The limits of monetary policy, part 2

Editor’s note: This is the second of a two-part post on monetary policy. Part one is here.

Today’s Commentary

In the aftermath of the financial crisis, policy makers’ aversion to fiscal policy is still large. So monetary policy rules the roost. With developed economies burdened by low growth, unemployment, and high levels of debt, monetary agents have become aggressive in policy responses. This will lead to unintended consequences. Below are my thoughts.

Separating fiscal and monetary policy

Yesterday’s post summed out my view that Europe and North America’s policy framework has become increasingly geared toward monetary policy and thus toward credit, asset prices, and financial markets. Some economists like Larry Summers believe this is a natural outgrowth of a secular stagnation in growth. Summers sees monetary policy being pushed to the limit and creating bubbles and crises just to reach full employment. Paul Krugman echoes these sentiments, adding that, “central bankers need to stop talking about “exit strategies.” Easy money should, and probably will, be with us for a very long time.”

On the other hand, economists like Fed President Charles Plosser are uneasy about the expansion in central banks’ role in the economy. Plosser advocates for a limited central bank and suggests a number of potential ways to circumscribe central bank activities. The lines in the Plosser speech which I found most illuminating were these:

  • “But the Fed has done more than just purchase lots of assets; it has altered the composition of its balance sheet through the types of assets it has purchased. I have spoken on a number of occasions about my concerns that these actions to purchase specific (non-Treasury) assets amounted to a form of credit allocation, which targets specific industries, sectors, or firms. These credit policies cross the boundary from monetary policy and venture into the realm of fiscal policy. I include in this category the purchases of mortgage-backed securities (MBS) as well as emergency lending under Section 13(3) of the Federal Reserve Act, in support of the bailouts, most notably of Bear Stearns and AIG.”
  • “Even with a narrow mandate to focus on price stability, the institution must be well designed if it is to be successful. To meet even this narrow mandate, the central bank must have a fair amount of independence from the political process so that it can set policy for the long run without the pressure to print money as a substitute for tough fiscal choices. Good governance requires a healthy degree of separation between those responsible for taxes and expenditures and those responsible for printing money.”
  • “I believe that monetary policy and fiscal policy should have clear boundaries. Independence is what Congress can and should grant the Fed, but, in exchange for such independence, the central bank should be constrained from conducting fiscal policy. As I have already mentioned, the Fed has ventured into the realm of fiscal policy by its purchase programs of assets that target specific industries and individual firms. One way to circumscribe the range of activities a central bank can undertake is to limit the assets it can buy and hold.”

If I had to sum up Plosser’s speech I would say he believes that monetary and fiscal policy are two well-defined and separate activities. As such, Plosser believes that the political process should dominate policy with elected officials deciding which actions a central bank should and should not be able to perform in order to set clear boundaries between fiscal and monetary policy. And according to Plosser, those officials should consider giving the central bank “a narrow mandate to focus on price stability” and that’s it. He does not support the dual mandate because he doesn’t believe monetary policy can effectively steer employment.

I have to reveal my cards here. I would take Plosser one step further and say that I don’t think monetary policy can “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production” either. That is the Fed’s legal role. And I don’t think it is up to the task. I don’t believe it is possible for a small group of people to accurately forecast outcomes in an economy of 300 million people by controlling the price of money, one of the economy’s most important variables. In Plosser’s world, monetary policy and fiscal policy are separate and there is no room for grey areas. Ideologically speaking, I agree with Plosser. And I see what I have called the creeping power grab by the executive branch and Federal Reserve as problematic for U.S. policy.

But, the Fed has a dual mandate legally. Therefore Fed policy makers are legally committed to fulfilling it. And, in a world in which fiscal policy has been neutered, it leaves the Fed as the only game in town.

The economics muddle on fiscal

Let’s look at the way economists see fiscal policy for one second. I will use three examples, John Cochrane, Paul Krugman and Lars Syll, to represent differing views on the subject. And the impression you should be left with after reading their views is that there is no general agreement at all on how to model fiscal policy, how it works, and whether it is effective.

Let’s start with John Cochrane. He is against using fiscal policy actively. Recently, he wrote this about Keynesian (fiscal) stimulus:

Many Keynesian commentators have been arguing for much more stimulus.  They like to write the nice story, how we put money in people’s pockets, and then they go and spend, and that puts more money in other people’s pockets, and so on.

But, alas, the old-Keynesian model of that story is wrong. It’s just not economics. A 40 year quest for “microfoundations” came up with nothing. How many Nobel prizes have they given for demolishing the old-Keynesian model? At least Friedman, Lucas, Prescott, Kydland, Sargent and Sims. Since about 1980, if you send a paper with this model to any half respectable journal, they will reject it instantly.

But people love the story. Policy makers love the story.  Most of Washington loves the story. Most of Washington policy analysis uses Keynesian models or Keynesian thinking. This is really curious. Our whole policy establishment uses a model that cannot be published in a peer-reviewed journal. Imagine if the climate scientists were telling us to spend a trillion dollars on carbon dioxide mitigation — but they had not been able to publish any of their models in peer-reviewed journals for 35 years.


…If you want to use new-Keynesian models to defend stimulus, do it forthrightly: “The government should spend money, even if on totally wasted projects, because that will cause inflation, inflation will lower real interest rates, lower real interest rates will induce people to consume today rather than tomorrow, we believe tomorrow’s consumption will revert to trend anyway, so this step will increase demand…”

That, at least, would be honest. If not particularly effective!

Paul Krugman on the other hand wrote about the New Keynesian case for fiscal policy in response to Cochrane saying that:

It’s been a bit funny on the academic front being a Keynesian during a Keynesian crisis. Much of the academic profession decided more than 30 years ago that the whole thing was nonsense and what we needed was an equilibrium model of the business cycle. By the time the utter failure of the equilibrium project became apparent, you had a whole generation of economists who knew that Keynesianism of any form was nonsense based on what they had heard somewhere, so they didn’t read any of the stuff, old or new — and were flabbergasted to learn that there was in fact an extensive New Keynesian literature that provided a justification for fiscal policy at the zero lower bound.


Now, is there a way to get a rise in consumption, and a multiplier bigger than 1? Yes. That Euler condition is based on the assumption that people have perfect access to capital markets, so that they can borrow and lend at the same rate. If some of them are instead liquidity-constrained, the increase in income from the rise in G will lead to some increase in C as well, and we have a story that is even closer to the old Keynesian version. This isn’t hard — at least it shouldn’t be for anyone with a graduate training in economics. Just try actually reading what New Keynesians write.

Krugman’s piece is a bit wonkish for non-Economists but suffice it to say he tries to make the case for fiscal stimulus using New Keynesian models. And this puts Lars Syll, a post-Keynesian economist from Sweden, over the top:

According to Krugman, this shouldn’t  be hard at all — “at least it shouldn’t be for anyone with a graduate training in economics.”

Hmm. This doesn’t seem convincing at all.

1 So, according to Wren-Lewis, macroeconomics has really made progress on monetary issues thanks to central bank economists and since we have been able to definitely conclude that wages are “sticky”. Wow! That’s really impressive! (And the earth still isn’t flat?) Keynes argued that conclusively more than 75 years ago …

2 And are central bank economists really “taking an objective view”? How is it even possible to think that thought today, when the “relevant jury” for at least four years has known that these guys to a large extent were the culprits of the latest financial and economic crisis. Devoted Ayn Randian Alan Greenspan “taking an objective view”? I’ll be dipped!

3 Is ideology only playing a role when it comes to fiscal policies? Hard to believe. As already Gunnar Myrdal argued 80 years go, ideology is all over all economists. Whether they are into monetary or fiscal policies is immaterial.

4 And — perhaps most disturbing of all — in both Krugman and Wren-Lewis we see a rather unbecoming self-congratulatory attitude, according to which all macroeconomists (allegedly) share the same basic mainstream neoclassical theory, so when we discuss and argue it’s only about which policy and model to choose.

Let me sum this up. None of these economists agree. For the non-economist, a lot of what I just quoted is dense and undecipherable technical jargon while dropping obscure names from the field of economics. Almost no one but an economist is interested in any of this. It would be really difficult to choose a story to follow based purely on the logic. And so the layperson has to pick based largely on ideological predisposition.

Cochrane says “Washington loves the story” of Keynesian fiscal stimulus ostensibly because he believes politicians are predisposed to spending. You get the impression from Cochrane that no one in Washington shares his anti-Keynesian stimulus views. However, the reality here in Washington is that Cochrane’s framing is popular. And this is exactly why, despite the worst financial crisis in 80 years, US government spending has grown at the slowest pace since Eisenhower.

My whole contention here is that fiscal policy is whipped out only as a last resort, Monetary policy is the only game in town. And it is because of the view Cochrane expresses, that this is so. Gavyn Davies says ”calls for fiscal action are bound to intensify”. But I am saying they won’t be heeded – at least not yet. Instead, we will continue to get solutions like QE.

Where is this headed?

I believe this is headed toward permanent zero i.e. a situation in which we have policy rates at zero percent for much longer than the market currently anticipates. Where this leads is unknown.

Last night, I had an exchange with Economist Ann Pettifor about where this was headed and her comments were insightful.

I was reading Paul Krugman’s piece on a permanent slump and was thinking about the line where he writes that, “Easy money should, and probably will, be with us for a very long time.” If easy money should be with us for a long time, is that because it worked in the 1990s and in the 2000s and will work again? If the 1990s and 2000s weren’t a period of easy money, what were they? And if they were periods of easy money, what were the benefits to the middle class? My thinking is that easy money will end in a bubble and that bubble will be a net negative for middle class income and wealth.

Ann wrote that the 1990s and the 2000s were a period of easy money in that policy rates were low but that money became more expensive for companies (and households). In her view, the Fed’s rate is almost irrelevant to ‘market rates’ across the spectrum of borrowing. The Fed rate may stay easy, but that doesn’t mean it will always be easy for the rest of borrowers. It is these higher rates, which are beyond the control of the Fed which will puncture the reinflated asset price bubble – as sure as night follows day. The only question is when? When and how next recession occurs will be instructive then. In Japan, we saw a recession in 200-01 despite zero rates, meaning that the business cycle continued in Japan despite the zero rate policy. And the result was a new secular low for stock prices in Japan in nominal and real terms. So I think that we should expect a recession to occur in the U.S. in the medium-term even if monetary policy stays accommodative.

At that point, we can look to Japan again for what happens in a situation when policy rates have been low, are presently low, and are expected to remain low indefinitely. In that case, the yield curve should flatten and permanent zero will become toxic for both banks and savers. Only deflation will make real interest rates positive.

Yesterday’s Wall Street Journal made for good reading on this score. As Japan’s banks are finding it hard to lend despite easy money. Here are some choice quotes:

  • At Koeido Co., a 156-year-old sweets maker based in this city in southwest Japan, chairman Shuichi Takeda says he feels the country may finally be coming out of a 20-year funk. But with future demand unclear, and costs for imported sugar rising, Koeido still isn’t bullish enough to take out bigger loans to replace equipment or expand its business—even though banks are begging it to borrow more. “The economy doesn’t necessarily get better just because of monetary easing,” says Mr. Takeda. “And you don’t borrow just because rates are low.” 
  • Normally, monetary easing filters into the economy through banks, which soak up the cheap cash and then lend it out again—stimulating spending, investment and growth. But decades of shrinking demand and falling wages have spooked potential borrowers. As borrowing dwindled, financial firms put more money in the safety of low-yielding government bonds. Currently, Japanese banks hold around 142 trillion yen, or about $1.4 trillion, in government bonds—roughly 14% of the market—versus about 2% in the U.S.
  • Chugoku Bank Ltd., Okayama’s biggest lender, now stashes nearly as much money in stocks and bonds as it dishes out in loans. The lender’s loan balance actually declined slightly in the quarter ended Sept. 30. Meanwhile, it continues to hold around $11.2 billion—more than a third of its portfolio—in Japanese government bonds. With demand for loans falling well below the amount of deposits flowing in, “we can’t do anything but invest that money in securities, in order to raise profits,” says Masato Miyanaga, Chugoku’s president.
  • In one sign of strain, funds flowing out from banks in the form of loans have fallen far below the amount of cash flooding in. That loan-deposit gap has been widening at an average pace of 8% each year over the past decade. Loans at Japanese banks amounted to 69% of deposits at the end of October, versus 76% for U.S. banks—even despite the broad credit curb that has lingered since the U.S. financial crisis. 
  • “The idea that the Bank of Japan will buy bonds, and then the extra money will start flooding into corporate or retail loans—that’s just a theoretical exercise,” says Chugoku’s Mr. Miyanaga. “Most important is [for the government] to hurry up and produce a concrete growth strategy, which will spur private economic activity.”

This is where the U.S. and Europe are headed unless something changes drastically.

What kind of policy solutions will we see then? Bailouts? Bail-ins? Even more aggressive monetary policy solutions to buy up different asset classes like municipal bonds? Will we get more fiscal solutions? Or will we see wealth confiscation schemes? Time will tell. But one thing is clear, relying primarily on monetary policy is not going to work. Aggressive monetary policy has unintended consequences. Japan is the best real economy example of what those consequences are.

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