Pushing on a string and similar notions on monetary policy ineffectiveness

As interest rates in the developed economies approach the zero bound, we must begin to ask ourselves how effective monetary policy can reasonably be in these circumstances. And if policy is to be effective, which policy tools will be most advantageous to use? Or are we just pushing on a string here?

In plain English: central banks are running out of bullets and the deflation bogeyman seems to be right on our doorstep. Can they even stop him from ripping our house to shreds and sending us into depression?

In 1990, when the Japanese were faced with this question, they felt confident that they had the solution. Anna Schwartz and Milton Friedman wrote the well-regarded book “A Monetary History of the United States, 1867-1960” , which argued that the Depression was due in large part to a restrictive monetary policy by the Federal Reserve. Therefore, the Japanese were prepared to act: initiating massive interest rate cuts and fiscal stimulus for five full years.

However, Marshall Auerback has argued persuasively that these measures were insufficient. When the Japanese economy recovered after 1994, many felt the coast was clear. A consumption tax that hit the middle class hard ensued. By 1997, Japan fell into recession and started to suffer consumer price deflation — all made worse by the Asian Crisis. Japan’s relapse was a repeat of the U.S.’s own relapse in 1937-38.

By 2001 the Japanese realized their error as the industrialized world suffered recession and stocks fell below 8,000. The Bank of Japan went on a massive monetary stimulus, the likes of which we had never witnessed to reflate the economy — to little effect. The Japanese had waited too long to begin quantitative easing (QE). To be sure, the carry trade (where Japanese retail investors, companies, and foreign speculators borrowed in Yen and invested abroad in higher yielding currencies) limited the policy’s effectiveness. But, most economists agree that the enormous lag between 1990 and 2001 was deadly.

Present Fed Chairman Ben Bernanke is one of those economists. He was particularly critical of the Japanese and their ineffective policy response. Soon after the Japanese began their experiment with quantitative easing, he delivered his famous “printing press” speech on how a central bank could fight deflation (The Federal Reserve was also worried about deflation, leading to a 1% Fed Funds rate).

Therefore, the main takeaway here was that the Japanese erred in not being aggressive enough, quickly enough. The Japanese should have cut rates sooner and more aggressively and instituted QE more quickly thereafter.

I would like to challenge that notion on two counts. First, I believe that quantitative easing should have been the preferred policy tool from the start if the desire was to reflate the economy. Second, I am unsure that monetary policy is particularly effective in the aftermath of a financial crisis due to credit writedowns and a reluctance to lend by banks as well as debt overhang and balance sheet repair in the private sector.

A central bank has a number of weapons in its arsenal. Traditionally, the principal weapon has been interest rate policy. However, one must ask whether lowering the rate of interest in the aftermath of a bubble can induce damaged banks to lend or overburdened debtors to borrow. In 1993 Japan, as property prices collapsed and bank capital dwindled, only few would borrow or lend as debt levels were high and Japanese banks were mistrusted domestically and abroad due to their thin capitalization. Similarly, today, we await hundreds of billions of dollars more in bank credit writedowns and a tidal wave of corporate bankruptcies. Few will lend in this environment. Few will borrow irrespective of the rate of interest.

Moreover, the idea is to reflate the economy not to induce excessive risk-taking or bad loans. Lowering interest rates makes low-risk, low return investments unattractive and increases the appetite for risk. It also distorts investment decisions causing investment in unprofitable projects that would not be undertaken in a different interest-rate environment — projects that will be written down at a late date.

Why not just start quantitative easing from the word go? If the central bank chairman said that they were going to flood the economy with money and push up inflation to unbearable levels, I guarantee you people would start to spend and credit markets would ease. To be clear: this is inflationary, but it represents a best worst choice pick between deflation and bubble-inducing interest rate reductions. To my mind, a dose of quantitative easing and government spending on under-invested economic sectors would induce lending and prop the economy while the private sector repaired its collective balance sheet. Moreover, with a steep interest rate curve, banks would be likely to recapitalize their balance sheets more quickly. Unfortunately, this train may have already left the station. The Fed is pushing on a string.

Have we learned from Japan’s mistakes or just made new ones of our own?

Comments are appreciated.

Quantitative easing – Wikipedia
All of the buzzwords in one post: quantitative easing, inflation and printing money – News N Economics
Remarks by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C.
November 21, 2002: Deflation: Making Sure “It” Doesn’t Happen Here
– Federal Reserve Board
It is time for the monetary authorities to jump into the liquidity trap – Willem Buiter, Mavercon00

  1. hbl says

    “If the central bank chairman said that they were going to flood the economy with money and push up inflation to unbearable levels, I guarantee you people would start to spend and credit markets would ease.”

    One could argue that to some degree your “if” condition happened between summer 2007 and summer 2008, minus the explicit central bank promise of quantitative easing — i.e., most knew that Bernanke had expressed confidence in being able to beat any deflationary threat, and hence most feared inflation (remember all the talk of stagflation), hence the blowoff peak of the commodity bubble (since many sought refuge in hard assets rather than simply spending all their savings). Without labor being able to participate via wage inflation (due to globalization, excess supply, concentration of wealth, etc) this inflationary burst was unsustainable and destined to be overpowered by debt deflation. So perhaps perfectly executed aggressive fiscal stimulus and tax policy changes could have steered us to prolonged inflation rather than deflation, but not monetary policy alone.

    IMO you are correct that few will lend and few will borrow when debts are already unsustainable high, and hence there is little hope of growth via new debt. And since many loans were essentially ponzi schemes (relying on continually appreciating asset prices in order to have any hope of repayment, a la Hyman Minsky’s theories), the whole debt pyramid is inherently unstable. And recent asset price growth that has outpaced underlying productivity and demographic growth is simply illusionary (resulting from fractional reserve broad money supply expansion). As it becomes clear this wealth is gone (no policy can bring it back quickly, after adjusting for inflation) the negative wealth effect seems likely to be an unavoidable drag on spending.

    For the US, a fall in GDP (inflation adjusted of course) appears inevitable no matter how perfect the policy response. Despite dramatic asset price declines, Japan’s GDP has kept growing due to its aggregate savings buffer. With a negative US savings rate, assuming ponzi leverage can grow no further (possibly debatable?), the US has to increase savings, which will be a negative drag on GDP. Roubini estimates this GDP loss at potentially 10% if we return to traditional savings rates.

    There is a human tendency to assume our leaders are in control far more than they really are in this type of scenario, IMO. It seems quite reasonable to me that Japan really did manage one of the less bad possible outcomes, even if might not have been the absolute least bad outcome possible.

  2. Denis says

    If they start QE I will certainly load up on gold before I start spending money. You can imagine what this will do to gold prices – it won’t be just me.

    But then of course I might spend money quicker on some of the things I was going to buy anyway, so it will help somewhat.

    By the way, any idea on how to make sure I do not miss QE when it happens? I don’t need perfect timing, just the ballpark. The best I came up with so far is TED spread – if it falls back to 1% we can assume that banks think the worst is behind. Well, I’m a noob, too, so help is appreicated.

  3. Edward Harrison says

    The key here in my statement is the explicit nature of the policy action. Bernanke has not been explicit enough in saying we will inflate if you do not lend. Notice, in 2007 and early 2008, the inflation bogeyman was at our door, but he beat a hasty retreat after the Lehman Brothers debacle and now we see the opposite problem coming to the fore.

    I had said all along that inflation was not the real threat. Yes, it had to be dealt with, but the real threat was asset price deflation leading to depression. The Fed waited too long to deal with this situation and we are now facing deflation. But, I still ask: could any amount of reflation do the trick when you have suffered a debt bubble of such proportions?

    As to the differences between the U.S. and Japan, you are right on the money: on the whole they make the situation in America look more dire than in Japan. You should note too that prior sources of funding i.e. China and the Middle East are both dealing with their own economic problems (property bubbles deflating, oil prices decreasing, industrial output collapsing). This does not bode well for the U.S. But, we should not expect policy-makers to throw up their hands and let the worst take effect. This leads to anarchy and chaos. We should continue to press for action: stimulus spent on investment in infrastructure (health, education, roads, energy) and continued monetary support. All of this should be done with a bit more transparency, however. The Treasury has been chastised by the GAO for lack of transparency and the Fed has been sued by Bloomberg for the same.

  4. Edward Harrison says

    @Denis: I would be looking to load up on gold already, and that much more if they did explicitly start QE. As far as QE is concerned, we will need to look at Bank Reserves on deposit at the Fed. Their goal would be to increase bank deposits and they have done. The problem is it has triggered a huge accumulation in excess reserves as banks are unwilling to lend.

    In the UK, some pundits have told the government to credibly threaten to fully nationalise the large banks which refuse to lend. This is testament to how dire the situation is.

    When I get some good charts on excess reserves I will post. If aanyone has the chart already, please share the link.

  5. hbl says

    @Ed Harrison: Thanks for the response. I guess my opinion is that even an explicit promise of QE earlier in the crisis would not have made much difference unless accompanied by massive fiscal stimulus and redistribution programs. While the target of new money injected via QE is broader than that injected via normal Fed Funds Rate operations (since more types of assets are purchased), I think the new money would still be concentrated in institutions and individuals with the least propensity to spend the additional dollars. Perhaps the commodity blowoff would just have been all the more extreme. Also, I think the majority who were already aware of the epic size of the credit bubble believed Bernanke would choose inflation over deflation (based on the 2002 helicopter speech, etc) and that he would be successful. Granted, other people were still in conceptual goldilocks land so perhaps being more explicit earlier would have scared more people into inflationary spending patterns… But escalating CPI and PPI were starting to scare even many of the previous goldilocks disciples, as far as I could tell.

    I agree we need action not just throwing up of hands. Part of my tangent was just recognizing that action really is about reducing bad outcomes and that there are no good outcomes. I think we agree on this.

    As for excess reserves, isn’t it one of the charts kept up to date at the St Louis Fed?

  6. Denis says

    @Ed, I would be loading up on gold, except that it’s currently falling and dollar is rising. All the general ideas of what’s “normal” are out of the window, so for all I know it will just continue and I will catch a falling knife buying gold right now. That’s one way I look at it.

    The other way to look at it is that we’re in the cash bubble, and in particular a dollar bubble. Gold is actually up or flat against Australian Dollar, Euro or Pound. So maybe you’re right, and the prudent thing is to abandon the dollar bubble while it’s hot and jump to gold now. Decisions…

    @hbl, thanks for the chart, it’s very valuable. I am struggling to interpret it now.
    One could say that banks are hoarding money out of fear of bad economy.
    Or one could say that the accounting is forged and what is deemed as “excess” reserve is actually not at all excessive – banks know they hold a lot of worthless paper (e.g. Opt ARMs, credit cards, commercial real estate etc) and they stock up in advance.

  7. Edward Harrison says

    That’s the chart I was looking for. Thanks for that. I will post.

    As for the cash bubble, every bubble/mania has its day. And then it is over — abruptly. The recent move down in Treasuries is looking much like the move in oil and commodities, something that started off for all the right reasons but then was pushed to extremes by a tidal wave of money. I fear this will end very badly.

    Why is everyone piling into Treasuries when the yield is already at record lows while some stocks are trading at 2 times earnings. It doesn’t make a lot of sense.

    As for Gold, it won’t go up until it is clear deflation is not a risk. Gold seems like a good play. I would say, it is a good hedge, but we still have to worry about deflation — asset and consumer price.

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