Central bankers, beware of bursting bubbles

As the world’s leading central bankers begin their annual meeting at Jackson Hole, Wyo., they will have some reason to celebrate. For the first time since the 2008-2009 global economic recession, the world economy is now experiencing a synchronized, albeit gradual, economic recovery.

However, before allowing themselves to get carried away, the world’s central bankers might want to consider the very flimsy basis of this economic recovery. They also might want to consider what is likely to happen to the world economy when they start to normalize the extraordinarily easy monetary policies that they have been pursuing over the past eight years.

{mosads}The good news is that the world is now at last experiencing a synchronized economic recovery. According to the Organization for Economic Cooperation and Development (OECD), all 45 of the countries that it covers are now experiencing positive economic growth.

Equally encouraging is the fact that the OECD now expects that 33 of these countries will experience accelerating economic growth next year. This is the highest such number to experience a growth acceleration since the 2008 economic crisis.

The bad news is that this global economic recovery has been achieved in large part by the extraordinarily easy monetary policies of the world’s leading central banks. Those ultra-loose policies are all too likely to have seriously distorted global asset market prices. If past experience is anything by which to go, those asset price distortions could have serious adverse long-run consequences for the global economy.

Over the last several years, not only have the world’s major central banks kept interest rates at close to their zero bound for a prolonged period of time; they have also massively built-up their balance sheets as they aggressively bought long-term government and private sector bonds. They did so with the explicit objective of reducing long-term interest rates and encouraging risk-taking to jumpstart the economy.

It is estimated that since 2008, there has been a staggering $10 trillion increase in the combined balance sheets of the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan.

Former Federal Reserve Chair Alan Greenspan recently warned that the highly expansionary monetary policies of the past several years have given rise to a global government bond market bubble. He might usefully have added that this bubble has hardly been confined to the world government bond market. Indeed, global equity price valuations are now at levels that are historically very elevated, while there are signs of bubbles in all too many housing markets across the globe.

Meanwhile, interest rates have been driven down to very low levels in the U.S. high-yield debt market and emerging economies’ corporate debt markets as investors have desperately stretched for yield. It is questionable whether these interest rates nearly compensate lenders for the long-term risk of default that they are exposed to on these debt instruments.

With the end of the easy monetary policy cycle now in sight, one must hope that the central bankers gathered in Jackson Hole are mindful of the asset bubbles that they have created and of the risks that the likely bursting of these bubbles will pose to the continued global economic recovery.

One also must hope that they are drawing up contingency plans for dealing with a bursting of these asset price bubbles and that they are not caught as flat-footed as they were when the U.S. housing and credit market bubbles burst in 2008. 

More important yet, one must hope that global economic policymakers in general draw the correct policy lesson from the last eight years’ experience of ultra-loose monetary policy. The basic lesson that they should be drawing is that there are considerable risks attached to placing an undue burden on monetary policy and that fiscal policy needs to shoulder more of the burden for promoting economic recovery.

If they do not draw that lesson, there is all too great a chance that the same policy mistakes will be made during the next global economic downturn and that the world economy will remain trapped in an asset price boom-bust cycle.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney. 

The views expressed by contributors are their own and not the views of The Hill.