Under these circumstances, if asset price inflation is driven by excessive leveraging, in theory, asset prices might drop first in search for a new equilibrium, and then stabilise at that point. Subsequently, asset prices will resume rising alongside economic recovery and a rebound in people’s income. (2)  The second possibility is that quantitative easing produces the desired results. Asset prices go up, stimulating consumption, and employment improves significantly as a result. This buys time for the relevant authorities to carry out reforms to enhance productivity so that, ultimately, asset price increases will be supported by economic  4  BIS central bankers’ speeches  fundamentals. This is, of course, a very desirable scenario as global economy will return to its normal growth path. I surely hope that this will be what eventually happens. (3)  What bothers me however is the third possibility, under which the process of deleveraging is disrupted by quantitative easing, leading to sharp increases in asset prices in the first place. Yet, since such increases are not supported by economic fundamentals, any increase in wealth will be seen as transient. As a result, households are unwilling to increase spending and in the end, the real economy fails to rebound. If inflationary pressure builds up alongside asset price increases, central banks may consider exiting the market and raise interest rates. When economic performance, inflation or monetary policy falls short of market expectation, asset prices might drop sharply and remain volatile.
Asset markets supported by an artificially low interest rate environment rather than economic fundamentals will skew resources allocation in society from expanding the productive sectors to pursuit of asset price appreciation. Such a shift will easily lead to investment mismatch, thereby eroding medium to long term productivity growth as well as growth potential of the economy. In addition, the more sizable and prolonged quantitative easing becomes, the more difficult and riskier will be the exit plan. Central banks should realise that there is not much they can do. In order to solve the structural imbalances built up in the past two decades, we must get to the bottom of the problem. Ladies and Gentlemen, up until 2008, the industrialised countries and various emerging economies had been enjoying a golden period of development which lasted for two to three decades. Income levels and living standards continued to rise. Some academics call this a period of “Great Moderation”. However, no one is sure why life during this period was so easy. Some say that this is due to technological and financial innovation of modern society, the so-called “paradigm shift”. We should now be awakened to the reality that this golden period was probably underpinned by little more than excessive debts, and is in fact unsustainable. If the major industrialised countries will have to undergo deleveraging in the foreseeable future, how will the global economy evolve?