These are exciting times. Europe is in disarray, unable to cope with a crisis requiring adjustments in relative prices, wages, and incomes that have been rendered impossible by a monetary policy that has produced almost no growth in nominal GDP in the Eurozone since 2008, placing an intolerable burden on the Eurozone’s weakest economies. The required monetary easing by the European Central Bank is unacceptable to Germany, so the process of disintegration continues. The US, showing signs of gradual recovery in the winter and early spring, remains too anemic to shake off the depressing effects of the worsening situation in Europe. With US fiscal policy effectively stalemated until after the election, the only policy-making institution still in play is the Federal Open Market Committee (FOMC) of the Federal Reserve. The recent track record of the FOMC can hardly inspire much confidence in its judgment, but it’s all we’ve got. Yesterday’s stock market rally shows that the markets, despite many earlier disappointments, have still not given up on the FOMC. But how many more disappointments can they withstand?
In today’s Financial Times, Peter Fisher (head of fixed income at BlackRock) makes the case (“Fed would risk diminishing returns with further ‘QE'”) against a change in policy by the Fed. Fisher lists four possible policy rationales for further easing of monetary policy by the Fed: 1) the “bank liquidity” rationale, 2) the “asset price” rationale, 3) the “credit channel” rationale, and 4) the “radical monetarist” rationale.
Fisher dismisses 1), because banks are awash in excess reserves from previous bouts of monetary easing. I agree, and that’s why the Fed should stop paying banks interest on reserves. He dismisses 2) because earlier bouts of monetary easing raised asset prices but had only very limited success in stimulating increased output.
While [the Fed] did drive asset prices higher for a few months, there was little follow-through in economic activity in 2011. This approach provides little more than a bridging operation and the question remains: a bridge to what?
This is not a persuasive critique. Increased asset prices reflected a partial recovery in expectations of future growth in income and earnings. A credible monetary policy with a clearly articulated price level of NGDP target would have supported expectations of higher growth than the anemic growth since 2009, in which asset prices would have risen correspondingly higher, above the levels in 2007, which we have still not reached again.
Fisher rejects 3), the idea “that if the Fed holds down long-term interest rates it will stimulate private credit creation and, thus, economic expansion.” Implementing this idea, via “operation twist” implies taking short-term Treasuries out of the market and replacing them with longer-term Treasuries, but doing so denies “banks the core asset on which they build their balance sheets,” thus impairing the provision of credit by the banking system instead of promoting it.
I agree.
Finally Fisher rejects 4), “the idea more central bank liabilities will eventually translate into ‘too much money chasing too few goods and services’ at least so as to avoid a fall in the general price level.” Fisher asks:
What assets would the Fed buy? More Treasuries? Would the Fed embark on such a radical course in a presidential election year?
Perhaps the Fed could buy foreign currencies, engineer a much weaker dollar and, thereby, stimulate inflation and growth. Would the rest of the world permit this? I doubt it. They would probably respond in kind and we would all have a real currency war. Nor is it clear the US external sector is large enough to import enough inflation to make a difference. If energy and commodity prices soared, would American consumers “chase” consumption opportunities or would they suppress consumption and trigger a recession? Recent experience suggests the latter. How much “chasing behaviour” would we get in a recession? Engineering a dollar collapse would be to play with fire and gasoline. It might create inflation or it might create a depression.
These are concerns that have been expressed before, especially in astute and challenging comments by David Pearson to many of my posts on this blog. They are not entirely misplaced, but I don’t think that they are weighty enough to undermine the case for monetary easing, especially monetary easing tied to an explicit price level or NGDP target. As I pointed out in a previous post, Ralph Hawtrey addressed the currency-war argument 80 years ago in the middle of the Great Depression, and demolished it. FDR’s 40-percent devaluation of the dollar in 1933, triggering the fastest four-month expansion in US history, prematurely aborted by the self-inflicted wound of the National Recovery Administration, provides definitive empirical evidence against the currency-war objection. As for the fear that monetary easing and currency depreciation would lead to an upward spiral of energy and commodity prices that would cause a retrenchment of consumer spending, thereby triggering a relapse into recession, that is certainly a risk. But if you believe that we are in a recession with output and employment below the potential output and employment that the economy could support, you would have to be awfully confident that that scenario is the most likely result of monetary easing in order not to try it.
The point of tying monetary expansion to an explicit price level or spending target is precisely to provide a nominal anchor for expectations. That nominal anchor would provide a barrier against the kind of runaway increase in energy and commodity prices that would supposedly follow from a commitment to use monetary policy to achieve a price-level or spending target. Hawtrey’s immortal line about crying “fire, fire” in Noah’s flood is still all too apt.
Uneasy Money 
The FOMC will keep “Waiting for Godot”:
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“Ralph Hawtrey addressed the currency-war argument 80 years ago in the middle of the Great Depression, and demolished it. FDR’s 40-percent devaluation of the dollar in 1933, triggering the fastest four-month expansion in US history, prematurely aborted by the self-inflicted wound of the National Recovery Administration, provides definitive empirical evidence against the currency-war objection.”
David, a single instance from a different regime does not constitute decisive evidence against this concern being valid. If anything, the wisdom about generals always fighting the last war ought to apply. (Since the 1950s every serious downturn is ‘a new Depression’). Ceteris were non paribus in the 1930s when compared to today. We were then at a different stage in the Kondratiev cycle (commodity prices had been weak since the early 1920s, with a big part of the dynamic explained by a tearing-down of the agricultural infrastructure as the combustion engine replaced horses), wage-setting behaviour was different, and money had been genuinely hard. Whereas today commodity prices have been strong for a dozen years; we never had deflation (even in Europe, inflation has been stubbornly high) and money has not been hard in living memory.
In the 1930s there was no doubt that the problem was in part that policy was too tight (whereas people feared the inflationary consequences of easing). What evidence is there today that policy is too tight? Spain’s problems are not a matter of a few hundred bps on the repo rate – they need to recapitalize the banks, and are halfway to doing so.
Nominal GDP growth was 3.9% last quarter, and I think people are expecting 2.4% real for next year (which may be conservative). It seems to me that you (along with the Establishment) just assume that potential GDP is what it was at the height of the crisis + some trend to reflect technological growth. But what gives you confidence that this is the case? In the 1960s and 1970s we made terrible mistakes just assuming that potential GDP must be higher, and it turned out this assumption is wrong. How are you so sure it’s different today?
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David
Perry Mehrling, another learned Hawtrey scholar, would disagree with you. It’s not just about crying fire in Noah’s flood (which some people are doing, but not the finance/banking types like Pearson, Mehrling et al). It’s also about what a monetary authority can and cannot do, in what states of the world, and what are the unintended consequences of activist monetary action.
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This seems to be a good moment for the Fed to take advantage of lower energy prices. Not only is there plenty of supply compared to demand, refinery capacity is now increasing in the town where I grew up. No one liked that the thoroughfare was rerouted last year, but now it’s clear why they moved that highway.
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The issue is that tightening to contain a terms of trade shock on the service sector throws the economy into a stall, which the broken financial system then transforms into a dive. We’ve arguably seen this happen at least three times in the past four years (mid-2008, spring-2011, and perhaps today).
I argue we are caught between a fragile financial system on the one hand and a service sector terms of trade shock on the other. The way out is to fix banks: forced loss recognition followed by recapitalization. Instead, the banks and shadow banks are propped up, and the economy oscillates between the two poles. In the early 30’s many more banks were allowed to fail, and later FDR cleaned up the remains. That, plus tradeables sector dominance, allowed him to succeed. So I agree: we need FDR. Instead, Bernanke seems to have concluded that the lesson of the GD was, “at all costs, do not let banks fail.”
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Here’s my latest post, discussing something Lord John Maynard Keynes wrote:
http://socialmacro.blogspot.com/2012/06/taking-minor-exception-to-lord-keynes.html
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I enjoyed this latest post. I was interested about “operation twist” impairing the provision of credit. Could you explain this in a forthcoming post or maybe just as a response to this comment?
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Marcus, And so will we. That’s our only alternative.
Cantillon Blog, Fair point. In my enthusiasm, I got carried away slightly. Nevertheless, the concerns about competitive devaluations do not seem all that different across different monetary regimes. How about “provides strong empirical evidence against the currency-war objection?” My view is that both the Great Depression and the Little Depression were monetary phenomena, exacerbated by debt deflation. In both cases, the way to eliminate the worst rigidities and balance sheet issues is through inflation that forces creditors to accept a tolerable partial repayment of the obligations due them when the attempt to extract an infeasible full repayment makes the creditors worse off than if they settle for (or are forced to accept) partial repayment. I agree that as a result of an unexpected quadrupling of the price of oil, potential GDP fell in the 1970s, but I don’t think that that was the cause of bad performance in the 1970s. There were many other negative policy and institutional factors that were exacerbating the situation. In the present situation, a reduction in potential GDP strikes me as being only a minor issue. But to be honest, that is not an issue that I have thought a lot about.
Ritwik, I know Perry, and agree that he’s a fine scholar. I need to read more of what he has been saying about the current situation.
Becky, I agree that the possibility that there is positive supply shock occurring should give the Fed a bit more comfort in erring on the side of easing monetary policy. So far, they don’t seem to be paying attention.
David, Thanks for putting your comments in a broader context for me.
Julian, The reason that operation twist could impair the provision of credit is that intermediaries make money by borrowing short and lending long. Intermediaries make money off the upward slope of the yield curve. By flattening the yield curve, operation twist discourages intermediaries from doing their job, providing credit.
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Cantillon Blog: “In the 1960s and 1970s we made terrible mistakes just assuming that potential GDP must be higher, and it turned out this assumption is wrong. How are you so sure it’s different today?”
Australia.
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David, thanks for that clarification…
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I believe more QE would result in better stock prices. Therefore returns would go up. The only once that would benefit are the big corporations.
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Lorenzo – what a funny way to make an argument. Australia benefited from a positive terms of trade shock requiring tremendous infrastructural investment. Are you suggesting the US could grow as fast as Australia, if only teh Bernank stepped harder on the gas?
David – “In the present situation, a reduction in potential GDP strikes me as being only a minor issue. But to be honest, that is not an issue that I have thought a lot about”. It ought to be worth spending a great deal of time and effort considering this possibility that potential GDP is not exactly as high as you believe it is (based on peak GDP and extrapolating the trend based on putative technological growth), because thats one of the questions at the crux of the matter. If you are wrong about this, then should Bernanke act as aggressively as you would wish, then there is a danger of setting in place an unfortunate inflationary tendency further down the road (which may be some years away).
David Pearson – “I argue we are caught between a fragile financial system on the one hand and a service sector terms of trade shock on the other. The way out is to fix banks: forced loss recognition followed by recapitalization. Instead, the banks and shadow banks are propped up, and the economy oscillates between the two poles.” On what basis do you think that weak credit growth in the US is holding back the recovery? Do you really have grounds for the belief that there are all these fantastically high ROI projects that are ready to be put in place and that the banks would love to finance if only they had the capital?
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Musings on the cause of the Great Depression:
http://socialmacro.blogspot.com/2012/06/balance-sheet-great-depression.html
Criticism is appreciated.
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Cantillon Blog: I am suggesting, that if the Fed had balanced credibility (i.e. credibility on both prices and incomes) as the RBA does rather than its current unbalanced credibility (on prices but not incomes) then yes, much misery could have been avoided. Bernanke has done nothing to create any expectations on income/spending, merely on prices (i.e. that he will not let deflation happen nor inflation above 2%). So people hold onto their money and don’t spend. Hence the level of base money in the US is vastly greater, as % of GDP, than it is in Australia.
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I would further point out that, due to the dramatic (if temporary) drop in commodity prices at the beginning of the Great Recession, Australia had a bigger drop in exports, as a % of GDP, than the US did and that Australia has not had a recession since 1991, despite our terms of trade continuing their long-term decline until just recently.
But, as I say, the RBA has balanced credibility (on prices and transaction levels) not unbalanced credibility (just on prices).
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