In 2008, monetary authorities around the world embarked on an unprecedented series of experiments.
As economies tanked and governments throttled back on fiscal measures in the face of huge debts and deficits, people looked to central bankers to use monetary policy to stimulate economic growth. Since then we have seen a range of once outlandish tools deployed, from historically low policy rates to quantitative easing.
Is this era now coming to a close? At the Conservative Party conference in October, Prime Minister Theresa May attacked the distributional consequences of QE and floated a more active fiscal policy. The OECD’s 2016 November Economic Outlook contained a chapter on “Using the fiscal levers to escape the low-growth trap”. Steven Mnuchin, President Trump’s pick for Treasury secretary, told Fox Business recently that “the problem for the last eight years, there’s been no economic growth” and promised a shift to fiscal policy with the “largest tax cut since Reagan”.
Mnuchin is right to say that economic growth has been poor in recent years when compared to previous recoveries. But it is unfair to blame monetary policy-makers entirely for this. With the tools at their disposal they are simply unable to generate high levels of real GDP growth.
A central bank has three tools. First, control of the size of the supply of base money; second, control of the price at which this base money is borrowed (the base rate); third, setting limits on the amount of broad money which can be pyramided out from this base money (reserve ratios).
Each of these has been a primary policy tool at some time in the past. None of them, however, is “economic growth”. When monetary policy-makers have been tasked with boosting such growth, they have had to do so using instruments which affect it only indirectly.
Under QE, central banks printed up new base money and handed it over to financial institutions in exchange for assets. It was thought that these financial institutions would take this new cash and use it to make loans to support investment spending, generating growth. Also, by buying up longer term dated assets, monetary authorities could push their price up, their yield/interest rate down, and stimulate investment by making it more profitable.
But whether QE does boost growth is largely out of the monetary authority’s hands. Financial institutions – especially under regulatory pressure such as Basel III – may just take that cash and use it to shore up their balance sheets. Even if they try to lend, they might be unable to find willing borrowers. Richard Koo argued that this was the reason for QE’s failure to boost GDP growth in Japan. Likewise, even if QE forces down long-term interest rates, investors could be so pessimistic about potential returns that it still doesn’t pay for them to invest.
That has been the case since 2008. As a result, QE has generated little if any economic growth and has simply recapitalised battered banks. Indeed, for all the talk about stimulating growth, this might have been the purpose all along.
Much the same goes for low base rates. If the central bank reduces the price of liquidity by lowering rates, it should incentivise financial institutions to expand their balance sheets by lending.
But again, if financial institutions are primarily concerned with fixing their balance sheets, the effort to get them to expand those balance sheets will be in vain. Likewise, if potential borrowers are looking to deleverage, then the attempt to get them to take on more debt will flounder. As JK Galbraith put it, monetary policy is like a string. You can pull it but you can’t push it; sufficiently high policy rates will drain credit from a financial system, but low rates are not guaranteed to flood it with credit.
Even if there had been willing intermediaries in the financial sector and eager borrowers in the private sector, it is still not clear that expansive monetary policy could have driven higher real GDP growth. A monetary expansion will simply produce inflation unless there is spare capacity or “slack” in the economy. While that might have been the case in Britain between 2008 and 2013, when unemployment was around 8 per cent, it is unlikely to be the case now with the rate down to 4.8 per cent.
There could be more scope for success in the US, whose unemployment figures are notoriously optimistic, and the Eurozone, where many countries still have double digit rates. But there is more to consider than just the raw rates. If the cost of hiring unemployed workers is too high, they won’t be hired. These supply-side considerations loom larger now in the US, thanks to the regulatory thicket of Obamacare, and the Eurozone, where labour regulations make it difficult to hire even where unemployment is over 20 per cent. Slack will stay slack if regulations block you from taking it up.
So what can monetary authorities do? Ordinarily, they can facilitate economic calculation by adhering to a predictable rules-based policy. In extremis, they can throw a mattress of liquidity under a collapsing financial system. Indeed, their failure to do so is what Milton Friedman and Anna J Schwartz argued exacerbated the Great Depression. When Ben Bernanke said to Friedman and Schwartz in 2002, “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again”, that is what he meant.
But the goal of growing GDP is beyond them. In 2008 monetary policy-makers took up a task which they were unequipped to accomplish. If politicians and pundits had been more willing to ask what monetary policy-makers could do rather than focusing on what they should do, the age of activist monetary policy might not have been quite so disappointing.