Central bank easing – could the “cure” exacerbate the problem?

A Financial Times article raised an intriguing point.  Specifically, are the monetary easing measures that China has undertaken (i.e. reducing loan requirements, stimulus measures, cutting reserve requirement ratios) potentially counterproductive?

As governments undertake monetary easing, their goal is to coerce investors to use capital, hopefully for productive purposes.  However, what if the surplus of capital is so readily available that it facilitates production of more inventory, even if the end-user demand is not there?  If excess capacity already exists, building more capacity is destructive.  If the capacity was built with borrowed money, the loan may not be repaid and the ‘collateral’ is worthless.  Additionally, any capacity that was already in the system is further impaired due to competition resulting from an even worse glut.

This is not to say that monetary easing will necessarily lead to destructive allocation of capital, but the risk certainly exists.  The end result in this scenario . . .for a brief time it looks like economic activity is continuing, but the stress in the financial system is actually increasing and the losses will be that much greater when reality sets in.  (To some degree, this is what happened leading up to the housing bubble in 2008.)

The FT article mentions China specifically, but this concern strikes me as broadly applicable.

source: Financial Times – Alphaville

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