Summary: We live in an age of wonders. We have technology that previous generations would consider science fiction or fantasy. Social changes beyond precedent, such as gender equality. Not least, we’re conducting monetary experiments on a scale never before attempted. Success by the Bank of Japan and Fed will create a new world, one with little or no fear of printing money. One the other hand, their programs create known risks — and seldom mentioned unknown risks. Today we have two articles that describe this monetary experiment, and aspects of it seldom mentioned.
(1) The Great Experiment
“The Ultra-Easy Money Experiment”
By William White, 12 June 2013
Former deputy governor of the Bank of Canada, former head of the Economic Department of the Bank for International Settlements. Excerpt:
The world’s central banks are engaged in one of the great policy experiments in modern history: ultra-easy money. And, as the experiment has continued, the risk of failure – and thus of the wrenching corrections and deep economic dislocations that would follow – has grown.
In the wake of the crisis that began in 2007, policy rates were reduced to unprecedented levels, where they remain today, and measures were taken to slash longer-term rates as well. Nothing like it has ever been seen before at the global level, not even in the depths of the Great Depression. Moreover, many central banks’ balance sheets have expanded to record levels, although in different ways and for different rationales – further underscoring the experimental character of the monetary easing now underway.
The risks implied by such policies require careful examination, particularly because the current experiment appears to be one more step down a well-trodden path – a path that led to the crisis in the first place.
… It can be argued that each cycle of monetary easing culminated in a credit-driven “boom and bust” that then had to be met by another cycle of easing. With leverage and speculation increasing on a cumulative basis, this whole process was bound to end with monetary policy losing its effectiveness, and the economy suffering under the weight of imbalances (or “headwinds”) built up over the course of many years.
The Swedish economist Knut Wicksell raised concerns about such problems long ago. He suggested that a money rate of interest (set in the banking system) that was less than the natural rate of interest (set in the real economy) would result in inflation. Later, economists in the Austrian tradition noted that imbalances affecting the real side of the economy (“malinvestments”) were of equal concern.
For a more detailed analysis see “Overt Monetary Financing and Crisis Management.”
(2) There are risks because it’s an experiment
“QE’s ‘inconvenient truth’”, Richard Koo, Nomura, 18 June 2013 — Excerpt:
QE debate has focused exclusively on benefits while ignoring potential costs
In spite of the ramifications of this issue for the central banks of Japan, the US, and the UK, there has been surprisingly little discussion or theoretical research regarding the question of how to approach and address it.
There have been many academic papers discussing the merits of QE ever since the BOJ first faced zero interest rates more than a decade ago. However, there have been almost no papers discussing the costs or risks involved in winding down QE.
This is an extremely irresponsible approach and is similar to arguing that fiscal stimulus will boost the economy while completely ignoring all the problems associated with fiscal deficits.
Most papers on QE ignore causes of zero interest rates
Moreover, the majority of academic papers on QE seek to investigate the additional policy options available to central banks facing zero interest rates. Very few have asked why economies have not recovered after interest rates were brought down to zero.
This is a blind spot shared by a large number of orthodox economists. Their analysis starts from the existence of an external shock and does not try to examine the properties of that shock. A good example here is Princeton professor Paul Krugman, who when prescribing an inflation target and QE for Japan’s deflationary woes declared that the cause of deflation was irrelevant.
But if balance sheet adjustments in the private sector are the reason why the economy did not recover even after the central bank took interest rates down to zero, the implication is that no matter how much QE is undertaken, the money multiplier will remain negative at the margin and the money supply will not increase as long as businesses and households are not borrowing. Without growth in the money supply, there is no reason why monetary policies should have any impact on the economy.
No analysis of what will happen to broader economy when QE is ended
In addition, the costs of QE cited in the IMF report noted above are limited to microeconomic effects, such as a delay in necessary structural reforms at banks and in the broader economy, an increase in future bad loans due to a dulling of banks’ ability to manage risk, a dysfunctional interbank market, and impairment of the central bank’s balance sheet. There is almost no detailed analysis of what will happen to the broader economy when QE is discontinued.
A look at papers published by the IMF and other organizations shows that while the authors do mention risk management at private-sector banks, they tend to discuss the broader economic costs of discontinuing QE in rather vague terms, perhaps because they themselves have been instrumental in promoting its adoption.
As one example, the report noted above mentions in just a few lines that, given the possibility of a sharp rise in interest rates, central banks need to maintain a close dialogue with the market and focus on the policy duration effect when bringing QE to an end. This is clearly not enough considering the extent of the potential problems when a central bank that has bought up 30% of longer-term government debt issuance decides to sell that debt. …
QE offers few benefits but has major side effects
Moreover, it would be one thing if we could say with confidence that QE leads to a quicker economic recovery. But money supply growth in Japan, the US, and the UK has been extremely low in spite of aggressive QE. In the UK, where the monetary base increased more than anywhere else on a percentage basis, private credit has contracted steadily ever since the Lehman failure, and the central bank was unable to prevent a double-dip recession.
The data show that—as balance sheet recession theory predicts — QE can do very little to stimulate an economy during a balance sheet recession. But when the economy finally emerges from recession, the central bank will be forced to mop up liquidity injected under QE, and that process can impede the recovery via an abrupt rise in long-term interest rates.
(3) Other posts in this series
- The April jobs report shows continued slow growth, bought at great cost, 3 May 2013
- The greatest monetary experiment, ever, 20 June 2013
- Status report on the US economy. Recession? Collapse?, 25 June 2013
- Look at the US economy: see the trends!, 1 July 2013
- Good news about the US economy!, 2 July 2013
(4) For More Information
Posts about Monetary Policy:
- Important things to know about QE2 (forewarned is forearmed), 21 October 2010
- Bernanke leads us down the hole to wonderland! (more about QE2), 5 November 2010
- Explaining the gold standard, the Euro, Default, Deflation, and Hyperinflation, 17 December 2011
- What every American needs to know about the Federal Reserve System, 31 March 2012
- What are the limitations of the Fed’s power? It’s neither impotent nor omnipotent!, 17 February 2012
- The lost history of money, an antidote to the myths, 1 December 2012
- Monetary Magic applied to cure America’s economic ills, 20 February 2013
- The World of Wonders: Everybody Goes Nuts Together, 21 February 2013