Peter Lyons: Global financial hangover and us

Quantitative easing in the US and UK has caused a huge increase in liquidity, but not yet the expected rise in inflation. Photo / Thinkstock

Powerful economic forces beyond our control mean we are very vulnerable in what is uncharted territory.

We are living in very strange times. Recently the European Central Bank announced it was effectively printing euros. Many shares on our share market that pay good dividends have surged in price.

I love macroeconomics. It is the study of the big picture of how economies fit together. It provides insights into the nasty faultlines in the current world economy that could dramatically impact upon us. The father of macroeconomics was John Maynard Keynes. He provided insights during the 1930s Depression that are still very relevant today.

Quantitative easing has become a familiar term in recent years but is little understood by most people. Following the GFC, the Federal Reserve in the United States and the Bank of England adopted aggressive policies of quantitative easing. In simple terms, they tried to flood their economies with money to prevent a reoccurrence of the Great Depression. It largely worked but it set the world economy on a journey into unknown territory. The European Central Bank is currently following a similar path.

Standard economic theory says that flooding an economy with money should lead to inflation. Yet since the GFC, the huge increase in liquidity in the US and UK has had minimal impact on inflation in these countries. But asset prices in some other countries, including New Zealand, have rocketed.

Keynes provides a possible answer. He identified a situation that can occur during a severe downturn such as the GFC. It is called a liquidity trap. During a nasty downturn, a central bank can flood the financial sector with cheap money by basically buying IOUs off the banks or the government. This effectively creates more money in the economy.

This is not actual notes and coins. It is digital entries in bank ledgers. The banks can then lend those funds out to whoever is keen to borrow. This should create more demand in the economy for new houses, cars, electronics, whiteware and other consumables. This should create more jobs and incomes and economic growth.

Critics of quantitative easing have always argued it will cause hyper inflation with too much money flooding economies. The mystery is why this hasn't happened in either the US or UK. The reason identified by Keynes in the 1930s is that no one is keen to borrow in these countries so the money stays in the banks rather than being lent out. However the money may also seep into other countries, creating asset bubbles in shares and property in these countries.

It is this unwillingness to borrow that Keynes called a liquidity trap. Businesses and households in the US and UK have been reluctant to borrow despite record low interest rates.

Households are too busy paying off their debts accumulated prior to the GFC for assets such as houses that have plummeted in value. High rates of unemployment and concerns about job security also reduce the willingness to borrow. But things may be about to change and this may have big implications for our economy. We need to be ready for a roller coaster ride.

It is estimated that the reserves of the banking sector in the US are 20 times greater than pre-GFC levels. They are bloated with cash from quantitative easing waiting for willing borrowers. When US consumers and businesses regain their mojo and start borrowing again this could unleash massive inflationary pressures in the US. The Federal Reserve will need to act quickly to mop up the big cash injections created by quantitative easing. It will need to rapidly raise interest rates.

The rub for New Zealand is that our economy has been partially buoyed by the easy cash on offer in these countries. Some of this cash has flooded into our share market and property market. When the Fed starts raising interest rates this could have big implications for our share market and property market as these flows reverse.

In June 2013, we had a brief insight into what might occur. The Federal Reserve announced it was considering reversing quantitative easing. Our share market tanked that day and our exchange rate dropped on this mere statement of intent.

As we congratulate ourselves on the buoyancy of our rock star economy, we need to appreciate that we are firmly locked into the global economy. Our economic fortunes can be dictated by the decisions of powerful people beyond our borders. Things can change very quickly because we are a minnow in the world economy.

Our policy settings that favour the accumulation of debt to bid up the prices of existing houses, shares and farmland have made us very vulnerable in a global economy still suffering from the GFC hangover.

Peter Lyons teaches economics at St Peter's College in Epsom and has written several economics texts.