The central banks of the advanced market economies (AME's) have embarked upon one of the greatest economic experiments of all time ? ultra easy monetary policy. In the aftermath of the economic and financial crisis which began in the summer of 2007, they lowered policy rates effectively to the zero lower bound (ZLB). In addition, they took various actions which not only caused their balance sheets to swell enormously, but also increased the riskiness of the assets they chose to purchase. Their actions also had the effect of putting downward pressure on their exchange rates against the currencies of Emerging Market Economies (EME's). Since virtually all EME's tended to resist this pressure, their foreign exchange reserves rose to record levels, helping to lower long term rates in AME's as well. Moreover, domestic monetary conditions in the EMEs were eased as well. The size and global scope of these discretionary policies makes them historically unprecedented. Even during the Great Depression of the 1930's, policy rates and longer term rates in the most affected countries (like the US) were never reduced to such low levels.

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In this paper, an attempt is made to evaluate the desirability of ultra easy monetary policy by weighing up the balance of the desirable short run effects and the undesirable longer run effects - the unintended consequences. In Section B, it is suggested that there are grounds to believe that monetary stimulus operating through traditional ("flow") channels might now be less effective in stimulating aggregate demand than is commonly asserted. In Section C, it is further contended that cumulative ("stock") effects provide negative feedback mechanisms that also weaken growth over time. Assets purchased with created credit, both real and financial assets, eventually yield returns that are inadequate to service the debts associated with their purchase. In the face of such "stock" effects, stimulative policies that have worked in the past eventually lose their effectiveness.

It is also argued in Section C that, over time, easy monetary policies threaten the health of financial institutions and the functioning of financial markets, which are increasingly intertwined. This provides another negative feedback loop to threaten growth. Further, such policies threaten the "independence" of central banks, and can encourage imprudent behaviour on the part of governments. In effect, easy monetary policies can lead to moral hazard on a grand scale. Further, once on such a path, "exit" becomes extremely difficult. Finally, easy monetary policy also has distributional effects, favoring debtors over creditors and the senior management of banks in particular. None of these "unintended consequences" could be remotely described as desirable.

The force of these arguments might seem to lead to the conclusion that continuing with ultra easy monetary policy is a thoroughly bad idea. However, an effective counter argument is that such policies avert near term economic disaster and, in effect, "buy time" to pursue other policies that could have more desirable outcomes. Among these policies might be suggested more international policy coordination and higher fixed investment (both public and private) in AME's. These policies would contribute to stronger aggregate demand at the global level. This would please Keynes. As well, explicit debt reduction, accompanied by structural reforms to redress other "imbalances" and increase potential growth, would make remaining debts more easily serviceable. This would please Hayek. Indeed, it could be suggested that a combination of all these policies must be vigorously pursued if we are to have any hope of achieving the "strong, sustained and balanced growth" desired by the G 20. We do not live in an "either?or" world.

The danger remains, of course, that ultra easy monetary policy will be wrongly judged as being sufficient to achieve these ends. In that case, the "bought time" would in fact have been wasted1. In this case, the arguments presented in this paper then logically imply that monetary policy should be tightened, regardless of the current state of the economy, because the near term expected benefits of ultra easy monetary policies are outweighed by the longer term expected costs. Undoubtedly this would be very painful, but (by definition) less painful than the alternative of not doing so. John Kenneth Galbraith touched upon a similar practical conundrum some years ago when he said

"Politics is not the art of the possible.
It is choosing between the unpalatable and the disastrous".

This might well be where the central banks of the AME's are now headed, absent the vigorous pursuit by governments of the alternative policies suggested above.

David Fuller's view This is an important paper which I commend to subscribers although it is not always an easy read.

It certainly reveals the extent of known unknowns regarding the eventual consequences emanating from our brave new world of Quantitative Easing (QE), not least regarding the longer term fire (inflation) versus ice (deflation) debate.

For this reason alone, as investors we need to keep our minds open and alert regarding financial market trends, and not rationalise moves evident on price charts which may be at odds with our expectations at the time.

One clear message from the Dallas Fed's paper is that our governing politicians need to take the economic breathing space made available by QE to get their budgetary houses in order. I see little evidence of this to date.

Returning to the fire versus ice debate, we have the ongoing evidence of Japan's deflation. We can see that Mr Bernanke is determined to fight deflationary pressures in the US economy at all costs. We also see examples of inflationary problems among emerging markets.

Additionally, we see that no country wants a strong currency. However, some countries, or regions in the case of the Eurozone, both need and want a soft currency more than others. The unstated but clear policy of competitive devaluation remains very much in evidence.

Those who understand that central bankers and the politicians who appoint them are mostly closet inflationists, also recognise that fiat currencies will never maintain their purchasing power. They never have and I see no reason why they ever should hold their value in future. Gold and its sister precious metals remain our best protection against the debasement of our fiat currencies.

Weak GDP growth increases deflationary pressures which most of us see in our salaries and the value of all but the most fashionable of our assets. QE undermines the purchasing power of our currencies, which we see in the rising cost of most things that we require for our everyday livelihood. The often scandalous rise in government deficits means that taxes and the cost of many essential services such as healthcare are rising.

This is a challenging environment for investors. However, if we hone our timing skills and invest wisely, we can be successful in most financial environments.