Martingale strategy - the folly of excessive monetary loosening

John Kay describes the European response to the sovereign debt crisis as a Martingale betting strategy - increase your stake everytime you lose, in the expectation that a win on the next game would recoup all your losses and leave you ahead. I feel that this description is also appropriate for much of what passes as unconventional monetary accommodation being pursued by central banks on both sides of the Atlantic.

Lower rates, print money, inject liquidity, buy assets, do maturity transformation, and so on, all in the expectation that the "animal spirits" will be revived and market valuations will return to its bubble-era days (given the magnitude of losses suffered, only such recovery can restore them). This would make the Greenspan put look a small-time bet. The recovery martingale bet through extraordinary monetary accommodation is arguably the mother of all bets.

John Kay writes,

"Whenever European institutions have failed to end the current crisis, they have returned with a new, larger, commitment. “We will do what it takes”, “we will see it through”, is the strategy, if it can be called that. “Just in time, just enough”, is how my colleague Martin Wolf last week described the tactics. These are the key components of the martingale system. But debt markets illustrate a malevolent game. A player on the other side of the table – global financial markets – has very large resources, and can ensure that each round of the game can be played for very large stakes.

The wise person’s reaction to the casino is not to go there. The next best course is to plan an early night. Leave while you are ahead, and if you cannot do so, accept a small loss. If the eurozone had quickly recognised defeat in Greece, it would have suffered a manageable failure and learnt an important lesson for the future. Instead it has followed the martingale. As the size of the bet grows after a run of losses, the commitment to do what it takes becomes steadily less credible.

The gambler who is confident his system will work looks to rich friends. When the indulgence of Berlin was exhausted, a banker was dispatched to Beijing. Now the players look to the only remaining credible supporter. Surely the European Central Bank can enable them to see the night through. The ECB really does have infinite resources: if it runs out of money, it can print more."

The fundamental urge behind the martingale strategy is the desire to restore the economy back to its pre-crisis normalcy. It is widely believed that this process of restoration can be achieved only through extraordinary monetary accommodation.

This strategy overlooks the possibility that a restoration of the pre-crisis normalcy may not only be not desirable but also unsustainable. It overlooks the severe excesses and inefficiencies that had got built-up in the boom years and the need to wring them out. It also glosses over the fortunate confluence of favorable factors that contributed to the long period of sustained low inflation, low unemployment and high economic growth rates. Now many of these factors have subsided or disappeared and the sins of the excesses have to be reaped.

The Martingale strategy is a classic case of kicking the can down the road and ignoring a continuous build-up of systemic risk. The perils of such a strategy are only too well known to be ignored.