Central banks can't seem to control total spending in the way macroeconomic textbooks suggest they can. In the aftermath of the Great Recession, the Federal Reserve and European Central Bank (ECB) opened their monetary spigots with experimental asset purchases, lending programs, bailouts and ultra-low interest rate targets. Conventional wisdom said aggregate demand fell too far and the world stood on the edge of stagnation, deflation or even depression. The Bank of Japan, which had been conducting similar policies ineffectively for decades, joined in as well.
The returns are less than encouraging. Growth is low, yet everyone and everything is levered up. Years of subsidized borrowing costs encouraged massive debt loads for governments, businesses and households. In 2015, U.S. nonfinancial debt climbed more than $1.9 trillion, or 3.5 times faster than nominal gross domestic product (GDP). Nonfinancial debt-to-GDP rose to a record level at 248.6%.
The U.S. economy is mired in the slowest recovery in its history, but it's still far better off than Europe or Japan. Now, faced with dangerously high asset prices and daunting interest payments, it's fair to wonder if it was a mistake to fuel growth through borrowing in the first place. Plenty of evidence suggests stimulative borrowing creates more problems than it solves.
Hair of the Dog
After the dot-com bubble popped around 2000, the Federal Reserve slashed interest rates and the federal government handed out tax breaks. In the United States and before the Great Recession, businesses and individuals borrowed huge sums of money and used rising home prices as collateral. Asset prices climbed higher, and the world borrowed even more. According to the Bank for International Settlements (BIS), the global stock of debt outstanding grew from $87 trillion in Q4 2000 to $142 trillion in Q4 2007, reaching 269% of the world's GDP.
In a traditional recession, businesses and individuals who borrow too heavily will deleverage, or reduce their debt liabilities. This allows inflated asset and consumer goods prices to fall and lets markets clear. Once prices again reflect the reality of underlying resources and productivity, economic progress can continue. Some economists call this the hangover effect, much as a body detoxifies after a night of exuberant drinking.
This didn't happen after the Great Recession. Instead, governments spent trillions of dollars, and central bankers issued trillions more in credit. Interest rates in the U.S. stood at the zero-bound for seven years starting in December 2008 and ending in December 2015. Several European banks, including the ECB, flirted with negative interest rate policies (NIRP) during that period.
Bankers wanted investors to pick riskier assets with higher yields, wanted savers to become spenders and wanted spenders to become borrowers. According to the circular flow logic, more spending would beget more jobs and more income in a self-reinforcing loop.
By Q4 2014, the global stock of debt outstanding was $199 trillion, which was $57 trillion higher than before the Great Recession and a full 286% of GDP. Many believe government debt is unsustainably high in numerous countries. Nearly every business sector, especially health care, was more leveraged in 2015 than in 2007. Bloomberg reported that one-third of global companies operate with funding deficits. The ultimate effect of monetary policy was to keep the tap running, prevent detox and risk making the hangover worse down the road.
Pushing on String
Many prognosticators anticipated the weakness of monetary responses to the Great Recession. Hedge fund manager Ray Dalio created his own model to explain huge deleveraging cycles, something he claims helped him anticipate the housing bubble. He argues that traditional monetary policy won't effectively encourage growth after interest rates hit zero, because debtors will use the new money to pay off their loans.
Though Dalio's model is new, the theory is old. John Maynard Keynes, in many ways the father of modern monetary policy, famously argued that easy money policies couldn't be effective unless there was demand for new dollars. He said adding money at this point would be as futile as pushing on a string.
Some academic research suggests debt becomes a burden on economic growth after it reaches 250 to 300% of total output. Many scholars from the Austrian school of economic thought suggest that low interest rates sow the seeds for the next recession, because governments and businesses borrow excessively and commit resources to wasteful long-term projects. When there aren't enough future savings or productivity to pay for the projects, a recession hits and bad debts have to unwind.
In terms of aggregate nominal GDP growth, the combined economies of the U.S., Japan, China and the eurozone grew at their second-slowest rate in 2015, only surpassing 2009. Each economy also finished 2015 with a debt-to-GDP ratio above 350%. Any evidence that easy money policies have helped the world's economic engine is quickly disappearing.