Quantitative easing short circuits economy

In her Guardian column, Heather Stewart looks at Japan's experience with quantitative easing and notes how it keeps companies going in a crisis, but the economic distortions QE brings about prevents them from adapting to reality in the long run.

Your humble blogger appreciates Ms. Stewart confirming what I have been saying about why the Japanese Model for handling a bank solvency crisis and its related policies like QE short circuit the economy and actually make the situation worse.

Despite the catastrophic Japanese economic collapse in the late 1980s that led to the so-called Lost Decade (which has lasted far longer than 10 years), ... 

There are plenty of reasons for the woes of the Japanese industrial sector, not least that independent directors are few and far between, and cross-shareholdings – one company owning a chunky stake in another – remain common..... 

But as John Plender pointed out in the Financial Times last week, there's another explanation for the country's flagging performance: its economy has been wrenched out of shape by many years of rock-bottom borrowing costs. 

Quantitative easing, the drastic policy of pumping electronically-created money into the economy, was part of the Bank of Japan's armoury long before it was unleashed in the UK in the teeth of the credit crisis. 

Driving down the cost of borrowing to bolster demand and staunch the flow of bankruptcies and job losses is the textbook response of a central bank facing an economy in crisis.

Actually, it is the textbook response if the goal is to preserve bank book capital levels and banker bonuses.  This response is known as the Japanese Model.

The textbook response if the goal is to preserve the real economy and the social contract is to require the banks to recognize upfront all of the losses that they would ultimately realize if the excess debt in the financial system goes through the process of default and foreclosure.  This response is known as the Swedish Model.

Once growth returns, the argument goes, debt levels can be brought down and necessary restructuring take place at a less painful pace.

This argument in support of the Japanese Model is 100% false.  Pursuing the Japanese Model has never, ever resulted in growth returning and debt levels brought down at a less painful pace.  

"Foaming the Runway", as the US Treasury Secretary Tim Geithner calls it, does not work and, more importantly, makes the situation much worse.  It makes the situation worse because policies like zero interest rates and quantitative easing are pursued. 

But over time, as cut-price loans become the norm, the corporate sector can become crystallised in its existing shape, too insulated from the cold winds of competition and progress that might have swept many firms away, or forced them to adapt to a different world, in a process the economist Joseph Schumpeter described as "creative destruction". 

By delaying the reckoning, and keeping "zombie companies" alive, there is a risk that when it eventually comes, the correction is even more dramatic.

Under the Japanese Model, a major contributor to the creation of "zombie companies" is regulatory forbearance.  This allows banks to engage in 'extend and pretend' with bad debt and transform companies into 'zombies'.

Bank of England governor Sir Mervyn King is well aware of this dilemma: keeping the economy afloat in the short term (or in the UK's case, preventing a deep recession becoming an even deeper one) may delay a much-needed economic adjustment in the long term. 

But the problem is that, as MPC members can't fail to notice if they've a moment to glance at the portents from Japan, if the return to "normal" never comes, a short-term sticking plaster can become a long-term crutch....

Please re-read the highlighted text again as Ms. Stewart has nicely summarized why pursuit of the Japanese Model and its related policies of zero interest rates and QE is fundamentally flawed.

But in a recent speech King gave just one alarming example of how low interest rates may be distorting the world. 

No one yet knows whether rocketing house prices in the late 1990s and early 2000s reflected a sensible adjustment to a fall in long-term borrowing costs or a drastic misjudgment on the part of Britain's householders about their future earnings potential. 

"Since long-term interest rates in financial markets are, if anything, even lower today, the question of sustainability has not yet been resolved," he warned. 

Housing may still be overvalued; but we can't tell, because cut-price mortgages have (rightly) helped to avoid the wave of repossessions that might have followed if the Bank had been less aggressive in cutting rates, and keeping them there.

Regulatory forbearance played a significant role in avoiding the wave of repossessions.

Also, please note how the Swedish Model would have handled the housing situation.  Under the Swedish Model, the banks would have had to absorb the losses on the excess mortgage debt upfront.

Repossessions, as shown by Iceland, would have been avoided as households would have stayed in their houses with a debt service level they could afford given their income.

Equally importantly, there would have been no need to distort prices in the housing market by pursuing the monetary policies that support cut-price mortgages.