Tuesday, August 28, 2012

Unintended Consequences

Humans are notoriously famous for engaging in Faustian bargains. An excellent paper has been published by William White, currently Chairman at the Economic Development and Review Committee at the OECD in Paris. The subject is ultra easy monetary policy and its effect on the macro economy. Full paper can be accessed here

Even the footnotes on the paper contain fantastic information like this:

1. Crises occur on a regular basis in complex systems. They also conform to a Power Law linking the frequency of crises to the inverse of their magnitude. 
2. Predicting the timing of individual crises is impossible.
3.There is no relationship between the size of the triggering event and the magnitude of the subsequent crisis. This way of thinking helps explain why “the Great Moderation” could have been followed by such great turbulence, and why major economic crises have generally emerged suddenly and with no clear warning.

Conclusions of the paper note that, ultra easy monetary policies have the following unintended undesirable effects:

1. Mal investments in the real physical plane of the economy
2. The health and viable functioning of financial institutions and markets are threatened
3. Central bank independence from the Government is constrained (central banking becomes more and more political, inching us closer towards Zimbabwe Hyperinflation)
4. Governments are actively encouraged to not do any meaningful fiscal policy reforms

So overall, lowering interest rates through outright bond buying (debt monetization, also known as quantitative easing) is not a free lunch, but actually a Faustian bargain (buying short term pleasure at the expense of long term pain).

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