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Walter Molano | Echoes of monetary malfeasance

Published:Friday | March 11, 2016 | 3:00 AMWalter Molano

Central bankers are a staid lot. As stewards of monetary policy, they are expected to be dour. They are not the types to don keffiyehs or balaclavas, but they may as well because of the damage they are committing to the global financial system.

The advances in monetary theory during the latter half of the 20th century gave policymakers more sway over economic behaviour. Milton Friedman's seminal work showed that inflation was purely a monetary phenomenon. Later works by Robert Mundell integrated monetary conditions with economic activity, currency movements and fiscal policy.

As a result, central banks became the main arbitrators of economic policymaking. Not subjected to the visceral political infighting that exists in the legislature, they were able to act quickly and unilaterally.

At first, such immense power produced important successes, such as Paul Volcker's ability to impose a draconian monetary adjustment in 1982 and bring the United States' runaway inflation rate to an immediate halt.

Emboldened, Volcker's successor embarked on a prolonged programme of monetary expansion that pushed the US into its longest period of prosperity. However, there was a dark side to the unbridled monetary expansion. Alan Greenspan was responsible for a succession of asset bubbles that ultimately ended in the financial crisis of 2008, which almost destroyed the US financial sector.

Instead of making the situation better, Greenspan's successor, Ben Bernanke, introduced an unprecedented programme of quantitative easing, which helped recapitalise the banks. Yet, it also created a new set of unintended consequences.

The Great Recession of 2009 was particularly harsh for much of the developed world, but it was relatively mild across the emerging markets. This was in contrast to previous global downturns, when the economic crisis was amplified in the developing world. The reason for this phenomenon was that a good chunk of the developed world's monetary stimulus was recycled into the periphery. This led to a rapid revival of commodity prices.

Given the dearth of promising investment opportunities, trillions of dollars quickly followed. Mining companies, oil giants and agricultural concerns aggressively expanded capacity, without any consideration as to what competitors were doing. Unfortunately, commodity projects have relatively long gestation periods and the over-investment did not become apparent until many years later.

At the same time, the commodity boom had other unintended consequences. The massive transfer of wealth to commodity-producing countries led to a windfall that manifested itself into sovereign wealth funds SWFs. These vehicles recycled their funds into the liquid asset classes, such as equities, bonds and currencies.

Given the illiquid conditions that existed in the markets due to post-crisis financial regulations, the recycling process triggered a steady rise in asset prices and the creation of bull market conditions, even though global economic conditions remained weak.

Today, the echoes of monetary malfeasance continue to propagate. The end of the US quantitative easing programme, the results of overinvestment in the commodity sector and the cyclical downturn in the emerging markets is triggering an unnecessary bear market.

US and European equities were in free fall at the start of the year, despite the fact that the US economy was sound and Europe was showing signs of life. The selling pressure was provoked by the SWFs that were reacting to the downturn in commodity prices. The same illiquidity that had triggered the rally at the start of the decade, was now leading to a sell-off.

To make matters worse, central banks are now segueing to a new form of monetary chicanery. Negative interest rates are introducing a set of perverse incentives and distortions that could bring the global financial sector to its knees.

Banks serve a crucial role in allocating capital. They take short-term deposits and channel them into longer-term investments. The problem is that households and businesses are taking money out of the banks. This is leaving the institutions with less ammunition to invest.

Consequently, gold prices are on the rise and people are even paying their taxes ahead of time as they look for alternate forms for parking their money.

Creativity is admirable, but it is irresponsible if unchecked. Political logjam motivated central bankers to overplay their hand, but excessive intervention borders on monetary terrorism.

Dr Walter T. Molano is a managing partner and head of research at BCP Securities LLC.

wmolano@bcpsecurities.com