The central bankers have been meeting in Wyoming over the weekend as part of the annual Economic Symposium organised by the Federal Reserve Bank of Kansas City. While not all of the papers and discussion are yet available for public scrutiny there were some notable presentations (that you can access in full) which suggest that key central bankers are starting to realise that the economic crisis in not over and the fiscal-led recovery is slowing and that monetary policy alone cannot provide the solution. Moreover, one leading central banker indicated that monetary policy is not a suitable tool for controlling longer term problems such as price bubbles in specific asset classes. This view challenges the basis of the mainstream macroeconomics consensus that has dominated the policy debate for 30 odd years and culminated in the worst financial and economic crisis in 80 years. It is certanly a welcome trend in a debate which is typically flooded with ideological input from the mainstream macroeconomics profession.
This afternoon (August 30, 2010), Bloomberg is reporting that – Bernanke Faces Skepticism on Policy Tools, May Need Fiscal Aid.
The news report is updating coverage of the Economic Symposium organised by the Federal Reserve Bank of Kansas City. You can access the papers for the Symposium – HERE – but at the time of writing they were not yet available for the 2010 event.
Over the weekend, the Economic Symposium at Jackson Hole, Wyoming heard two strong presentations from central bankers – Ben Bernanke and Bank of England deputy Charles Bean.
Modern Monetary Theory (MMT) posits that fiscal policy is the most effective counter-stabilisation tool available to national governments if they are sovereign (that is, run a currency-issuing monopoly and float the currency on international foreign exchange markets).
MMT downplays the effectiveness of monetary policy claiming it is a blunt instrument which cannot be targetted (by demographic cohorts, region etc) and has uncertain aggregate impacts on overall spending because it creates winners and losers each time the interest rate is changed.
At the Economic Symposium this theme has begun to emerge among the mainstream speeches of Bernanke and Bean. I guess they cannot go on ignoring the empirical evidence forever even if the mainstream academic economists seem unable to poke their heads out the window to see what actually happens in the real world and why.
Ben Bernanke’s speech on August 27, 2010 has received a lot of press coverage.
It essentially admitted that monetary policy alone cannot keep economic growth moving. It was reported by Bloomberg that “some attendees at the annual symposium said … that the effects of … quantitative-easing measures may be weak or that fiscal policy should play a bigger role”.
So the point is that the mainstream emphasis on monetary policy has been exposed as a flawed policy stance and the insistence by the profession on fiscal austerity is now likely to cause more damage.
Bernanke told the Symposium that:
Notwithstanding some important steps forward, however, as we return once again to Jackson Hole I think we would all agree that, for much of the world, the task of economic recovery and repair remains far from complete. In many countries, including the United States and most other advanced industrial nations, growth during the past year has been too slow and joblessness remains too high … [and] … Central bankers alone cannot solve the world’s economic problems.
This is clearly the case. Remember that economic growth (real GDP) has to at least outstrip the growth in the labour force and productivity growth for the unemployment rate to start falling. In most countries (including Australia) real GDP growth is still not strong enough to eat into the pool of unemployed that expanded during the early part of the downturn.
As a consequence long-term unemployment is rising and labour markets are stagnating.
Given the significant monetary policy shifts in the last three years, it is quite clear that the interest-rate sensitive components of spending (the targets of monetary policy) have not been responsible to the lower rates. Further, while the quantitative easing has reduced long-term interest rates the result has been a massive build up of bank reserves and very little investment spending.
So there is not much evidence to suggest that monetary policy has saved the day during this downturn.
As Bernanke notes – “(e)xpansionary fiscal policies and a powerful inventory cycle, helped by a recovery in international trade and improved financial conditions, fueled a significant pickup in growth”. That is, economic growth comes about as a consequence of aggregate spending driving production decisions by firms.
The demand for credit by the private sector is still low exactly because there is not enough spending in the US at present and so firms fear that sales will not be strong enough to justify the expansion of their working capital (via credit) and further production growth.
He then said:
At best, though, fiscal impetus and the inventory cycle can drive recovery only temporarily. For a sustained expansion to take hold, growth in private final demand–notably, consumer spending and business fixed investment–must ultimately take the lead. On the whole, in the United States, that critical handoff appears to be under way.
This statement is clearly wrong. What he is saying is that politically the US government is not able to fill a greater proportion of aggregate demand with public spending.
Fiscal spending impulses can always underwrite whatever proportion of activity is desired into perpetuity. A permanent expansion public employment would immediately increase and maintain a rise in productive activity.
If net public spending “fueled a significant pickup in growth” then it can also sustain the same growth. A budget deficit, after all, is just a flow of spending. For the flow of spending to be maintained the deficit has to be maintained. Some people (including me) might not like where the spending is flowing too (that is, the composition of final demand) but that is a different issue which doesn’t negate the obvious fact that the spending is beneficial for economic activity.
Bernanke is correct though in his summation that:
… although private final demand, output, and employment have indeed been growing for more than a year, the pace of that growth recently appears somewhat less vigorous than we expected.
This is because the rise in private spending that was predicted to follow the low interest rates has not materialised. Why would it when the overal uncertainty relating to on-going fiscal support for spending and sales is rising as the deficit terrorists win the battle and push governments into austerity programs? The lack of responsiveness of aggregate demand to the rather substantial shifts in monetary policy is one of the stories of the recession.
For too long the mainstream has promoted monetary policy as the sole aggregate policy with fiscal policy being relegated to providing passive support. That is, governments have been pressured for a decade or more to run tight fiscal positions which has entrenched persistently high unemployment so that the inflation genie would not break out of the bottle. Monetary policy was aimed squarely at that genie.
The problem is that inflation really was culled from the system in the 1991 recession rather than by inflation targetting. The downside of this policy mix has been that the private sector has kept growth going as tight fiscal policy squeezed their purchasing power by increasing their levels of undebtedness – to unsustainable levels.
The economic crisis is, in part, an adjustment to these excessive private debt levels. Please read my blog – The origins of the economic crisis – for more discussion on this point.
In this context, Bernanke notes that:
The prospects for household spending depend to a significant extent on how the jobs situation evolves. But the pace of spending will also depend on the progress that households make in repairing their financial positions. Among the most notable results to emerge from the recent revision of the U.S. national income data is that, in recent quarters, household saving has been higher than we thought–averaging near 6 percent of disposable income rather than 4 percent, as the earlier data showed. On the one hand, this finding suggests that households, collectively, are even more cautious about the economic outlook and their own prospects than we previously believed. But on the other hand, the upward revision to the saving rate also implies greater progress in the repair of household balance sheets. Stronger balance sheets should in turn allow households to increase their spending more rapidly as credit conditions ease and the overall economy improves.
MMT proponents have been saying for some years (more than 15) that this re-adjustment had to eventually come. This insight is not one of the predictions that eventually have to come true so you just keep saying it for long enough and you will be right some time. The claims by MMT proponents come from an understanding of the way the sectoral balances interact and, in particular, from an emphasis of the impacts of fiscal positions on the non-government sector. These are all insights that are ignored or denied by mainstream macroeconomists.
Bernanke should have followed up his point by noting that these developments in the private sector (which are occurring in all advanced nations) reinforce the case for increased fiscal intervention. Expanding fiscal policy further will provide further support to private saving while continuing to expand aggregate demand and employment growth.
If the non-government sector desire a surplus then the government sector has to target a deficit for growth to be maintained.
Most of Bernanke’s speech that followed was not particularly insightful or objectionable and showed that he is seemingly coming to terms with the limitations of monetary policy.
For example, in relation to the FOMC’s decision to lower long-term interest rates by buying debt instruments in the markets he notes that:
I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.
Clearly he realises that the build-up of bank reserves that followed from this policy has not had any impact in their own right. The main impact has come via the “portfolio channel”.
This (new) understanding is further demonstrated when he says:
We decided to reinvest in Treasury securities rather than agency securities because the Federal Reserve already owns a very large share of available agency securities, suggesting that reinvestment in Treasury securities might be more effective in reducing longer-term interest rates and improving financial conditions with less chance of adverse effects on market functioning.
So the build-up of reserves was not considered to be inflationary.
But he admitted that the changes to the Federal Reserve’s balance sheet was sailing into unchartered territory and they “do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions”.
MMT tells us that the increasing reserves will not impede anything of consequence or promote any damaging trends. The growth in credit will not be enhanced by the excess reserve holdings and there are thus no aggregate demand impacts to consider.
The uncertainty that I worry about relates to the lack of knowledge about the impacts of the portfolio channel on aggregate demand. It is clear that despite fairly large movements in portfolios in recent years between the government and the non-government sector aggregate demand has not proven to be very sensitive.
That means that monetary policy is not a suitable tool for stimulating and maintaining aggregate demand.
This message was also reflected in the other significant speech presented to the Economic Symposium at Jackson Hole on August 28, 2010 which was based on the paper by Bank of England deputy, Charles Bean (with co-authors) – Monetary Policy After the Fall/
You can also read the Bank of England News Release.
The UK Guardian (August 30, 2010) in the article – Interest rate rises not enough to stop a crash, says Bank of England chief – described the article as a:
… startling departure from the orthodox view … [and] … warned that central bankers will be unable to prevent the next financial crisis if they are forced to rely on raising interest rates alone … [the] … speech … overturned the orthodoxy that has determined policy for the last 20 years …
Bean summarised “the pre-crisis consensus over the appropriate macroeconomic policy framework” as such:
- “Automatic stabilisers aside, fiscal policy was unsuitable as an instrument of macroeconomic demand management”. Bean claims that this was “justified theoretically” using “Ricardian Equivalence” notions. He doesn’t mention that there has was never any empirical support for these theories.
- “Monetary policy was therefore assigned the primary role in short-term aggregate demand management, with policy conducted through the manipulation of a suitable short-run interest rate.”
- “The monetary transmission mechanism operated mainly through longer-term interest rates, asset prices and expectations of future inflation”. So the central bank was pushed into a position where it vigorously pursued an anti-inflation agenda.
- “The conduct of monetary policy was best delegated to an independent central bank, free of short-term political considerations”. This followed from the last point. It was claimed by the mainstream macroeconomists, without any empirical support, that it was “optimal” for the central bank to only focus on what Bean calls “long horizons” and ignore short-term considerations like rising unemployment. It was believed (erroneously) that unemployment in the long-run would not persist beyond some optimal rate (the natural rate) and that governments could not influence this rate using aggregate policy.
- “Asset markets were thought to be efficient at distributing and pricing risk and financial innovations were normally welfare enhancing”. So there was a belief in the efficiency of self-regulated financial markets.
- “Systemic financial crises were seen only in history books and emerging markets; they were unlikely to happen in advanced economies” because these markets were efficient in the sense just noted.
Clearly the financial and then real economic crisis has shown each of these mainstream consensus perspectives to be deeply flawed despite the vast bulk of the profession seemingly intent on hanging on to every last vestige of their belief system.
The purpose of Bean’s paper was to examine whether the mainstream macroeconomic consensus still held water.
He concludes that it does not!
He initially confirms the conclusions that I provided in this blog – Monetary policy was not to blame – which counters the mainstream claim that US interest rates were too low and cause the housing bubble. Bean categorically concludes (with associated empirical support) that monetary policy decisions can only explain “part of the excess growth of credit in the United Kingdom and United States prior to the crisis”.
He also investigates how effective the monetary policy responses to the crisis were and how effective the monetary policy tools (interest rate adjustments) would be in combatting asset and credit bubbles.
He notes that:
… the sharp increases in a range of credit spreads from the onset of the crisis in August 2007, and especially after the collapse of Lehman Brothers in the Autumn of 2008, meant that policy rates had to fall sharply merely to maintain the pre-existing levels of key borrowing rates4, let alone lowering them in order to stimulate aggregate demand to counteract the substantial contraction over 2008 Q4 and 2009 Q1. As a result, many monetary policymakers soon found themselves with policy rates at, or near, the zero interest rate lower bound (ZLB) and were forced to turn to other means to inject further monetary stimulus.
Monetary policy in this situation has only two options: (a) a commitment to “keep future policy rates low”; and (b) “reducing the spreads of longer-term interest rates over expected policy rates through asset purchases financed by money creation” (that is, quantitative easing).
He notes that mainstream economics eschews option (a) because it suggests inflation and doesn’t consider option (b) because Ricardian households and firms will “internalise the budgetary implications of the public sector’s asset acquisitions” and constrain their spending (for example, because they fear higher taxes).
In relation to the mainstream (religious) belief in Ricardian Equivalence, Bean notes that “it is relatively easy to think of reasons why it might not hold in practice” and then lists all the crazy assumptions that have to be satisfied for the theory to be predictive. In the real world none of the assumptions ever hold.
Please read my blog – Pushing the fantasy barrow – for more discussion on this point.
He concluded that quantitative easing and asset purchases works (a bit) but “are probably best kept in the locker
marked For Emergency Use Only” because: (a) the impacts of changes in long-term interest rates is uncertain and not well understood; (b) during a crisis there is insufficient financial market activity to “to correct any excessive compression of the spread between government bond yields and expected policy rates”; and (c) it will stir the conservatives up who will accuse the central bank of operating “at the behest of the government in order to lower the cost of budgetary finance, rather than for monetary policy purposes”. So an ideological complaint!
Overall Bean concludes:
But, generally speaking, monetary policy seems too weak an instrument reliably to moderate a credit/assetprice boom without inflicting unacceptable collateral damage on activity. Instead, with an additional objective of managing credit growth and asset prices in order to avoid financial instability, one really wants another instrument that acts more directly on the source of the problem. That is what “macro-prudential policy” is supposed to achieve.
I agree with that conclusion but not what followed.
Bean correctly notes that the “twin beliefs that financial markets are efficient and that financial innovation is necessarily welfare-enhancing have been
dealt a serious blow by the crisis” and that “financial markets are riddled with any number of incentive distortions and market failures.” He also correctly notes that the crisis ” has also raised serious question marks about a policy of benign neglect towards credit/asset-price booms”.
So he is really railing against the mainstream Greenspan-Washington consensus that was embodied in the smug conclusion by many mainstream macroeconomists that the business cycle was dead. Please read my blog – The Great Moderation myth – for more discussion on this point.
He then concludes that the “deployment of macro-prudential instruments, focussed more directly on the source of the excessive exuberance seems more appropriate” is not the complete story in my view. He admits that central bankers “still have much to learn about how such instruments work in practice and how they interface with monetary policy”. In other words, this pursuit is still not able to overcome the endemic bluntness and uncertainty that makes monetary policy an unsuitable tool for counter-stabilisation.
I am for increased regulation which would change the face of banking and the way financial markets work, but the main work to stabilise the economy and its sub-markets should be done by fiscal policy.
The following blogs outline from an MMT perspective how specific asset price inflations (bubbles) should be addressed – Operational design arising from modern monetary theory and Asset bubbles and the conduct of banks.
From the MMT perspective fiscal policy is capable of targetting specific segments of specific markets without endangering wider economic activity. Monetary policy is incapable of achieving that state of fine tuning.
But the essential point that Bean was making – that monetary policy as it stands is not an effective tool to place all your counter-stabilisation hopes on is sound and should reverberate within the mainstream profession. The problem is that as a religous community the mainstream macroeconomists will just hold up their crosses and expel any new ideas that might cause them discomfort.
And to reinforce that point, consider the continued attacks on fiscal policy – Saddled with legacy of fiscal extravagance – by former Australian Treasury official now professor of economics at Griffith University (one of the lower ranked research universities in Australia) Tony Makin published by the right-wing propaganda machine otherwise known as our national daily The Australian.
All spending must be funded one way or another, however, and the funds borrowed for that purpose exhaust funds that could finance other economic activity. This brings to mind an observation by Walter Bagehot, the influential late 19th-century editor of The Economist Magazine who opined, way back in 1873, that: “We have entirely lost the idea that any undertaking likely to pay, and seen to be likely, can perish for want of money; yet no idea was more familiar to our ancestors.”
Yet it is still not at all familiar to many Keynesians.
Poor Tony. What he fails to mention and perhaps even understand is that to the penny the funds borrowed by the federal government are made available to the private sector courtesy of the deficit spending anyway.
He clearly is still hanging onto the old Classical theory of loanable funds, where the interest rate was alleged to mediate saving and investment to ensure that there was never any gluts in real production (the old Say’s Law).
The erroneous mainstream logic claims that investment falls when the government borrows to match its budget deficit – the borrowing allegedly increases competition for scarce private savings pushes up interest rates. The higher cost of funds crowds thus crowds out private borrowers who are trying to finance investment. This leads to the conclusion that given investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate.
It is clear that governments do borrow – for stupid ideological reasons and to facilitate central bank operations – so doesn’t this increase the claim on saving and reduce the “loanable funds” available for investors? Does the competition for saving push up the interest rates?
No and No! MMT never says that central banks will not increase interest rates. There is also the possibility that rising interest rates reduce aggregate demand via the balance between expectations of future returns on investments and the cost of implementing the projects being changed by the rising interest rates.
But the Classical claims about crowding out are not based on these mechanisms. In fact, they assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans. The result competition for the “finite” saving pool drives interest rates up and damages private spending.
Central banks push up interest rates up because they believe they should be fighting inflation and they think the rising interest rate stifle aggregate demand.
Most significantly, from a macroeconomic flow of funds perspective, the funds (net financial assets in the form of reserves) that are the source of the capacity to purchase the public debt in the first place come from net government spending. We call this “a wash” – the funds used to buy the government bonds come from the government!
There is also no finite pool of saving that is competed for. Loans create deposits so any credit-worthy customer can typically get funds. Reserves to support these loans are added later – that is, loans are never constrained in an aggregate sense by a “lack of reserves”. The funds to buy government bonds come from government spending! There is just an exchange of bank reserves for bonds – no net change in financial assets involved. Saving grows with income.
But importantly, deficit spending generates income growth which generates higher saving. It is this way that MMT shows that deficit spending supports or “finances” private saving not the other way around.
Finally, the consumer smoothing argument is based on the Ricardian Equivalence nonsense that I have blogged about regularly. Please read my recent blog – Defunct but still dominant and dangerous – for more discussion on this point.
Please read my blog – Fiscal austerity is undermining growth – the evidence is mounting – for more discussion on the fallacies that accompany the crowding out hypothesis.
In fact, the only time that national government borrowing does squeeze liquidity is when they continue to issue debt to satisfy the demands of the financial markets who desire continued access to the guaranteed annuities that are embedded in the government bonds but run budget surpluses.
Can someone send Tony a knitting book so that he might occupy his time more productively instead of insulting our intelligences with the stuff he writes? It would be a win-win strategy!
Meanwhile the US Republican Party seems to be pursuing increasingly irrelevant issues such as whether the US President is a muslim or not. When the same party continually quotes from the US Constitution in ways that suit themselves I have read their allegations about the Presidents supposed religious preferences with some amusement. Even if they were true who should care? They should just get out more often!
That is enough for today!