Death To The New Monetary Consensus And Quantitative Easing

LEGO Grim Reaper Death

Photo: Flickr

Over the past decade and a half a new approach to macroeconomics was developed.In a sense, it integrated the old Bastard “Keynesian” ISLM model that we all learned in intermediate macroeconomics with a Monetarist-inspired “Taylor Rule” for formulating monetary policy and a dynamic “Phillips Curve” to determine inflation.

We do not need to go deeply into the technical details. What is important is that it relegated fiscal policy to the backburner and brought monetary policy front and centre.

Unlike Milton Friedman’s monetarism, the Fed would not adopt a money growth rule, but rather would focus directly on inflation. Adjustment of the fed funds rate would allow it to keep inflation in check.

On this view, policy does not work directly but rather indirectly through influence on market expectations. Hence, the word “consensus” has a dual meaning: first it refers to the “consensus” among macroeconomists that the aforementioned integration brings the various approaches under one big tent.

The second refers to the Fed’s attempt to achieve a consensus of market participants and policy makers on the goals of policy.

The consensus idea is that inflation slows growth so it must be diligently fought. The Fed will keep inflation expectations low, inflation will be low, and growth will be robust. But in truth, every link in that sentence is a delicious illusion. The Fed supposedly manages expectations by convincing markets that it controls inflation, and so long as it controls expectations it can control inflation. But if it cannot control expectations it cannot manage inflation and all bets are off. What a flimsy reed upon which to hang public policy!

And in any case, why should low inflation generate robust growth? Because—well, because the Fed says it will, contrary to all evidence. There are, quite simply, no plausible theories or empirical studies that show that the low-to-moderate inflation rates common in the developed post-war world affect growth rates. Chairman Greenspan simply made the (false) claim so often that it was picked up by the media, by policy-makers, and by economists without any justification. Like almost everything Greenspan ever claimed, it is just dead wrong.

Returning to the obsession with control over expectations, out in the real world, expectations alone cannot govern any economic phenomena: inflation expectations will determine actual inflation only if those with ability to influence prices act on those expectations. And inflation below the high double digits has never proven to be a barrier to economic growth. Let us take the current experience as an example. We have moved on to QE2, an application of the NMC that will have the Fed engage in another round of asset purchases.

Helicopter Ben is supposedly injecting trillions of dollars of money into the economy to create expectations of inflation—to counter the deflationary real world forces. And many wingnuts actually ARE expecting inflation—running around like Chicken-Littles, buying gold and screaming about hyperinflation and collapse of the dollar. And, yet, no inflation. Why not? Because those who might have pricing power—corporations and organised labour—cannot create inflation. Workers cannot increase their wages given massive global unemployment, and firms cannot increase prices in the face of competitive pressures. So no matter how strong is the will to believe, it has no purchase against the facts of experience.

The wingnuts will be proven wrong. The Fed cannot create inflation. It is within the power of the central bank to lower the price of reserves—the overnight rate–as close to zero as it wants. It can also lower longer term rates on assets it is willing to buy, but there is a nonzero practical limit to that based on what Keynes called the square rule (as long term rates fall, the dangers of capital losses should they rise easily swamp any yields).

Quantitative easing supposedly pumps money into the economy to generate spending in order to create expectations of inflation. But all it really amounts to is substituting reserves for treasuries on bank balance sheets—lowering their interest earnings. QE won’t work because:

(1) additional bank reserves do not enable or encourage greater bank lending;
(2) the interest rate effects are small at best, and are swamped by private sector attempts to deleverage;
– The best estimate based on NYFed work: QE2 will lower long term rates by 18 basis points
(3) purchases of Treasuries are simply an asset swap that reduces the maturity of private sector assets, but does not raise private sector incomes; and
(4) given the reduced maturity of private sector portfolios, reduced interest income could actually be deflationary.

But we knew all that—Japan has been doing QE for 20 years, trying to create expectations of inflation in the face of deflationary headwinds. 20 years later, they still have falling real estate prices, deflation, and no recovery (indeed, the worst economic collapse of any of the major developed nations since the crisis began).

As they say, history doesn’t repeat itself but in this case it rhymes nicely. Only insanity would lead us to follow Japan’s path while expecting different results. Japan relied mostly on monetary policy to generate recovery. It allowed its financial institutions to hide bad assets. It refused to deal directly with insolvencies and collapsing real estate prices. True, its budget deficit expanded, but this was mostly a passive response to destruction of tax revenue. So far, the US is adopting exactly the same policies—but it (arguably) suffering to a much greater extent due to massive and pervasive fraud.

And Washington is not only looking the other way, it is actually promoting fraud to allow the banksters to try to generate another bubble. In short, the public policy response has been (mostly) based on the theory that we need Money Manager capitalism and that the only hope is to generate another bubble.

It won’t work. Financialization is the problem, not a sustainable economic strategy. We need to turn instead to an updated Keynesian-Minskian New Deal based on jobs, growing wages, consumption—especially public consumption, constrained and downsized finance, and greater equality. Monetary policy also has to be downsized, while fiscal policy has to play a bigger role. Not fine-tuning but a positive and permanent presence to counter and guide and supplement the private purpose. It is an audacious hope at this point.

L. Randall Wray is a Professor of Economics, University of Missouri—Kansas City. A student of Hyman Minsky, his research focuses on monetary and fiscal policy as well as unemployment and job creation. He writes a weekly column for Benzinga every Thursday.

He also blogs at New Economic Perspectives, and is a BrainTruster at New Deal 2.0. He is a senior scholar at the Levy Economics Institute, and has been a visiting professor at the University of Rome (La Sapienza), UNAM (Mexico City), University of Paris (South), and the University of Bologna (Italy).

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