Is monetary policy alone enough to stimulate economic recovery?

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H.D Jorgensen's picture

While it seems hard to believe in the wake of the global financial crisis, some central bankers spent the years before the collapse of Lehman Brothers boasting about how reliably boring and ‘automated’ the management of stable monetary policy had become: ‘treat the economy like a car engine and money supply as the gas pedal; when the engine gets too hot, decelerate and let it cool down, when it gets too cold, accelerate more.’ The decades-long success of this ‘mantra of money supply manipulation’ was dubbed by US Fed Chairman Ben Bernanke as ‘the great moderation.’1

Yet, as every car owner knows, there are a few instances where an accelerator can do more harm than good: the first is when the ‘engine’ completely overheats and explodes; the second, when it freezes solid.  Unhappily for America and Europe, before they had time to fully repair the damage of the 2008 economic ‘explosions’, their economic ‘engines’ had frozen over due to the ongoing sovereign debt crisis, leading to abnormally low growth in employment and investment.2

In this essay, I argue that the scale of excess capacity in the European and American economies means that traditional monetary policy is currently impotent. I also highlight innovative monetary policy initiatives that might ‘jump start’ an economic recovery by, perversely, boosting inflation and devaluing the domestic currency. While there may be no ‘perfect’ monetary policy solution to the present crisis, this essay concludes that the unique level of trauma in the global economy makes one thing clear: while a relatively stable and functional political and fiscal environment is an obvious prerequisite for economic recovery, in our ‘depression 2.0’ situation, it is in the economic ‘backbone’ of monetary policy that a recession ‘circuit breaker’ is most likely to occur.

MONETARY POLICY WHEN TIMES ARE GOOD

All monetary policy relies upon the truly magical trick that every central bank has at its disposal - the ability to create money from nothing.  Thanks to this ‘superpower’, central banks can influence the cost of borrowing money from commercial banks by ‘pumping’ or ‘sucking’ money in and out of the economy through a system called ‘open market operations’ (OMO – terminology varies across jurisdictions).

OMO rely upon the requirement that every commercial bank holds a mandated proportion of its balance sheet (the capital ratio) in an exchange settlement account with their central bank. Invariably, commercial banks will either hold too much or too little collateral in their ‘exchange settlement’ accounts, and they redress this imbalance by borrowing/loaning from/to their fellow banks at an overnight interest rate.3

When the central bank places more cash into the exchange settlement accounts than commercial banks desire, banks must compete to loan out the cash by charging lower rates, causing commercial interest rates to fall. Even though the base rate at which commercial banks ‘buy’ cash is the only interest rate that central banks can directly control, commercial banks nevertheless use it as a guide for the rate they charge clients for taking out longer-term loans on real world things like cars and houses. 

While the method used by central bank governors to calibrate the base rate varies across jurisdictions, it is enough to note that if gross domestic product (GDP), current inflation and, significantly, the expected rate of inflation for a defined future period (say, the next six months) are all growing above expectations, then the base rate will probably go up. This is because the base rate set by the central bank is basically the difference between expected inflation and current inflation added to the long-term ‘real interest rate’ of the economy – economists refer to this as the ‘Taylor rule’.4

ZIRP ROYALE

If the economy is in crisis, traditional interpretation of ‘Taylor rule’ “moderation” implies that a central bank should dramatically lower base rates in order to boost the immediate attractiveness of domestic consumption and investment. Yet if the real interest rate remains stubbornly high, the central bank can not offset it by pushing the base rate any lower than zero.5 This conundrum, known as a ‘liquidity trap’, looms over the heads of central bankers in the UK, USA and Europe, where central banks should theoretically lower interest rates to jump-start spending and economic growth, but cannot do so due to their zero interest rate policies (ZIRP). The Federal Reserve target current official target rate is between 0.00% and 0.25% - it clearly cannot go any lower, rendering traditional monetary policy impotent.6

CREDIBLE IRRESPONSIBILITY

Fortunately, the Taylor rule reveals an alternative method for influencing real interest rates beyond the calibration of the base rate.  Unfortunately, this alternative method calls on central bankers to do “a deal with the devil” –inflation: because if nominal interest rates are determined by adding the real interest rate to the difference between current inflation and expected inflation, then a large enough increase in expected inflation will equate to pushing the nominal rate below zero. 

Essentially, if a central bank can convince market participants that it is going to engineer an increase in the inflation rate for the next few years, then the real interest rate will decline as domestic currency will be worth less in the future than it is today.  Market participants who have been delaying investments would thus have a strong incentive to start spending as soon as possible. 

The unusualness of a central bank looking to increase inflation is why Paul Krugman once stated that to escape a liquidity trap, central banks must make a long-term commitment to a ‘credibly irresponsible’ expansion of the money supply (quantitative easing), so as to assure naturally suspicious market participants that interest rates will not go up as soon as the liquidity trap has been vanquished.7  Therefore, in an effort to stimulate economic recovery, central banks must adopt a variety of unprecedented inflationary policies to prove to market participants they are serious about devaluing the domestic currency.

However, having worked so hard to establish a historical reputation for good inflationary management, governors at the ECB and the BoE appear increasingly reluctant to further loosen their grip on inflation by making a long-term commitment to monetary stimulus.  Better, they suggest, to revalue the interest rate above the inflation rate and to encourage governments to move from ‘stimulus’ to deflationary ‘austerity.’8

This ‘back to business’ approach is both regrettable and wrong. It is regrettable, because it fails to recognise that times of economic crisis require a different brand of monetary policy than when times are ‘normal’ – the impossibility of enforcing negative interest rates by traditional means in a liquidity trap makes this clear. We also know that the ‘austerity’ approach is wrong in the midst of a crisis because it has been tried before – it turned the 1929 recession into a great depression. As the lone ‘pro-growth’ governor at the BoE Adam Posen notes, terminating creative monetary stimulus policies now, for fear of overreach, “[is] like saying ‘[the] fire must be out, because we’ve already pumped more water than for any previous fire we’ve fought.9

Critics of prolonged monetary stimulus like to use Japan as a negative counter-proof:10 Japan has been in a liquidity trap for nearly twenty years, yet, despite having monetary stimulus programs and ZIRP for most of that period, has barely seen any significant economic growth. The problem with this criticism is that Japan took several years to introduce ZIRP, experienced multiple economic (and natural) disasters over that period and only seriously started to target an increase in inflation in the mid 2000s - in fact, Japan has actually experienced deflation for most of the last decade11. A better example of credible ‘central banking’ occurred last September in Switzerland, where, to counter the negative growth effects of an overpriced Swiss Franc, the Swiss National Bank successfully enforced a minimum exchange rate with the euro of 1.20 CHF/EUR by promising unlimited intervention in the global currency markets to attain its goal. 

For political reasons, the ECB, US Fed and BoE cannot realistically devalue against one another or another currency without inspiring a cascading ‘currency war’, meaning a more credible policy from these three central banks would be a devaluation of their currencies against a less controversial indicator – perhaps a composite price index of core commodities such as iron, oil and nickel.  This, in combination with ZIRP, quantitative easing and an aggressive expansion of the money supply would represent a bold and heretofore untried monetary policy package.12

History does not definitively tell us how to respond to a crisis - every recession is unique - however it is a crucial guide for what not to do and the biggest risk central bankers could possibly take in this ‘1930’s moment 2.0’ is to not respond to the uniqueness of the current global economic environment with a suite of unique solutions.  Central Bankers must accept that they need to lead a double life – one for when times are normal, the other for when the economy is in a liquidity trap.

Bibliography

  1. Bernanke, Ben. February 20, 2004. ‘Remarks by Governor Ben S.  Bernanke at the meetings of the Eastern Economic Association, Washington, DC: “The Great Moderation”’
  2. Norris, Floyd. February 3, 2012. ‘Bleak Outlook for Long-Term Growth’, The New York Times.
  3. This overnight rate has different names according to jurisdiction i.e. it is named ‘The Effective federal funds rate’ in the USA, LIBOR in the UK etc.
  4. To see the formula: http://www.investopedia.com/articles/economics/10/taylor-rule.asp#axzz1mqJabVXa
  5. commercial banks will not pass on a negative rate as this would mean paying off borrowers’ loans on their behalf - this is theorised to be a poor business strategy.
  6. For the current rate, see http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm
  7. Krugman, Paul. 1999. ‘Japan: Still Trapped’. http://web.mit.edu/krugman/www/japtrap2.html
  8. Tabellini, Guido. 2008. ‘Why Central banking is no longer boring’ available at: http://www.voxeu.org/index.php?q=node/1259
  9. Posen, Adam. 2010. ‘The case for Doing More: Speech to the Hull and Humber Chamber of Commerce, Industry and Shipping.  28 September 2010.
  10. Ueda, Kazuo. 2011. ‘The Effectiveness of Non-traditional Monetary Policy Measures: The Case of the Bank of Japan’. CARF Working Paper series. http://www.carf.e.u-tokyo.ac.jp/pdf/workingpaper/fseries/262.pdf
  11. Ibid.
  12. This is a modified version of the suggestions made by Lars Svensson in his 2006 paper: “Monetary Policy and Japan’s Liquidity Trap”, CEPS Working Paper No. 126. (Svensson supports currency depreciation but does not accommodate for the political difficulty of such a measure).