Willem Buiter, monetary dominance and the convergence to zero
I have still yet to get my hands on Willem Buiter’s recent research piece about his proposed China-led global recession. However, I have since seen snippets of the piece and have heard what he has to say about it. And frankly, he makes a lot of sense. Let me review the bits I have seen of what he is saying, using my own parlance and analysis. The title says it all about the economic environment and the economic model: disninflationary environment dominated by weak fiscal policy and a monetary offset globally. The outcome, I believe, like Buiter, is likely to be serious economic under-performance.
Now, let me say out the outset here that what I am referring to when I write “monetary dominance” is an economic policy response to a changed economic environment that is dominated by monetary policy with fiscal policy either weak, acting in a counterproductive manner or used only in extremis. This puts central banks front and center and makes them the all-powerful decision makers they have become in today’s global economy.
Before we get to Buiter, let’s look at the history. I would characterize that history as one heavily influenced by high inflation in the 1970s at the end of a long period of fiscal dominance. The economics turned its back on fiscal policy as a main policy lever and went increasingly toward monetary policy as the main or sole plank of cyclical policy. This during a period marked by steadily lower policy rates, coming down from the high teens under Paul Volcker at the Fed during the 1980-82 double dip recession to zero by 2008.
When one looks at literature on monetary dominance, two pieces that pose different views come to mind. And these were both produced just as the Great Financial Crisis and the subsequent convergence to the zero lower bound began. The first from the Fed by Nunes, Yakadina, and Kumhof was called “Simple Monetary Rules Under Fiscal Dominance” and published by the Fed in July 2008. The conclusion:
“Only solid fiscal fundamentals allow for both a benign outcome in terms of welfare and for the ability to fight inflation aggressively. Fiscal reform in developing countries is therefore an in dispensable step before implementing inflation targeting regimes.”
This means that the authors believe fiscal dominance leads to high and variable inflation which makes rule-based monetary policy impossible. Fiscal policy must be neutered and only then can monetary policy be effective.
The other piece — from less august origins but nonetheless interesting — by Peter Siklos from November 2008 is called “The End of Monetary Dominance? How Crises Can Influence Monetary Policy Decisions and Institutions” from the Centre for International Governance innovation. He leads by writing:
“Has the global financial crisis made monetary policy more powerful, or it has exposed its limitations? For the most part, the answer is the former, at least today, but the outlook may not be so rosy…We have certainly witnessed in the last year a series of events that are challenging policy makers as well as their beliefs about how monetary policy ought to be conducted in future. Indeed, these same events may come to haunt the monetary authorities, and we may well see a return to a period when monetary policy was subservient to a fiscal policy that steps in, ostensibly to impose order on an apparently unruly private sector. Central banks, among other players, appear to have unwitingly put in place the conditions necessary for what we can now confidently call the perfect storm of 2008. There were several observers who predicted that a train wreck was looming on the horizon. Indeed, perhaps most stunning of all, the Bank for International Settlements (BIS), created from the ashes of World War I and which quickly became the forum for central bank cooperation, a role it continues to fill to this day, had repeatedly warned about the troubles that lay ahead. “…these facts also suggest that the magnitude of the problems yet to be faced could be much greater than many now perceive” (BIS Annual Report, 2008: 9). The failure of central banks to act on these warnings may come back to haunt them in the near future”
I am not going to take sides except to note that the premise of the second piece, that monetary dominance would soon end, has already been disproven.But I like the message of the second piece, namely that monetary dominance is dangerous in that it cannot respond to crisis adequately. A balanced approach is necessary. And I believe this is true not just in extremis but in all situations.
But fast forwarding to today, Willem Buiter doesn’t see this happening. And this is why he believes a Chinese slowdown will infect the global economy and lead to a global recession. His view is that the Chinese slowdown, mixed with zero rates, limited unconventional monetary policy and a reluctance to even use fiscal policy will mean that a Chinese slowdown will have a greater impact on the global economy than it should do. I agree.
What I believe is likely to occur globally is what is occurring in Canada right now. The economy slows due to the impact of the global growth slowdown. And in Canada’s case, the slowing has meant outright recession. And then the question is: what kind of policy space do we have and how should we use it? This is where Buiter’s view comes into play. He is saying quite clearly that, while some like Canada have policy space on the monetary side, that space is limited and many have none because they are at the zero lower bound. But more importantly, because monetary dominance is still very much entrenched, there will be no fiscal response. In fact, it will be just the opposite.
In the UK, for example, the fiscal situation is considered to be in “excessive deficit” and austerity is deemed necessary to correct the excess. This is true a full six years after the recession of 2007-2009 ended. And George Osborne, the UK Chancellor has independently pledged to take on deficits and make surpluses the norm in the UK. Something that would require large private sector deficits given the negative external balance in the UK.
In Finland, the country is expected to lose its AAA rating this week. The government there will do what it has to do in order to bring down deficits and debt. And given the already high unemployment numbers, this drag on net transfers to the private sector will slow the economy even further. But of course, the ECB is at the zero lower bound. And so there can be no monetary offset to accommodate this retrenchment. At least the Brits have 50 basis points to work with.
This is the situation right across the developed economies. Thus, while the catalyst for China having a major impact on developed economies is not in place yet, the slowdown in China will still have enough impact to slow global growth down further, perhaps to recessionary conditions below 2% by the end of 2016. That’s the baseline case that Willem Buiter is making at Citi.
My view: we are in a largely disinflationary environment with supply outstripping demand in product markets and in terms of labor due to the high levels of private debt prevailing in many developed economies. And this high level of private debt is an outgrowth of a secular period of monetary dominance that has made credit growth the primary driver of economic growth in the World’s largest economy as wage growth has stalled. Now, at the zero lower bound, that game is done. And every nation that has not cut rates to near zero will do so. This means New Zealand Canada and Australia. I don’t think fiscal policy will be on the table, however, unless and until there is a crisis. And by then it will be too late.
For now, the macro them that will continue to dominate is the convergence to zero and the outperformance of Anglo-Saxon bonds that have more room to the downside on yields.