Monetary policy cannot carry the counter-cyclical weight

In his – Introductory Statement – at the Press Conference last week (November 8, 2012) announcing the decision of the ECB Governing Council, ECB Boss Mario Draghi provided us with all the evidence we need that the conduct of macroeconomic policy is being based on false premises, which makes it unsurprising that the world economy is enduring slow to negative growth and millions are unemployed. The ECB decision was to keep interest rates unchanged. But that isn’t the point of this blog. We all look to monetary policy to solve the crisis when it is ill-equipped to do so. The reliance on monetary policy and the hostility towards fiscal policy is all part of the same ideological baggage that caused the crisis in the first place. Dr Draghi’s promise that the ECB would buy unlimited quantities of government bonds was held out as part of the solution but in fact only confines the central bank to maintaining solvency, which is intrinsic to any currency-issuing government anyway. But the main Eurozone problem is a lack of aggregate demand. The ECBs action do nothing to resolve that problem. Similarly, the Federal Reserve, the Bank of England, the Bank of Japan and all the rest of the central banks do not have the tools to ensure that the main problem is addressed. The crisis has confirmed that yet so deep has been the indoctrination that we (the collective) still hang on to the idea that fiscal policy is bad and monetary policy has to carry the counter-cyclical weight. The fact is that it cannot.

The ECB President noted that:

Economic activity in the euro area is expected to remain weak, although it continues to be supported by our monetary policy stance and financial market confidence has visibly improved on the back of our decisions as regards Outright Monetary Transactions (OMTs). At the same time, the necessary process of balance sheet adjustment in large parts of the financial and non-financial sectors as well as high uncertainty continue to weigh on the economic outlook. It is essential for governments to support confidence by forcefully implementing the necessary steps to reduce both fiscal and structural imbalances and to proceed with financial sector restructuring.

The Governing Council remains firmly committed to preserving the singleness of its monetary policy and to ensuring the proper transmission of the policy stance to the real economy throughout the euro area. As we said before, we are ready to undertake OMTs, which will help to avoid extreme scenarios, thereby clearly reducing concerns about the materialisation of destructive forces.

Which tells you everything you need to know that the macroeconomic narrative is being conducted on false premises.

For readers who haven’t followed the developments in monetary policy in Europe recently, the – Outright Monetary Transactions – refers to the ECB decision in September 2012 to signal an intention to purchase unlimited quantitites of short-maturity (one to three years) sovereign government debt in secondary markets in Europe.

The announcement included the intention to make these purchases “conditional” on the relevant member-state being included in a “bail out” program and abiding by the terms imposed.

This all meant that the ECB was completely aware that it could fund any deficit spending within the Eurozone – which in the language of the September announcement – would have “(n)o ex ante quantitative limits”. Which we could easily express there being no financial constraints.

The only intrinsic constraints on government spending are the availability of real resources. Of-course, there are elaborate institutional structures that governments erect to constrain their capacity to fully utilise their capacities as the currency-issuer.

These structures include complex bond-issuance structures and requirements, so-called independent central banks (see below) and fiscal rules. The entire Eurozone is a very elaborate version of these sort of institutional structures.

These constraints are, however, of an ideological origin. Of-course, the Australian government (like most) has to borrow to spend – given the voluntary constraints it has placed on itself. The problem is that the public are mislead about the nature of these constraints.

We are led to believe they are financial constraints rather than an ideological imposition designed to make it hard for governments to spend “freely” or, from my way of thinking, responsibly.

When the government say it has run out of money and cannot provide public jobs to give income earning opportunities to the millions that are unemployed due to a lack of spending it is lying. What it is really saying is that the high levels of unemployment suit its political aims – which are usually expressed in terms of irrelevant financial ratios rather than things that matter.

The government then spend millions on advertising and engages us via public appearances trying to convince us that the irrelevant things are the highest priority. When the spending austerity impacts on power lobbies there are screams – think about the military machine in the US in Virginia who screamed in the lead up to the election that defence spending could not be cut as planned.

Draghi’s statement clearly tells that the currency issuer can fund without “quantitative limits” any deficit spending. What the ECBs statement meant was that private bond markets were only given scope if the central bank so chose. At any time the central bank wanted to, it could render the preferences of the bond markets for yield and maturity irrelevant.

Where the ECB erred was then to make that support conditional on fiscal austerity. That was an ideological imposition and, of-course, guarantees that the member states in the Eurozone will not be able to use fiscal deficit expansion to promote the growth that is necessary to resolve the crisis.

The OMT program is about maintaining the solvency of the member-state governments who have fallen foul of the private bond markets. If the earlier version of the OMT (the Securities Market Program) had not have been introduced, Greece would have defaulted a few years ago. The ECB is capable of ensuring any government which uses the Euro remains solvent at all times if it so desires.

So then think about what could he be thinking of when after admitting that economic activity will remain weak he said the ECB would be “ready to undertake OMTs, which will help to avoid extreme scenarios, thereby clearly reducing concerns about the materialisation of destructive forces.”

A little later in his “introductory statement” to the press conference Draghi said:

Turning to the monetary analysis, the underlying pace of monetary expansion continues to be subdued … The annual growth rate of loans to the private sector … declined further to -0.4% in September, from -0.2% in August. This development was mainly due to further net redemptions in loans to non-financial corporations … To a large extent, subdued loan dynamics reflect the weak outlook for GDP, heightened risk aversion and the ongoing adjustment in the balance sheets of households and enterprises, all of which weigh on credit demand.

In other words, credit expansion which drives “monetary expansion” (he referred to the growth in M3 – broad money – in the sections of the quote I edited out for space reasons) is primarily about real economic conditions. If asked he would have said that adding bank reserves (via OMT) does nothing much to stimulate credit demand if at the same time the real economy is contracting.

In other words, the problem in the Eurozone is one of deficient aggregate demand not solvency. The ECB’s main (latest) monetary policy intervention (the OMT) has taken the threat of insolvency out of the equation – unless of-course, the central bank renegs on the commitment and refuses to fund a particular member-state via the secondary bond market purchases.

But what the central bank does not address is the deficiency in aggregate demand, which is the main problem facing the member-states.

The question then is whether the central bank should be relied on to stimulate aggregate demand.

In the Eurozone context, the combination of the fact that the member-states effectively use a foreign currency (the Euro) and are subject to largely self-destructive fiscal rules (for their economies) means that the only way the central bank can stimulate demand is via fiscal policy.

That is, the ECB would have to guarantee that the fiscal deficits of all governments will be sustained at levels necessary to fill the non-government spending gap, irrespective of what size deficits that would require. That would be the responsible strategy.

The recovery has to be spending-based and monetary policy can only indirectly impact on spending, which makes it an inferior policy tool for governments to rely on for several reasons.

Consider this New York Times article (March 29, 2012) – Who Captured the Fed? – which provides an interesting account of the evolution of the central banking system in the US. While the article has a specific US focus

The article (by MIT economists Daron Acemoglu and Simon Johnson) noted that the early history of central banking in the US was one where the institutions that set interest rates were used by politicians to “prop up Wall Street banks”. As time passed, the authors claim that politicians learned that they could “use central banks to manipulate the business cycle, boosting output growth and cutting unemployment ahead of elections”.

This was considered to be a negative because it allowed economic policy to be at the behest of politicians. The authors claim that the move to so-called “independent central banking” emerged after the “high inflation of the 1970s”, and fed inflationary expectations that meant inflation would be a self-fulfilling process.

Peope formed the view that the central bank would not take hard decisions to control inflation and so acted as if inflation would continue to increase – and so it did as a result of these actions.

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

The authors conclude that since the period financial deregulation:

… the Wall Street banks are calling the shots again … [monetary policy] … has a major impact on stock market prices. Any central banker raising interest rates is reducing stock market values and thus eroding the bonuses of top bankers and other chief executives. Those people will lobby, asserting that higher interest rates will undermine the economy and cause us to plummet into recession, or worse.

The problem they raise is that the US Federal Reserve bankers “are quite deferential to financial-sector ‘experts'” and these firms “offer very nice income-earning opportunities to former central bankers”.

The result has been “the Fed … given way completely” with deregulated finance, low interest rates when they should have been higher, “unconditional bailouts in 2007-08” and a failure to “raise capital requirements by enough to make a difference”.

My response to this is that economic policy is part of the political process and that is inescapable. That means that we (the people) get to pass judgement on politicians who misuse economic policy against our best interests on a more or less regular basis. A lot of damage can be done in between elections but at least we get the final say.

In the case of these “independent” central banks – they are managed by unelected and unaccountable technocrats. It is clear that the top central bank officials are mostly appointed by the majority elected government. But it still remains that the image of “independence” allows the central bankers to make decisions that play into the hands of the financial markets elites.

The reality is that in monetary terms, the central bank is part of the government sector and there is very little (sustainable) reason for separating out the central bank from the treasury. It would be far better if the monetary operations that the central bank performs be integrated administratively into the treasury and then all macroeconomic policy would be formally accountable to the voters.

Please read my blog – The consolidated government – treasury and central bank – for more discussion on this point.

The current crisis has demonstrated several things but in terms of the relative merits of fiscal and monetary policy it has been very enlightening.

Apart from the higher levels issues relating to democracy and accountability there are practical issues that predicate against the reliance on monetary policy.

First, the crisis has shown that the main tools of monetary policy have certainly maintained financial stability but have failed to stimulate aggregate demand.

Private borrowers will only seek credit if there are good prospects ahead. Consumers will not borrow when they face an increased risk of unemployment. Firms will not borrow to build new productive infrastructure if they can satisfy the current reduced level of demand with the existing capital stock and if they, too, are uncertain about their future revenue prospects.

The quantitative easing experiments have certainly altered the central bank balance sheets and added unprecedented levels of reserves in the banking system. But they haven’t stimulated demand. The only route via which they may have stimulated demand was via lower rates of interest at the investment maturities of the yield curve (by inflating demand for financial assets in those segments).

The financial press and the central banks themselves led us to believe that banks were not lending because they were short of funds and QE would give them the necessary funds. That was a fallacy and you will note Dr Draghi’s statement is clear – the demand for credit is about the strength of the economy.

Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion on why banks are not reserve constrained.

Also please read – Quantitative easing 101 – which I wrote 3.5 years ago at the outset of the QE interventions. At that stage I predicted it would have little impact because all it really leads to is an asset swap.

Moreover, at present, the private sector is still over-burdened with debt as a result of the credit-binge in the lead up to the collapse. The imperative and desire (it seems from the evidence) is that the debt levels are reduced so that the balance sheets of firms and households are less precarious and more robust against variations in employment levels and national income movements.

The combination of a highly-levered private sector and deficient demand occurs when we encounter a balance sheet recession – the origin of the latter being the unsustainability of the former balance sheet strategy.

Please read my blogs – Balance sheet recessions and democracy and The government is the last borrower left standing – for more discussion on this point.

This has significant implications for the conduct of monetary and fiscal policy. The actual underlying issues at present are weak aggregate demand and persistently high unemployment and rising long-term unemployment.

When we talk about deficient aggregate demand we are considering spending in relation to the capacity of the economy to produce real goods and services. This can also be viewed of as the capacity to employ workers at current productivity rates. So deficiency is a shortfall in spending which provokes firms to reduce output (so that they do not accumulate unsold inventories) and lay off workers.

All recessions have this dynamic. Private spending falls perhaps because firms feel negative about the future growth in sales. Perhaps the fall in private spending originates as reduced consumption. Either way, overall aggregate demand falls.

The normal inventory-cycle view of what happens next notes that output and employment are functions of aggregate spending. Firms form expectations of future aggregate demand and produce accordingly. They are uncertain about the actual demand that will be realised as the output emerges from the production process.

The first signal firms get that household consumption is falling is in the unintended build-up of inventories. That signals to firms that they were overly optimistic about the level of demand in that particular period.

Once this realisation becomes consolidated, that is, firms generally realise they have over-produced, output starts to fall. Firms lay-off workers and the loss of income starts to multiply as those workers reduce their spending elsewhere.

At that point, the economy is heading for a recession.

So the only way to avoid these spiralling employment losses would be for an exogenous intervention to occur. This could come from an expanding public deficit or an expansion in net exports. It is possible that at the same time that the households and firms are reducing their consumption net exports boom. A net exports boom adds to aggregate demand (the spending injection via exports is greater than the spending leakage via imports).

So it is possible that the public budget balance could actually go towards surplus and the private domestic sector increase its saving ratio if net exports were strong enough.

However, in the current balance-sheet recession the huge levels of private indebtedness have to be cleared before private spending growth can occur. The balance sheet urgency complicates the recovery process and make the policy intervention even more critical because private saving has to be supported to allow the balance sheet corrections to occur.

The problem we have been facing for several years now is that the credit binge that preceded this crisis has left a lot of private consumers and investors in diabolical straits with too much nominal debt and declining values of the assets the debt backed.

The need to remedy this problem led to a widespread withdrawal of private spending as the pessimism of future growth spread and the expenditure multipliers reverberated this pessimism across the world economies. Please read my blog – Spending multipliers – for more discussion on this point.

So what started as a financial problem spread into the real economy via the negative spending reactions and the multiplier mechanism. The latter always drives recession whereas the former instigation is not always present.

Imagine if monetary policy was effective. Take Australia, for example. Our household sector is groaning under huge levels of housing debt (relative to disposable income) after the escalation that accompanied the credit binge. The nominal stock of debt will take years to bring down (relative to growth in disposable income) but at the same time increasing numbers of debt-holders are experiencing housing stress – falling prices and negative equity becoming more common.

If reducing interest rates did stimulate growth it could only do that via increasing private credit growth. In the current environment, the non-government sector requires less overall debt not more.

It is of-course unlikely that reducing interest rates, in nations where there is scope to do that, will generate the required boost in aggregate demand.

There are many reasons why monetary policy is less effective than direct government spending.

From a Modern Monetary Theory (MMT) perspective, monetary policy has dubious effectiveness because it is highly dependent on the reactions of creditors (facing low incomes) and debtors (facing higher incomes). The timing and magnitude of these spending reactions are unclear.

For those on fixed incomes, an interest rate cut means they have less to spend. Many people on fixed incomes will be at the lower saving time of their lives so the impact on total spending is likely to be negative.

Monetary policy is a blunt instrument and cannot be targetted at all, except we know it can only influence creditors and debtors and those on fixed incomes.

But fiscal policy can be targetted in many ways that provide more flexibility in the way stimulus can be provided. It can be regionally targetted to attack chronic areas of disadvantage, which impact on private spending.

It can be demographically targetted to provide increased purchasing power to groups that will spend the extra income more effectively.

It can target certain sectors – for example, Obama’s car plan (although I don’t hold that out as an example of a good target).

Further, fiscal policy can reduce the spending capacity in some areas of the economy while at the same time stimulating other areas. For example, increase taxes on higher income earners while introducing public works programs for the unskilled. This might be useful if both the level and composition of spending needed to be changed.

The bottom line is that monetary policy is not capable of this level of fine-tuning. spatially and demographicall

Conclusion

The uncertainty about how monetary policy works and the questionable distributional assumptions that are relied on in the modelling all suggest to me that it is a poor counter-stabilisation vehicle. But, moreover, the concept of counter-stabilisation was perverted under the neo-liberal ideology to mean inflation stability and sacrifice real growth and employment in pursuit of price level stability.

This ideological traph has meant that there has been increased pressures on fiscal policy to contract to “support the inflation fight” and that has further weakened the prospects of recovery. Lower productivity and lower real wages growth has accompanied the inflation targeting period as has persistent labour underutilisation.

It is one of those con jobs that the mainstream of my profession have inflicted on the innocents – all of us.

That is enough for today!

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