... on the eventual outcomes of central banks’ endless monetary expansion

This is an article I wrote back in September 2013 for FXStreet. It might still be of interest to some readers:

In previous rounds of interest rate reductions, the cause-and-effect chains functioned in the following fashion. Let’s start at the point where the economy shows signs of weakness. Market participants start to perceive these signs and government bonds at the long end start to rise as expectations of lower nominal interest rates rise. This could also cause an inverted yield curve, depending on how rates are positioned along the term structure. Stocks usually start to be bid up some time after, as market participants discount the expected positive effects that lower nominal interest rates will eventually bring. Eventually, other asset classes follow suite as money supply also grows in the process.

The liquidity also flows into the real economy, where companies benefit by being able to service their debts better as well as increasing their borrowing for purposes of capacity expansion and other fixed capital investments. Consumers respond to the lower interest rates environment by buying more goods and services, also increasing their debts. It is important to keep in mind that these two factors work together: the companies expand within the country, creating jobs for people who are the consumers and buy the products created by the companies.

The reason why this has not occurred in the past few years, as indicated by an unresponsive unemployment rate, and why the central bank just continued pumping more and more money into the economy instead of identifying the real underlying factors relate partly to the low Chinese Yuan exchange rate and partly to the economic growth of China in general. In a nutshell, companies decided to expand production in China, thereby not creating jobs within the local economy. This factor is generally recognized.

It is the following factor which is of more concern.

When we have a bout of monetary expansion, people that own fixed assets such as real estate and stocks are usually the first that stand to benefit from “making money for doing nothing,” while people who do not own capital are still being laid off in the real economy. While the money supply grows, rising prices eventually work themselves through the system until they end up at a place where one has rising food prices and general higher living costs. Only when this pressure is being felt by people earning the minimum wage do they start to express political unrest, which manifests itself in strikes and negotiations for higher wages, which are eventually awarded to them after some time lag.

The important question relates to what has actually happened during that whole period. The answer is very simple: the “inflation” generated during that time made the rich even richer, as many were most probably able to leverage their “inflation” of real assets, while the same “inflation” actually made the poor poorer as living costs where already rising while they were still earning the same wage before the pressure became unbearable.

Now, this “casualty” of capitalism is well know, but if one combines that outcome together with the unemployment issue caused by companies moving production abroad, we can clearly see that continuing on the path to endless monetary expansion will eventually cause a huge wealth gap between the haves and the have-nots.

A rising income gap may also cause other “collateral damage.” For example, it might be argued that the haves become more unproductive: why work and contribute to research and development if one is able to sit on ones laurels and have leveraged assets earning ones income. While, the have-nots might be additionally affected by changing states of mind such as rising levels of depression and other social dysfunction issues, also causing further loss in productivity.

Central banks need to become more flexible in recognising that if their objectives, such as unemployment rate targets, are not being achieved—that they need to find solutions outside of the box. Governments, for example could look into transferring significant portions of that “unearned” wealth from the haves to the have-nots by changing the tax structure. A rising income gap that is left unchecked is likely to cause a threat to social cohesion, which may eventually lead to civil unrest, perhaps war, something that, both history and current events tell us, would benefit no one in the short to middle term!