Raghuram Rajan is right about the perils of today’s monetary policy
University of Chicago Professor Raghuram Rajan, one of the few mainstream economists to predict the financial crisis, has written a very good article at Project Syndicate questioning central bank monetary policy. His main point is that central banks are supposed to provide liquidity to panicked markets to restore order. They are not supposed to supply liquidity as a means of supporting economic growth because legislatures refuse to do. I think Rajan adds a needed voice of reason given how much other economists denigrate fiscal policy as a policy tool.
Central banks can play an important role in a cyclical downturn. Interest-rate cuts can boost borrowing – and thus spending on investment and consumption. Central banks can also play a role when financial markets freeze up. By offering to lend freely against collateral, they “liquefy” assets and prevent banks from being forced to unload loans or securities at fire-sale prices. Anticipating such liquidity insurance, banks can make illiquid long-term loans or hold other illiquid financial assets.
To the extent that unconventional monetary policy – including various forms of quantitative easing, as well as pronouncements about prolonging low interest rates – serves these roles, it might be justified.
For example, the US Federal Reserve’s first round of so-called quantitative easing (QE1), implemented in the midst of the crisis, was doubly effective: by purchasing mortgage-backed securities, the Fed brought down interest rates in that important market (in part, probably, by signaling its confidence in those securities), and restored it to vitality. Similarly, with its outright monetary transaction (OMT) programme, the European Central Bank has offered to buy peripheral eurozone countries’ sovereign bonds in the secondary market – provided that they sign up to agreed reforms.
This is exactly right.
As I have been writing here at Credit Writedowns, interest rates are the traditional policy tool of central banks. Unconventional policy tools like quantitative easing and ‘permanent zero’ are not first choice tools. Hardly, they are a sign of desperation. And Ben Bernanke keeps telling us the Fed can do more but that it doesn’t want to. It wants fiscal policy to get into high gear because that’s the appropriate way to deal with the present situation. No one seems to be listening – not on Capitol Hill, not in academia and not in the financial press. So the Fed has been forced into a corner and now monetary policy is the only game in town, as Rajan puts it.
What Rajan is saying is that QE1 and the OMT are legitimate actions by central banks fighting crises due to market dislocations. But, in his view, central banks’ supporting economic activity through unconventional monetary policy goes a step too far. I agree. As I explained when describing the differences between QE1, QE2 and what I correctly anticipated to be the Fed’s third round of easing, “QE1 was also a legitimate lender of last resort operation. We should question the terms of QE1 i.e. “The Fed lent freely, but at a low rate, on dodgy collateral” not the operation per se….
“The second round of quantitative easing was distinct from the first – and more akin to what the Japanese had done. The aim was to support economic activity in the US domestic economy….
“But, as we have detailed many times here at Credit Writedowns, quantitative easing doesn’t actually have an impact on the real economy. It is an asset swap. The Federal Reserve buys Treasury bonds and sells dollars it has created expressly for that transaction.”
The Fed doesn’t add net financial assets to the private sector. That happens via fiscal policy. Easy money will not create sustainable growth. These are the kinds of policies that created the crisis to begin with. QE and permanent zero are not being used to create order in dislocated markets, but rather to artificially suppress risk premia. These policies represent a tax on saving and create a distortion in market signals, which causes a misallocation of capital. Eventually, this misallocation of resources will be discovered – just as it was after the Telecom and technology bubble in the 1990s and the housing bubble last decade. But, by then the problems will be even larger. This is the path we are now on.
Just as Rajan warned us about the housing bubble, he is warning us now about the present policy responses. We would do well to heed that warning.
Source: The Guardian