The monetary dilemma
According to the minutes of the last meeting of the monetary policy committee of the US Federal Reserve Bank, the most powerful monetary authority in the world, the committee members are split and unclear on what to do. “Some participants who counselled patience expressed “concern about the recent decline in inflation” and said the Fed “could afford to be patient under current circumstances.”They “argued against additional adjustments” until the central bank was sure that inflation was on track. On the other side, more hawkish members “worried about risks arising from a labour market that had already reached full employment and was projected to tighten further…..backing off from a steady diet of rate hikes could cause the Fed to overshoot its employment target and cause financial instability”, they said.
The problem is that the Fed’s economic models were failing to provide guidance on what to do. The current mainstream model has two strands. The first is the Wicksellian idea that there is a ‘natural rate of interest’ that brings a capitalist economy into harmonious equilibrium where economic growth and full employment and stable and low inflation are combined. The Fed calls this R*. The second is the Keynesian view that there is a trade-off between unemployment and inflation, so that as an economy heads towards ‘full employment’, this drives up ‘effective demand’ beyond any ‘slack’ in supply in the economy and so wages and price inflation ensues. This is enshrined empirically in the so-called Phillips curve, named after a British economist of the 1960s.
The trouble with this mish-mash of a central bank model is that it is not working. The trouble with the Wicksellian bit is that it is nonsense – there is no equilibrium rate. Even worse, the Fed’s economists have no idea what it should be anyway. The Fed’s central estimates of the real neutral interest rate has declined by nearly two-thirds in five years, from 2 per cent to 0.75 per cent. On that basis, the Fed has already exceeded the ‘natural rate’ and is in danger of causing a downturn in the economy.
But the figures are again little more than guesswork. As Ms Yellen said, “[the neutral rate’s] value at any point in time cannot be estimated or projected with much precision”.
The second half of the model is equally faulty. The Phillips curve, measuring inflation against growth and full employment, was proven faulty in the 1970s when inflation rocketed but economies had rising unemployment and falling growth – ‘stagflation’. Indeed, the inadequacy of this Keynesian model led to a counter-revolution in mainstream economics, as economists and politicians swung over to monetarist policies like the quantity theory of money proposed by Milton Friedman and adopted by his epigone, former Fed chief Ben Bernanke.
This was eventually taken to its extreme in quantitative easing (QE). This was the ultimate policy – if an economy is in a depression, it’s because of a lack of money. So just keep pumping it out until things get, things have supposedly got better, so QE has been dumped and the old Keynesian Phillips curve has been restored as guidance to the Fed. Unfortunately, just as in the 1970s, the model is not working. Unemployment rates are near lows – at least in this current business cycle of 8-10 years – but higher inflation in prices and wages has not returned.
Indeed, it has been a quarter of a century since the Fed’s favoured measure of inflation — personal consumption expenditures excluding food and energy — last punched up above the still relatively sedate level of 3 per cent. It was just 1.4 per cent in the year to July. Wage growth, meanwhile, remains well below its pre-crisis pace at just 2.5 per cent.
Janet Yellen, chair of the US Federal commented: “Our framework for understanding inflation dynamics could be ‘misspecified’ in some fundamental way.” Mario Draghi, president of the European Central Bank, observed, “the ongoing economic expansion . . . has yet to translate sufficiently into stronger inflation dynamics”. He’s still hoping. And of course, Ben Bernanke, the monetarist extraordinaire, continues to believe that the Fed’s policy models will work, as he argued in a new paper presented to the Peterson Institute and the IMF this week.
But the evidence is not there. Monetary policy has failed to ‘manage’ the capitalist economy. Monetary policy did not avoid the global credit crunch or save capitalist economies from going into the Great Recession – even if non-stop zero interest credit saved the banking system from complete meltdown (and even that conclusion is open to doubt).
And QE did not revive the ‘real’ economy, the productive sectors, afterwards and instead only inspired a humongous new speculative boom in property, stocks and bonds that continues today (boosting the incomes and wealth of the top 1% everywhere).
In this Long Depression, jobs may have appeared in some economies, but only at low wage rates, only temporary, part-time or self-employed. Real GDP growth has been strangled at no more than 2% a year in the US and even lower in other advanced economies. Business investment has crawled along and, as a result, productivity growth, essential to a long-term revival in capitalist economies, is sluggish and even non-existent.
So what to do? The Keynesians, still believing that the Phillips curve model works, conclude that ‘effective demand’ is still too low and the major economies are stuck in ‘secular stagnation’, not seen since the immediate post-war period (an idea developed by Keynesian Alvin Hansen and proved wrong by the revival of economies form 1947 onwards). In their latest contribution, former IMF chief economist Olivier Blanchard and top Keynesian Larry Summers tell us in another Peterson Institute presentation that what is needed is a combination of monetary easing and fiscal spending:
“What we specifically suggest is the following: The combined use of macro policy tools to reduce risks and react more aggressively to adverse shocks. A more aggressive monetary policy, creating the room needed to handle another large adverse shock—and while we did not develop that theme at length, providing generous liquidity if and when needed. A heavier use of fiscal policy as a stabilization tool, and a more relaxed attitude vis-a-vis debt consolidation. And more active financial regulation, with the realization that no financial regulation or macroprudential policy will eliminate financial risks. It may not sound as extreme as some more dramatic proposals, from helicopter money, to the nationalization of the financial system. But it would represent a major change from the pre-crisis consensus, a change we believe to be essential.”
Actually, what the two gurus advocate is not “a major change”, but really just more of the same that has failed so far to revive the economy.
They had little to say about the Fed’s plan to sell off its huge stock of bonds that it built up under its QE policy of purchases. The Fed wants to do this because it reckons the economy is sufficiently recovered to cope with a reversal of QE and a tightening of credit. Well, you could argue that, as QE had little effect on boosting the ‘real’ economy, reversing QE will have little effect in dampening it.
Maybe so, but what also worries the Fed is that a near-decade of easy money Bernanke-style has so boosted levels of debt in the household and corporate sectors that any rise in interest rates and tightening of credit would drive up debt servicing costs and tip the economy into recession. On the other hand, the Fed does not want to go on pumping yet more credit to make the situation worse. As Janet Yellen put it: “Persistently easy monetary policy might also eventually lead to increased leverage and other developments, with adverse implications for financial stability.”.
This fear has been promoted by the Bank for International Settlements, the central bankers’ bank, which in true Austrian school of economics style, reckons that increased costs of debt servicing from rising interest rates driven by the Fed’s ‘normalisation’ policy could tip things over.
And the IMF in its latest Global Financial Stability report out this week, is also worried that the very size of global debt could eventually lead to serious defaults and retrenchment that would push the global economy back into recession.
The IMF comments that “a shock to individual credit and financial markets well within historical norms could decompress risk premiums and reverberate worldwide, as explored later in this chapter. This could stall and reverse the normalization of monetary policies and put growth at risk.” So if the Fed and other central banks now decide to reverse QE and opt for ‘normalisation’ of their balance sheets, this could be damaging. “Too quick an adjustment could cause unwanted turbulence in financial markets and international spillovers.” On the other hand, “the expected process of normalization is likely to be gradual, with continued easy monetary conditions and low volatility that could foster a further buildup of financial excesses and medium-term vulnerabilities.”. So heads you lose and tails you lose.
The IMF sets the dilemma: “Managing the gradual normalization of monetary policies presents a delicate balancing act. The pace of normalization cannot be too fast or it will remove needed support for sustained recovery and desired increases in core inflation across major economies …On the other hand, the likely prolonged period of low interest rates could further deepen financial stability risks as investors take on more risk in their search for yield.”
The IMF reckons such a debt disaster could hit global growth by up to 1.7% pts a year through 2022 – in effect, cutting current growth by more than half and taking it to levels not seen since the Great Recession. The ensuing recession would “about one-third as severe as the global financial crisis”.
The Fed’s dilemma reveals that monetary policy has failed. It failed to save the world economy from the Great Recession and it failed to get it out of the ensuing Long Depression. Central bank models of the economy, based on a combination of monetarist neo-classical and Keynesian economics, appear to offer no guidance on what stage the major economies are now in and therefore what to do. Should central banks hold back on hiking rates and reversing QE in case economies are still too weak; or should they act now to avoid a huge debt crisis down the road? They don’t know.