Monetary policy will not save the day

Day 2 in Darwin – hot – but back to business. Thanks for all the nice remarks. The IMF once again demonstrated why their entire public funding should be withdrawn by the contributing governments, who could spend it more usefully introducing direct job creation schemes. Once again they have downgraded their growth forecasts as if the situation has changed from when they last told us what they thought would happen. Nothing has changed except the IMF have worked out their previous forecasts were wrong. But then they could never have been right given the policy agendas that the IMF and its repressive partners (such as the EC and the ECB) are pushing on nations that deserve better. More generally, the failure of the IMF to produce reliable estimates is linked to the overall misunderstanding of the relative roles of fiscal and monetary policy that exists among commentators and economists. The neo-liberal dislike of fiscal policy skews the debate towards thinking that monetary policy will save the day. Unfortunately, an understanding of how monetary works and the current problem would not lead one to that conclusion. Only a significant renewed fiscal policy stimulus will arrest the decline towards recession. The IMF has one thing correct – the world economy is backsliding. But then we knew that a long time ago while they were still trumpetting the virtues of fiscal austerity and solid growth prospects.

Remember when the old LP records became a bit worn and the stylus would get stuck. Well I am going to be like that today – and if you want the blog in brief so that you can get back to do other things here it is:

1. The IMF is incompetent not because its staff are stupid but because the staff use the wrong models and operate in a make-believe world.

2. The world economy is enduring on-going stagnation because there is not enough spending.

3. Monetary policy – whether it being normal interest rate management or the aytpical operations such as quantitative easing – will not resolve a situation where the non-government sector is intent on not spending and the government is intent of pursuing fiscal austerity. The obsession that the policy watchers have with “what is the central bank going to do” is revealing but a waste of time.

4. Fiscal policy activism is desperately required and most nations should introduce new stimulus programs, targetted at direct job creation, to kick-start spending in their economies and provide some optimism to the private sector. This will also allow national income growth to occur, which, in turn, underpins the current desire of households and firms to reduce their precarious levels of debt (following the neo-liberal-inspired credit binge).

Now I will explain all this.

The ABC News covered the IMF’s latest update in this story (October 9, 2012) – IMF warns recession risk ‘alarmingly high’.

They said that:

The International Monetary Fund has again cut its predictions for the global economy, tipping the slowest growth since the peak of the global financial crisis in 2009.

I know this is just a news story but if I was the journalist I would wonder what the “again” reference might mean. Each of these snapshots is reported as a standalone event but the “again” is the link to a historical litany of failure.

I have previously dealt with the IMF forecasting errors in these blogs – What do the IMF growth projections mean? and The IMF continue to demonstrate their failings and 100 per cent forecast errors are acceptable to the IMF.

The ABC Report said that the IMFs “modelling” (that is, giving it an air of authority) “shows the risk of recession is ‘alarmingly high’ and “Another IMF staff model suggests a 15 per cent chance of recession in the US next year, a one-in-four chance that Japan will slip into recession, and an 80 per cent likelihood of a euro area recession”. So two models is better than one I suppose!

In this blog – 100 per cent forecast errors are acceptable to the IMF – I prepared a Table which traced the various forecasting sequences that

The pattern is clear. They initially assume a higher inflation, higher real GDP growth trajectory and a lower unemployment rate profile.

This ensures that they forecast a very quick fiscal consolidation – with a major disconnect between that and the real economy. They also are overly optimistic about the estimated budget outcomes – predicting primary surpluses would materialise out of some virtuous cycle of public cutbacks and private resurgence.

Their forecasts of growth in tax revenue are typically very optimistic given the scale of adjustment that would have been required to accomplish the fiscal transformations they advocate.

But we know all this is just a smokescreen. They know as well as anyone that if they told the truth then people would not be quite as complacent and social resistance to their continual demands for more cutbacks would rise.

Occasionally, the IMF reveal their true (dirty) nature like when last week the IMF boss – she who receives a huge pay and ridiculously generous future pension entitlements – claimed that, in relation to Argentina, that the IMF (Source):

… had to choose between the yellow card and the red card. We chose the yellow card. If no progress has been made, then the red card will be out …

What was that about? This was in relation to the September 18, 2012 – Statement by the IMF Executive Board on Argentina – which demanded that Argentina produce more reliable growth and inflation data.

In English there is an expression – the pot calling the kettle black – which is apposite, given the appalling record by the IMF in its own forecasting and data dissemination.

These occasional outbursts from the IMF reveal how little regard they have for people. I thought the response by the Argentinean President Cristina Fernandez de Kirchner captured the situation admirably (Source):

My country is not a football pitch. It is a sovereign nation which makes sovereign decisions … As such it is not going to be submitted to any pressure, and much less to any threat … I would like to tell the IMF managing director: this is not a football match. This is an economic and political crisis, and the worst one in memory since the (Depression era) 1930s … And since we are comparing football (soccer) with politics and economics, I would like to say that the performance of the head of FIFA has been much better than those of the head of the Fund or the IMF directors … The rich countries don’t want partners or friends; they just want employees and subordinates … And we’re not going to be anybody’s employees or subordinates. We are a free country, with dignity and national pride.

Leadership!

So this little exchange revealed the IMFs true nature. But mostly they lie behind this smokescreen of forecasts – all clothed in mystery and authority – “our models” – “our estimates” – etc. And they rely on journalists just accepting each snapshot as a standalone event without tracking the sequence and asking the appropriate questions.

Last week (October 4, 2012), Joseph Stiglitz published an Op Ed article – Adding liquidity is not enough – a fiscal stimulus is needed – in the UK Guardian.

There is a broad alignment of economist emerging spanning the softer New Keynesian edges, the Post Keynesians and those of us who identify with Modern Monetary Theory (MMT).

If you dig very deeply (that is, the meagrest scratch of the surface) you will find deep divisions between these groupings of economists based on how they construe the monetary system. But it is telling that after 4-5 years of crisis the alignment is clear cut – expansionary fiscal policy is required now and monetary policy innovations will not be sufficient to arrest the decline back into recession that is occurring because policy makers are misusing their fiscal capacity.

Joseph Stiglitz is on the softer New Keynesian edge. He still writes things that make me shiver but at present his

In the UK Guardian article he notes that the “extraordinary monetary policy measures” taken “on both sides of the Atlantic” in September will not solve the crisis.

He considers the “euphoria” of the markets to the recent announcements and the manic fear mongering from the “political right” about the certainty of hyperinflation are “unwarranted”. Why?

Simple:

With so much underutilised productive capacity today, and with immediate economic prospects so dismal, the risk of serious inflation is minimal.

There are two sources of inflation in a monetary economy. First, demand-pull inflation results from nominal demand growth (spending) exceeding the capacity of the real sector (supply) to meet it with increased output. That occurs around full capacity (full employment), although certain sectors might get to this point before others and start pushing up the price index.

Second, cost-push inflation occurs when a key cost component (for example, energy) rises and firms attempt to pass on the squeeze on their profit margins arising from the increasing unit costs by hiking prices. Inflation (being a continuous increase in the price level rather than a once-off adjustment upwards) will only occur in these circumstances if workers then attempt to protect their real wages by winning nominal wage increases. The process could work in reverse – wage push followed by margin defence.

In relation to monetary policy, it is the first type of inflation the scare mongerers are referring to, even if they themselves are not particularly knowledgable about the difference. They trot out phrases like “too much money chasing too few goods” – a vision derived from the old classical Quantity Theory of Money, which via an identity (that is, an accounting statement) – MV = PQ (where M is the money stock, V is turnover or velocity of that stock in transactions per period, P is the price level and Q is real GDP) – links monetary growth to prices.

So it is a matter of accounting that the money stock (M) times the velocity of money – the turnover of the money stock per period (V) is equal to the price level (P) times real output (Q).

To render that a theory of inflation, the mainstream had to directly link M to P and they did that by assuming that V is fixed (despite empirically it moving all over the place) and claiming that Q is always at full employment as a result of free market adjustments.

Even on its own terrain, the theory has no traction in the current crisis.

But overall, it was a theory that denied the existence of unemployment. The more reasonable mainstream economists admit that short-run deviations in the predictions of the Quantity Theory of Money can occur but in the long-run all the frictions causing unemployment will disappear and the theory will apply.

By claiming that V and Q are fixed, it becomes obvious that changes in M cause changes in P – which is the basic Monetarist claim that expanding the money supply is inflationary. They say that excess monetary growth creates a situation where too much money is chasing too few goods and the only adjustment that is possible is nominal (that is, inflation).

Given that the central bank was deemed responsible for the growth of the money supply the conclusion was simple.

Governments (central banks) are thus to blame for inflation because they were too busy “printing money” to try to keep unemployment low (lower than the supposed but mythical NAIRU) and that they should adopt a monetary targetting rule to provide certainty.

Please read my blog – Central bank independence – another faux agenda – for more discussion on this point.

This sort of reasoning is behind all the current scaremongering that is trying to relate the non-standard type liquidity augmenting measures that central banks have been (misguidedly) engaged in over the last few years (thinking, erroneously, that if banks had more reserves they might lend more)

But, as is often the case, humans fail to heed the lessons of history. This is especially the case for those who have trouble seeing beyond their blinding ideological blinkers at the best of times.

One of the contributions of Keynes in the 1930s was to show the Quantity Theory of Money could not be correct. He observed price level changes independent of monetary supply movements (and vice versa) which changed his own perception of the way the monetary system operated.

Further, with high rates of capacity and labour underutilisation at various times (including now) one can hardly seriously maintain the view that Q is fixed. The assumption of full employment came directly from the so-called classical labour market model that survives in undergraduate textbooks even today, which assumes that flexible wages will resolve any excess supply (unemployment) or demand (over-full employment).

The narrative goes that anyone who is unemployed is voluntarily choosing that state because otherwise they could just offer themselves at a lower wage and there would be an instant demand for their services.

But in the real world, workers are powerless to improve their job prospects in this way when there is an overall shortage of spending. Firms will not hire workers to produce things when there is no demand for them no matter how cheap the labour becomes.

All of this was slugged out in the 1930s and the lessons were clear. It is a pity they are conveniently forgotten.

The reality is that there is always scope for real adjustments (that is, increasing output) to match nominal growth in aggregate demand when there is unemployment and idle productive capacity. So if increased credit became available and borrowers used the deposits that were created by the loans to purchase goods and services, it is likely that firms with excess capacity will respond by increasing real output to maintain market share.

Moreover, as I explain in this blog – Money multiplier and other myths and these blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – the central bank cannot control the money supply anyway.

Joseph Stiglitz makes the case against monetary policy very clear:

Nonetheless, the Fed and ECB actions sent three messages that should have given the markets pause. First, they were saying that previous actions have not worked; indeed, the major central banks deserve much of the blame for the crisis. But their ability to undo their mistakes is limited.

Second, the Fed’s announcement that it will keep interest rates at extraordinarily low levels through to mid-2015 implied that it does not expect recovery anytime soon. That should be a warning for Europe, whose economy is now far weaker than America’s.

Finally, the Fed and the ECB were saying that markets will not quickly restore full employment on their own. A stimulus is needed. That should serve as a rejoinder to those in Europe and America who are calling for just the opposite: further austerity.

All of which should warn all the “Fed watchers” and “ECB watchers” off. I am always amused by the host of press speculation about what Dr Bernanke or Mr Draghi is going to do next. Will they or won’t they! QE2, 4, 8, 10, whatever. All of this angst is, as Joseph Stiglitz notes – missing the point.

Emphatically:

But the stimulus that is needed – on both sides of the Atlantic – is a fiscal stimulus. Monetary policy has proven ineffective, and more of it is unlikely to return the economy to sustainable growth.

The reasons are simple and as the record is well and truly stuck here they are:

1. QE can only work if it stimulates aggregate demand – that is, increase spending. The only way it can do that is via the lowering of longer-term interest rates (as the central bank buys up bonds and drives their yields down). But that relies on the private sector having a taste for risk (borrowing) and it is clear that, even with significant reductions in the investment maturity rates, there is little thirst out there for borrowing.

Why should there be? The private sector is being confronted with fiscal austerity and a household sector intent on battening down and paying down debt. Firms will only invest in new productive infrastructure if they expect that households (and other firms) will purchase the consumer or capital goods that they produce.

At present, it is clear that firms have more than enough productive capacity to meet current expected aggregate demand. Result? No big investment boom is coming and so borrowing is mute.

Further, with more governments scorching the earth with fiscal austerity – mindlessly claiming that by cutting spending you get more – a sort of sick alchemy – households are facing increased unemployment risk again. With record levels of debt hanging over the sector and the risk of joblessness rising in an environment where high levels of unemployment and underemployment persist – why would there be a renewed outbreak of frenzied borrowing?

2. Building bank reserves – which is all the non-standard liquidity measures have done – will not increase loans. Why? Because banks do not lend out reserves. A lack of reserves is not the constraint. Loans create deposits. The constraint is point 1 – no thirst for borrowing.

3. Monetary policy is not spending. It might influence spending but only indirectly, with a lag (if at all), and the ultimate impact may well be perverse if the distributional consequences of interest rate cuts lead creditors to spend less by more than the borrowers spend more. Further, monetary policy cannot be regionally or demographically targetted.

Which tells us that if spending is required then it would be better for the spending arm of policy to be activated – that is, fiscal policy. Government spending is direct, can be targetted (indivually, spatially, etc), and can be part of an overall package of redistribution (where tax policy might reduce the purchasing power of one income cohort, for example, and public spending might boost the purchasing power of another).

Joseph Stiglitz is mostly correct but if we scratch … we read:

In traditional economic models, increased liquidity results in more lending, mostly to investors and sometimes to consumers, thereby increasing demand and employment. But consider a case like Spain, where so much money has fled the banking system – and continues to flee as Europe fiddles over the implementation of a common banking system. Just adding liquidity, while continuing current austerity policies, will not reignite the Spanish economy.

Which isn’t exactly a critique of so-called “traditional economic models” but rather a special case exception (being Spain). Modern Monetary Theory (MMT) provides a comprehensive critique of the notion that increasing bank reserves (“increased liquidity” in this context) increases the capacity of the banks to lend.

Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.

But his account of why borrowing will not be stimulated by anything that monetary policy might do at present is generally agreeable.

He also talks about the flawed logic that longs for an export-led recovery. He notes that lower interest rates in, say the US, puts downward pressure on the exchange rate and other things equal would stimulate external competitiveness (boost exports).

But, of-course, other things are not equal. He points to lower interest rates in Europe as offsetting any gains the US might enjoy (via trade) from its low interest rate regime.

But the stronger argument is that fiscal austerity drains the capacity of a domestic economy to import. For one nation to export, at least one other has to import that much.

Please read my blog – Fiscal austerity – the newest fallacy of composition – for more discussion on this point.

Continuing to scratch the surface a bit, we read that:

In Europe, monetary intervention has greater potential to help – but with a similar risk of making matters worse. To allay anxiety about government profligacy, the ECB built conditionality into its bond-purchase programme. But if the conditions operate like austerity measures – imposed without significant accompanying growth measures – they will be more akin to bloodletting: the patient must risk death before receiving genuine medicine. Fear of losing economic sovereignty will make governments reluctant to ask for ECB help, and only if they ask will there be any real effect.

The impression given to readers is that monetary policy might work without fiscal austerity. I don’t think that is correct for reasons outlined above.

As in the US or Japan or Australia, the Eurozone could be saved from this crisis by a strengthening of aggregate demand. That has to come from fiscal policy.

Which means that the ECB could rescue the Eurozone if it acted in a fiscal manner and provided the funding for relevant member states to expand their deficits and create jobs etc. That is the only way a “monetary intervention” will help. But then, I wouldn’t call that a monetary intervention because it misleads the reader into thinking that it is an act of monetary policy.

Overall, I agree with Joseph Stiglitz when he says:

For both Europe and America, the danger now is that politicians and markets believe that monetary policy can revive the economy. Unfortunately, its main impact at this point is to distract attention from measures that would truly stimulate growth, including an expansionary fiscal policy and financial-sector reforms that boost lending.

Very clearly!

Conclusion

Now I have to meet with someone and then go and look for a place to live!

That is enough for today!

(c) Copyright 2012 Bill Mitchell. All Rights Reserved.