This column was written by Richard Portes, Professor of Economics at the London Business School and was first posted at VoxEU. It explains how the large economies, which are creating excess liquidity in fear of deflation, are in fact exporting inflation via the violation of “uncovered interest parity” which leads to a profitable carry trade into the emerging markets which in turn fear loss of export competitiveness and attempt to resist the appreciation of their currency with intervention and capital controls.

Though the analysis of the theory sounds convincing, what is sorely lacking is an evaluation of the success of monetary easing policies in the light of Japan 1990 – 2010 and USA 2007 – 2010, where monetary easing has failed to rescue the economy from the liquidity trap. Proponents of the strategy often claim that the reason monetary easing keeps failing is that central bankers did not do enough of it, however central banks can’t take the risk of a massive injection which might overshoot and complicate the bank’s exit strategy, or fail to stimulate altogether and expose the central bank as impotent. The medical analogy is chemotherapy – the side effects are severe, hence there are limits to its use lest we kill the patient outright. But the analogy is imperfect: most of the negative side effects of US easing go to the emerging market economies, who predictably cry “foul”. The bottom line is that for whatever reason, the only real example of a strategy that successfully broke out of the liquidity trap was the massive centrally directed military-industrial mobilization of World War II that ended America’s bout with deflation in the 1930’s.

Anyway, the entire article, which is quite long but worth reading, is found at VoxEU where it was first posted. An excerpt follows:

Now move to a world of big countries, all at the zero bound. Ideally, all should inflate in a coordinated fashion, so that exchange rates are not affected. Uncoordinated policies could bring currency volatility. This destabilises markets, creates a highly uncertain environment for business, and raises pressures for trade policy interventions. With simultaneous QE, there might not be first-order effects on the exchange rates between the big countries. And simultaneous QE could achieve simultaneous expansion, which would have first-order effects on the natural rate of interest, helping to restore more normal monetary conditions.

Although simultaneous QE in all big economies might wash out in exchange rates, there are also many small economies – including the emerging market countries. What happens in such a world? Some of the additional liquidity in the economies at pursuing QE at the zero lower bound flows to countries with higher interest rates. Their currencies appreciate, and expected appreciation attracts more capital flows. (Yes, the carry trade is indeed profitable; uncovered interest parity is violated.) Global liquidity goes up, foreign-exchange reserves rise in those smaller countries that intervene to try to resist appreciation. The big economies are exporting bubbles. But global rebalancing should be achieved by raising consumption in the rest of the world, rather than investment in financial assets and real estate.

Meanwhile, if one large economy does not participate (e.g., the Eurozone), then its currency will also appreciate, with accompanying political and trade tensions. And volatility between exchange rates of large countries is more harmful than if it is confined to small countries.

Here, it is vital to see that simultaneous QE is not the same as simultaneous exchange-rate intervention. In the latter case, central banks will typically hold reserve increments in foreign short-run debt (as noted above). If all do this, the net effect is that of domestic open-market operations in short-dated government securities. At zero interest rates, these securities are perfectly substitutable for money. There is a liquidity trap, so exchange-rate intervention at the zero lower bound achieves nothing – whereas QE does seem to have an impact on both interest rates and exchange rates (see e.g. Joyce 2010).

If the large developed market countries do more QE, however, then the flow of liquidity to the emerging markets may force the latter to respond. They may try to resist exchange-rate appreciation by intervening in the foreign exchange markets. Here we do have competitive devaluation – the “currency wars”. And if the emerging market countries do not sterilise the intervention, or if sterilisation is at least partly ineffective, then they experience inflationary pressures. So capital inflow controls look tempting – but experience suggests they may not be very effective, unless there is much broader financial repression (e.g., China).

This is why we see statements like “The US will win this war: it will either inflate the rest of the world or force their exchange rates up against the dollar” (Wolf 2010). But there is a potential downside for the US. Substantial dollar depreciation will weaken the global position of the dollar, as it did in the late 1970s (Chinn and Frankel 2007).

As I said above, this analysis stops short of comparing the theory to the real world results. Japan’s QE failed to stop a long term deleveraging and debt deflation, because it kept their highly leveraged and insolvent banks on life support, a mistake which ensured that the entire economy would keep on deleveraging even with interest rates at the zero bound. This mistake caused deflationary psychology to become deeply entrenched and self-sustaining, making the liquidity trap harder to escape from. The American QE is also intended to stand up to a deleveraging – deflationary avalanche and like Japan, they are also doing it the wrong way: by keeping zombie banks on life support. Zombie banks are in survival mode and are not interested to lend, even if there were willing borrowers. After decades of banks stuffing public and private balance sheets with debt, these borrowers have indigestion, so not surprisingly they too, like the banks, are focused on deleveraging. This is why the first QE did not bring about a V-shaped recovery in GDP growth, housing prices or jobs.

The point that we keep coming back to is simple: accumulation of debt is a cop-out, an easy way to keep everybody happy for a very long time. When that debt burden becomes too much to bear, and when there are no more greater fools to assume new debt, growth seizes up and the party ends. Thus, credit is a Ponzi scheme of global proportions, played out over decadal time scales. The eruption of the global financial crisis was actually the collapse event for a sixty year old Ponzi scheme which grew out of the best intentions in 1947 with the Marshall Plan for the reconstruction of Europe. From this perspective, the reason why zero interest rates fail to stimulate growth in countries where the credit bubble has burst, with liquidity flowing instead to higher interest overheating emerging economies, is also explained by Ponzi dynamics: those burned once by a Ponzi scheme do not fall for it a second time. That is why the events of 1929 had to pass out of living memory before we could get to 2007 in the first place, and that is why Americans and Europeans will continue to deleverage.