On September 2, 2021, the Head of the BIS Monetary and Economic Department, Claudio Borio gave an address – Back to the future: intellectual challenges for monetary policy = at the University of Melbourne. The Bank of International Settlements is owned by 63 central banks and provides various functions “to support central banks’ pursuit of monetary and financial stability through international cooperation”. His speech covers a range of topics in relation to the conduct of monetary policy but its importance is that it marks a clear line between the way the mainstream conceive of the role and effectiveness of the central bank and the view taken by Modern Monetary Theory (MMT) economists. I discuss those issues in this blog post.
First, note that Claudio Borio openly admits:
… the loss of policy headroom is not technical in nature … as central banks purchase a growing amount of assets, they risk being perceived as eroding the basis of a market economy.
In other words, all this talk about the need for fiscal rules, and other constraints on government (treasury or central bank) are really not financial (“technical”) but, rather, issues of ideology.
If you think the “market economy” is the ultimate arbiter, then, of course, intervention into those processes will be seen as sub-optimal.
I do not hold the outcomes of an unfettered market economy as being the desirable benchmark upon which we assess government policy.
Quite the opposite in fact.
Other Issues arising from Claudio Borio’s Speech:
1. “inflation has proved rather insensitive to monetary policy easing, thereby thwarting central banks’ efforts to push it up to target post-GFC.”
2. “in its recent review, the Federal Reserve downplayed the role of an unobservable equilibrium rate of unemployment in setting policy” – meaning that the US central bank has effectively abandoned the NAIRU mentality that has ruled monetary policy for several decades and sustained elevated and very wasteful levels of labour underutilisation.
It was all in vain folks.
And in this paper from June 1987 (which was actually written in 1985) – The NAIRU, Structural Imbalance and the Macroeconomic Equilibrium Unemployment Rate – I provided a comprehensive framework and empirical evidence as to why it would be in vain.
34 years later it is, according to Claudo Borio a “well known factor”.
Takes time to catch on, eh?
3. “inflation expectations may be rather backward-looking or at least unresponsive to policy announcements” – all the academic papers that claimed that monetary policy had to pursue inflation targetting and fiscal policy should be submissive to that agenda because that was the way inflationary expectations would remain anchored – what do they say now?
4. That the economic cycle is now driven by the “financial cycle” – which means excessive credit and private debt accumulation as financial market regulation and oversight was weakened.
Claudio Borio says:
There is no question that a key reason for the rise in the financial cycle has been financial liberalisation.
And if you go back to the 1980s, when the mainstream New Keynesian macroeconomists were falling over each other to extol the virtues of financial market deregulation as the path to financial stability, and setting us up for decades of financial instability and crisis, you have to wonder how they can still retain their highly-paid, protected jobs and keep getting the public platform.
5. To all the inflation-mavens, who have run out of credibility claiming government deficits would send them broke, and now hang onto the only thing left – inflation scaremongering, Claudio Borio noted:
It is hard to believe that the inflation process could remain immune to the entry of 1.6 billion lower-paid workers in the global economy, as the former Soviet bloc, China and emerging market economies opened up.
Add to that the relentless labour market deregulation and anti-union attacks in advanced countries, which have made “the wage-price spirals of the past (“second-round effects”) less likely”.
This is a point I have been making for ages – you need propagating mechanisms for inflation to become entrench after an initial shock.
At present, the global supply chains are in chaos.
I was told last week from a friend who uses large bulk freighters as part of his company’s business that the freight prices are rising steeply, in part, because there is huge congestion in China’s system of ports as a result of the Delta Covid strain causing long delays in port clearance.
And, the short-term price spikes are evident.
But to become entrenched as an accelerating inflation, the real income struggle between labour and capital has to be ignited.
That propogation will not be forthcoming any time soon.
The Volcker Shock
Claudio Borio invokes the “Volcker’s efforts” in the 1980s as evidence that:
… central banks worldwide succeeded in taming inflation.
This is one of those dubious claims that persist in history.
The Volcker Shock was like treating a mild headache with a morphine overdose.
It should not be used to demonstrate the ‘effectiveness’ of monetary policy in disciplining price pressures.
Here is a plot of the University of Michigan Inflationary Expectations data from January 1978 to July 2021 and the Federal Reserve Funds Rate for the same period.
You can see that there is not a close correspondence between the time series behaviour of the two series.
Just to satisfy my curiosity, I spent a little while running Vector Autoregressions and Granger causality tests on the data with various lags. Cutting through the jargon, these econometric procedures are standard ways to investigate the associations across time at various lags of the variables.
While the work was nascent, experience tells me that there was no causality running from the federal funds rate to price expectations, although it did work the other way. The interrelationship is thus complex and one cannot infer that monetary policy (adjusting the funds rate) disciplines inflationary expectations.
History tells us that in all the nations I have studied, it was the large recessions (1981-82, 1991 depending on country) that expelled the persistently high inflationary expectations (as a result of the OPEC oil hikes) from the economies.
Those episodes were not exclusively brought on by monetary policy adjustments.
You might say that Volcker knew that if he hiked the funds rate, he would choke off borrowing and that would create a recession, which would discipline expectations.
The problem was that the Monetarist causality he had in mind did not prove to be realised.
He thought he could control the broad money supply by controlling the base money (reserves plus currency) – making it harder for banks to acquire, which would push up rates in the financial markets and squeeze borrowing.
Interest rates went into a sharply upward spiral and borrowing was reduced.
But as a result of the higher rates, there was a dramatic increase in capital inflow in pursuit of dollar-denominated financial assets, which pushed the exchange rate up from the Autumn of 1980 to November 1982 (by around 40 per cent against the major currencies).
This severely undermined US exports and the recession.
Unemployment started to escalate sharply.
The inflation that was in train at the time was the result of oil price hikes in 1979 (quadrupling) and this caused recessions everywhere. The cost pressures were working their way through to other commodities (food, housing, etc) and so by the time Volcker set about wrecking prosperity, the inflation dynamic was already waning.
Further, I am often surprised when people introduce the so-called Volcker Shock as evidence that monetary policy should be the primary macroeconomic counter-stabilisation tool.
Within normal limits of interest rate movements, adjusting interest rates has very little impact at all on the real economy.
The fact that Volcker was prepared to push the overnight rate so high (around 20 per cent) and precipitate a widespread financial crisis, which then pushed thousands of firms into bankruptcy and forced unemployment to rise above 10 per cent in order to kill inflation that was already dissipating is not something to be recommended.
Extolling the virtues of a policy tool that only really achieves the stated aims by invoking a massive crisis, when the target is hardly a worry is not very clever.
One can cure a headache by taking massive overdose of morphine. But the patient dies!
Claudio Borio then expressed a view that the standard New Keynesian macroeconomics:
… by playing down the role of financial factors and overestimating the self-equilibrating properties of the economy, it could not identify the build-up of risks ahead of the crisis nor replicate its dynamic.
In this context, history has caught up with the mainstream paradigm:
1. “There is also a growing recognition that financial factors are important” – remember that the standard NK macroeconomics discounts the impact of financial shocks on “the smooth return to a steady state” and that shifts in monetary aggregates only have temporary effects (if at all) on the real economy.
The evidence is quite the opposite.
2. “the concept of the financial cycle is at the very heart of the macroprudential frameworks implemented post-GFC” – once again, contrary to the way macroeconomics is taught in mainstream programs.
3. “there is still a certain divide within central banks and among their researchers” – the macroeconomists preach NK market-clearing principles and those researchers who understand the impact of financial instability and how it causes recessions.
The advice received by policy makers is schizoid in nature given these two polar opposite views.
Why does this divide persist in the face of evidence that the NK macroeconomists have missed the mark?
He says that “professional experience matters”.
This is code for persistence in thinking reinforced by Groupthink. As one who has worked in economics departments all my life (except for the last several years when I have been working on in a research centre separate from a departmental structure – to my relief), I can tell you that the forces for conformity are strong.
I have written often about that process. It just doesn’t ‘pay’ for a young academic in a tight-knit NK department to buck the system. They want promotion, publications, research money and invitations to the ‘prestige’ conferences.
Prestige doesn’t equate to any notion of quality. It is defined by the inner group as the benchmark everyone has to aspire to within the Groupthink paradise.
Claudio Borio essentially challenges the core beliefs of the NK paradigm.
1. “More to the point, once it is recognised that monetary policy has an impact on the financial cycle, it is hard to believe that for any relevant policy horizon monetary policy could be neutral. There is substantial evidence that financial booms and busts leave very long-lasting if not permanent scars on the economic tissue, especially if banking crises follow.”
2. Once inflation is low, “there could be a stronger tendency for inflation to remain range-bound” and “expectations may well play a smaller role. On the one hand, they may be less responsive to actual inflation; on the other hand, they may have a weaker impact on it.”
The last point is important.
The whole NAIRU paradigm is predicated on the fact that inflationary expectations drive the inflationary process independently of the state of activity in the economy.
And, that central banks can discipline the expectations through ‘credible’ deflationary strategies.
But, now, Claudio Borio, who is reflecting on the evidence concludes that “Inflation expectations may be less responsive to inflation” and an important reason for this is “the absence of second-round effects is loss of bargaining and pricing power.”
This is a point I have been making for some years.
Workers have much less capacity to defend their real wages now than they did in the 1970s.
Which means that price shocks are unlikely to trigger entrenched inflationary episodes.
But finally …
With all that said, Claudio Borio reverts back to form and claims that:
… a key challenge ahead for monetary policy is to regain room for policy manoeuvre, ie to rebuild buffers. Economies that operate with small safety margins are exposed and vulnerable. Building buffers will be especially important in the wake of the Covid-19 crisis, which has also dramatically cut fiscal policy headroom.
He wants rising interest rates – because they won’t be that damaging to output and will reduce “higher risk-taking, weaker financial institutions, capital misallocation, etc”.
This is code for – avoiding taking a harder line of lax financial decision making within banks etc; boosting bank profits with higher rates (screwing the borrowers); and poorly designed tax systems that allow speculative behaviour in asset accumulation to be financially rewarded.
He also claims that the current central bank narrative around the world that they are trying to push up inflation to levels consistent with ‘price stability’ runs against the facts that low levels of inflation are hardly a problem.
He didn’t elaborate on the fiscal ‘headroom’ but he is just running a standard and erroneous line that continuous deficits are unsustainable.
Which is a claim that runs against the facts.
The Speech was interesting because it demonstrated the chaos that the mainstream are now in as their core models are running against the facts and some of the economists within that tradition are breaking ranks to try to save their own credibility.
That is enough for today!
(c) Copyright 2021 William Mitchell. All Rights Reserved.