: We just don’t know. But there is a limit.

What are the lessons for central banks?
At some point we somehow will get through these debt problems, in an orderly way or a disorderly way. One thing that has come out of all of this is that credit growth and developments in the credit sphere need to be looked at much more carefully than prior to the crisis. This goes back to Austrian economics. Also, central banks will need a broader mandate and more discretion.

How should monetary policy be changed?
One thing is clear: The single minded focus on price stability, defined as inflation of the CPI over a two year horizon, is far too narrow. It ignores all the problems having to do with financial markets and financial institutions. Central banks will have to be much more concerned about developments affecting financial stability, since such developments can affect price stability over longer horizons, and also with developments in the real economy that can lead to financial instability. There has got to be a much broader mandate of financial stability and price stability.

Critics want less discretion and specific rules for central banks.
Central banks should not be forced to follow specific rules. But they should pay much more attention than they have done to various indicators. Their policies allowed the system to become dangerously unstable. Such an indicator might be the rate of growth of credit over trend. A corresponding rule might state: If credit is growing by two standard deviations above trend, the central bank must act.

Have central banks been on the wrong track?
In Europe, Japan and the US, everything that central banks have done in the last few years was oriented towards pursuing the two percent inflation target. But by not taking into account potential future problems associated with the pursuit of that objective, they have dug the hole even deeper and made our medium term problems more severe.