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The impotence of monetary policy

The Federal Reserve has released its latest statement on the state of the US economy.Its Chairman Ben Bernanke has now spoken to the press as well. The overall assessment was rather downbeat.

(video below)

Monetary Policy’s Impotence

If you compare the Fed statement to its previous one, you will understand the Fed has downgraded the economy’s outlook. And indeed its economic projections shade lower. The Economist’s Greg Ip asked Mr. Bernanke, why the Fed had lowered its medium-term outlook if the impediments to continued growth were temporary as the Fed had indicated in its statement. Here is what Mr. Bernanke said in response:

Part of the slowdown is temporary, and part of it may be longer-lasting. We do believe that growth is going to pick up going into 2012 but at a somewhat slower pace than we had anticipated in April. We don’t have a precise read on why this slower pace of growth is persisting. [S]ome of the headwinds that have been concerning us, like … weakness in the financial sector, problems in the housing sector, balance sheets and deleveraging issues…may be stronger or more persistent than we thought. And I think it’s an appropriate balance to attribute a slowdown partly to the identifiable temporary factors, but to acknowledge a possibility that some of the slowdown is due to factors which are longer-lived and which will be still operative by next year.

Now remember, since the Panic of 2008, the Fed has brought its policy rate down to zero. It has taken on all sorts of lower-quality assets as collateral for loans at effectively zero percent interest. And the Federal Reserve has more than tripled it balance sheet. Just looking at this objectively, it is an extraordinary amount of monetary liquidity. Yet the economy remains weak. What’s going on?

The Balance Sheet Recession

Nomura’s Chief Economist Richard Koo wrote a book last year called “The Holy Grail of Macroeconomics” which introduced the concept of a balance sheet recession, which explains economic behaviour in the United States during the Great Depression and Japan during its Lost Decade. He explains the factor connecting those two episodes was a consistent desire of economic agents (in this case, businesses) to reduce debt even in the face of massive monetary accommodation.

When debt levels are enormous, as they are right now in the United States, an economic downturn becomes existential for a great many forcing people to reduce debt. Recession lowers asset prices (think houses and shares) while the debt used to buy those assets remains. Because the debt levels are so high, suddenly everyone is over-indebted. Many are technically insolvent, their assets now worth less than their debts. And the three D’s come into play: a downturn leads to debt deflation, deleveraging, and ultimately depression. The D-Process is what truly separates depression from recession and why I have said we are living through a depression with a small ‘d’ right now.

Secular inflation will be non-existent

Therefore, the problem is a lack of demand for loans not a lack of supply. The Federal Reserve can print all the money it wants. But, if there is little demand for more indebtedness, it is not going to have the desired effect of permanently reflating the economy – although it can create bubbles.

The corollary of this is that inflation will be non-existent on a secular basis. For the increase in liquidity to feed into consumer price inflation, people have to actually buy more stuff. And that’s not what happens in a balance sheet recession because people are concentrated on reducing debt and increasing savings.

-Weak consumer spending will last for years, Aug 2009

For his part, the father of the Balance Sheet Recession theorem Richard Koo says QE2 drove speculation, but what about the real economy? His view is that monetary policy can aid speculative sentiment with residual feed through into the real economy but that it is largely impotent in a balance sheet recession. Only fiscal policy will have any measurable impact in driving the underlying demand side factors holding the economy back.

I believe Ben Bernanke senses this as well. I have noted this in the past at Credit Writedowns. Mr. Bernanke’s comment that “I’m a little bit more sympathetic to central bankers now than I was 10 years ago” underlines this.

Inflation Targets

It’s interesting to look back to that period, at the Japanese experiment with quantitative easing early in the prior decade after its policy rate fell to zero. At the time, a lot of foreign monetary policy experts were advising the Bank of Japan to do more.

For example, Ben Bernanke, now the Chairman of the Federal Reserve, remarked in a 2003 speech:

As you may know, I have advocated explicit inflation targets, or at least a quantitative definition of price stability, for other leading central banks, including the Federal Reserve. A quantitative inflation target or range has been shown in many countries to be a valuable tool for communication. By clarifying the objectives of the central bank, an explicit inflation target can help to focus and anchor inflation expectations, reduce uncertainty in financial markets, and add structure to the policy framework. For Japan, given the recent history of costly deflation, however, an inflation target may not go far enough. A better strategy for Japanese monetary policy might be a publicly announced, gradually rising price-level target.

What I have in mind is that the Bank of Japan would announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred.

-Some Thoughts on Monetary Policy in Japan, Remarks by Governor Ben S. Bernanke Before the Japan Society of Monetary Economics, Tokyo, Japan, May 31, 2003

So what was Mr. Bernanke saying there? He was saying that an explicit inflation target would not necessarily be used only to limit consumer price inflation, but rather to target consumer inflation. In a deflationary environment, that would mean the Fed would use unconventional means like quantitative easing or interest-rate caps to create inflation. When the inflation target overshoots, the Fed would use conventional means like open market operations combined with increases the target Fed Funds rate to create disinflation.

Add inflation targets to interest rate caps and municipal bond purchases as policy tools the Fed will consider using in future.

My conclusion from reading Mr. Bernanke’s prior statements and his most recent ones is that he wishes fiscal agents would take the lead. But he has accepted this will not happen because of the political environment. Reluctantly then, he is going to have the Fed assume the stimulative role. Yet, here again, the same political forces which constrain fiscal policy are at work. And that means Bernanke will only resort to unconventional policy when the economy deteriorates significantly.

For my part, I am with Richard Koo. Monetary policy reflation will not work in a balance sheet recession when fiscal policy is contractionary. But at some point, the Fed will be compelled to act anyway.

Source: Serial disappointment, Greg Ip, The Economist

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

8 Comments

  1. Mike Valotta says:

    Totally agree. A guy with a Phd from Princeton can’t see this?

  2. Anonymous says:

    Has Richard Koo ever explained how a country works its way out of debt at 200% GDP, particularly with Japan burying and cremating its savers at a rapid rate?  I’m open to the possibility that Japan will be able to monetize because they’ve spent so thoroughly crushed inflation expectations they don’t run large current account deficits, and the JGB market–while diminishing–is largely captive.  Given the difference in initial conditions, I don’t see how the US stands a chance.

    • Namazu, there are two issues: the level of debt and the way it gets reduced.

      On the level, the question is not of expunging the debt per se but of getting it down to lower levels. Countries have lowered debt from greater than 200% levels of debt to GDP without hyperinflation or default. The most obvious example is post-WWII Britain.  

      On the way debt at 200% of GDP gets reduced, in my view, currency depreciation and inflation are likely. This was certainly how Britain did it and I expect no different for Japan.

      • Anonymous says:

        Thanks for your reply, Edward.  I take your first point, but of course the US and Japan don’t have the pent-up demand or supply of recently-captive labor the victors of WWII did.  To your second point, do you have a view on how gradually the Yen will reverse course?  I’m toying with a pet theory that I haven’t heard anywhere else, and am not sure even I believe:  if the yen appreciates gradually, given a declining population* and a generation’s worth of zero inflation in the collective memory bank, Japan just might be able to gradually monetize the debt (literally buy JGBs and retire them) without bumping up against a lot of capacity constraints and causing inflation.  This runs counter to the nightmare scenario put forth by Kyle Bass and others, which otherwise I don’t take issue with.  I have no rosy scenario for the US.

        * Here’s where the proposition may get shaky:  everything else equal, you would expect wage inflation to become an issue.  On the other hand, they’re probably half a cycle behind the US in terms of automation in the service sector, creating a push in the opposite direction.  One thing I’ve never seen quantified, but which I believe constitutes a significant piece of the “scary deflation” in Japan has been improvements in supply chain management, where I think they were a full cycle behind.  Not all inflation or deflation is created equal.

  3. David Beckworth says:

    Edward,

    Leading up to the Great Depression households acquired a vast amount of
    debt and began a deleveraging process during the downturn. 
    Consequently, there was a “balance sheet” recession in the 1930s too. 
    Monetary policy, however, was not impotent during this time.  At least
    when it was done the right way.  FDR’s price level targeting from
    1933-1936 sparked a robust recovery.  In my view, this
    experience provides a great example of why Richard Koo’s balance sheet recession views are wrong.  Yes, deleveraging is a drag on the economy, but for every debtor deleveraging there is
    a creditor getting more payments. (And if the debtor is not making
    payments and defaulting then the debtor still has funds to spend.)  In
    principle the creditor should provide an offset to the debtor.  The
    reason they don’t–they sit on their newly aquired funds from the debtor
    instead of spending them–is because they too are uncertain about the
    economy.  There is a massive coordination failure, all the creditors are
    sitting on the sideline not wanting to be the first one to put money
    back to use. If something could simultaneously change the outlook of the
    creditors and get to them to all start using their money at the same
    time then a recovery would take hold.  Enter monetary policy and its
    ability to shape nominal spending expectations.  That is what FDR did
    from 1933-1936 when he forcefully communicated that he wanted the price
    level to return to it pre-crisis level. He backed up the message by
    devaluing the gold content of the dollar and not sterilizing gold
    inflows.  (See Mike Konczal for more on this experience.) It could happen
    here too if the Fed would commit to a level (not growth rate) target, preferably a nominal GDP level target.

    QE2′s limited success was not because monetary policy is impotent
    in such situations, but because they failed to properly shape and
    anchor nominal expectations. Ryan Avent
    summarized this problem well: QE2 changed the direction of monetary
    policy, but didn’t set the destination.  I supported QE2 and hoped the
    best for it.  I also acknowledged,
    however, from the start that in the absence of a well defined level
    target it was bound to be limited and politically polarizing.  I believe
    Bernanke knows all this–as is suggested by work on Japan–but he is
    faced by political constraints and has burned up most of his political
    capital on QE1 and QE2. 

    • Art says:

      David, I think you have to look carefully at the political economy of the years around the GD (though I admit I haven’t read Konczal’s take on it). You had new generations of leadership at the Bk of France and Fed who tried to forcefully push the world back to nominal 1914 gold parity of ~$20 when real parity was probably closer to ~$40 (the gold holding stats should be readily available). By resetting parity between those levels, FDR was trying to stem deflation. That’s certainly related to price-level targeting, but seems a little odd to call it that. After all, once the POG was reset, they intended to keep it there. In any case, the initial result was that saving preferences were better accomodated, albeit at a still somewhat deflationary level.

      An equally effective solution would have been a massive gold discovery capable of bringing real and nominal parities more in line, as with Witswaterrand in 1896.

      The Fed can only do something like this when it creates net financial assets (e.g., QE1), right, as opposed to normal open market operations or QE2? But Treasury can technically do the same thing as well by running deficits, and in a more democratic manner, imo. So why the Fed? Why does it ALWAYS have to be monetary policy to the rescue, when both institutions are capable of creating the net financial assets demanded by prevailing saving desires, whether in Koo or FDR’s time? It’s certainly a widely shared view, but it seems like an odd fetish to me.

  4. David Beckworth says:

    Edward,

    U.S. households during the 1920s acquired a vast amount of debt and began a deleveraging process during the Great Depression.  Consequently, there was a “balance sheet” recession in the 1930s too.  Monetary policy, however, was not impotent during this time.  At least when it was done the right way.  FDR’s price level targeting from 1933-1936 sparked a robust recovery.  In my view, this experience provides a great example of why Richard Koo’s balance sheet recession views are wrong.  Yes, deleveraging is a drag on the economy, but for every debtor deleveraging there is a creditor getting more payments. (And if the debtor is not making payments and defaulting then the debtor still has funds to spend.)  In principle the creditor should increase their spending to offset the debtor’s drop in spending.  The reason they don’t–creditors sit on their newly aquired funds from the debtor instead of spending them–is because they too are uncertain about the economy.  There is a massive coordination failure, all the creditors are sitting on the sideline not wanting to be the first one to put money back to use. If something could simultaneously change the outlook of the creditors and get to them to all start using their money at the same time then a recovery would take hold.  Enter monetary policy and its ability to shape nominal spending expectations.  That is what FDR did from 1933-1936 when he forcefully communicated that he wanted the price level to return to it pre-crisis level. He backed up the message by devaluing the gold content of the dollar and not sterilizing gold inflows.  (See Mike Konczal for more on this experience.) It could happen here too if the Fed would commit to a level (not growth rate) target, preferably a nominal GDP level target.

    QE2′s limited success was not because monetary policy is impotent in such situations, but because they failed to properly shape and anchor nominal expectations. Ryan Avent summarized this problem well: QE2 changed the direction of monetary policy, but didn’t set the destination.  I supported QE2 and hoped the best for it.  I also acknowledged, however, from the start that in the absence of a well defined level target it was bound to be limited and politically polarizing.  I believe Bernanke knows all this–as is suggested by work on Japan–but he is faced by political constraints and has burned up most of his political capital on QE1 and QE2. 

  5. Namazu says:

    Has Richard Koo ever explained how a country works its way out of debt at 200% GDP, particularly with Japan burying and cremating its savers at a rapid rate?  I’m open to the possibility that Japan will be able to monetize because they’ve spent so thoroughly crushed inflation expectations they don’t run large current account deficits, and the JGB market–while diminishing–is largely captive.  Given the difference in initial conditions, I don’t see how the US stands a chance.

    • Namazu, there are two issues: the level of debt and the way it gets reduced.

      On the level, the question is not of expunging the debt per se but of getting it down to lower levels. Countries have lowered debt from greater than 200% levels of debt to GDP without hyperinflation or default. The most obvious example is post-WWII Britain.  

      On the way debt at 200% of GDP gets reduced, in my view, currency depreciation and inflation are likely. This was certainly how Britain did it and I expect no different for Japan.

    • Namazu, there are two issues: the level of debt and the way it gets reduced.

      On the level, the question is not of expunging the debt per se but of getting it down to lower levels. Countries have lowered debt from greater than 200% levels of debt to GDP without hyperinflation or default. The most obvious example is post-WWII Britain.  

      On the way debt at 200% of GDP gets reduced, in my view, currency depreciation and inflation are likely. This was certainly how Britain did it and I expect no different for Japan.

    • Namazu, there are two issues: the level of debt and the way it gets reduced.

      On the level, the question is not of expunging the debt per se but of getting it down to lower levels. Countries have lowered debt from greater than 200% levels of debt to GDP without hyperinflation or default. The most obvious example is post-WWII Britain.  

      On the way debt at 200% of GDP gets reduced, in my view, currency depreciation and inflation are likely. This was certainly how Britain did it and I expect no different for Japan.

    • Namazu, there are two issues: the level of debt and the way it gets reduced.

      On the level, the question is not of expunging the debt per se but of getting it down to lower levels. Countries have lowered debt from greater than 200% levels of debt to GDP without hyperinflation or default. The most obvious example is post-WWII Britain.  

      On the way debt at 200% of GDP gets reduced, in my view, currency depreciation and inflation are likely. This was certainly how Britain did it and I expect no different for Japan.

    • Namazu, there are two issues: the level of debt and the way it gets reduced.

      On the level, the question is not of expunging the debt per se but of getting it down to lower levels. Countries have lowered debt from greater than 200% levels of debt to GDP without hyperinflation or default. The most obvious example is post-WWII Britain.  

      On the way debt at 200% of GDP gets reduced, in my view, currency depreciation and inflation are likely. This was certainly how Britain did it and I expect no different for Japan.

    • Namazu, there are two issues: the level of debt and the way it gets reduced.

      On the level, the question is not of expunging the debt per se but of getting it down to lower levels. Countries have lowered debt from greater than 200% levels of debt to GDP without hyperinflation or default. The most obvious example is post-WWII Britain.  

      On the way debt at 200% of GDP gets reduced, in my view, currency depreciation and inflation are likely. This was certainly how Britain did it and I expect no different for Japan.

      • Namazu says:

        Thanks for your reply, Edward.  I take your first point, but of course the US and Japan don’t have the pent-up demand or supply of recently-captive labor the victors of WWII did.  To your second point, do you have a view on how gradually the Yen will reverse course?  I’m toying with a pet theory that I haven’t heard anywhere else, and am not sure even I believe:  if the yen appreciates gradually, given a declining population* and a generation’s worth of zero inflation in the collective memory bank, Japan just might be able to gradually monetize the debt (literally buy JGBs and retire them) without bumping up against a lot of capacity constraints and causing inflation.  This runs counter to the nightmare scenario put forth by Kyle Bass and others, which otherwise I don’t take issue with.  I have no rosy scenario for the US.

        * Here’s where the proposition may get shaky:  everything else equal, you would expect wage inflation to become an issue.  On the other hand, they’re probably half a cycle behind the US in terms of automation in the service sector, creating a push in the opposite direction.  One thing I’ve never seen quantified, but which I believe constitutes a significant piece of the “scary deflation” in Japan has been improvements in supply chain management, where I think they were a full cycle behind.  Not all inflation or deflation is created equal.

  6. sbh_home says:

    “There is one all-important ingredient that supply-siders ignore; namely that the demand for capital goods is a derived demand, derived from primary consumer demands.  That even in a capitalistic system the end and objective of all production is human consumption.  The demand for inventory or plant and equipment, however far removed from the ultimate consumer, is derived from final consumer outlays in the marketplace. 
     
    Demand is always paramount in successful business planning and commitment decisions.  If sufficient demand is not expected to exist, it matters not what the expected costs will be.  “Sufficient” demand, of course, covers all costs plus and expected after tax profit margin. 

     Supply-siders approach the demand side of the equation on a “trickle down” basis; build the plants and produce the goods, and demand will take care of itself.  Supply creates its own demand. 

    Unfortunately, we do not live in that kind of world.  The proposition is simple.  An economy such as ours which is geared to mass production requires concomitant mass consumption.  Payrolls must be sufficient to buy the goods and services produced – at the asked prices. 

    Only in the frictionless world created by the mathematical model builders are the asked prices in equilibrium with consumer spendable income.  In the real world, there is always a purchasing power deficiency gap of varying proportions.  This is just another way of saying that to have high levels of production and employment, we need not only a vastly more competitive price structure, we also need a steady but slightly inflationary monetary policy (prices increase c. 2-3 percent annually), and a tax policy that contains some elements of compulsory income redistribution – downward.”  LJP Ph.D, economics, Chicago 1933

  7. sbh_home says:

    “There is one all-important ingredient that supply-siders ignore; namely that the demand for capital goods is a derived demand, derived from primary consumer demands.  That even in a capitalistic system the end and objective of all production is human consumption.  The demand for inventory or plant and equipment, however far removed from the ultimate consumer, is derived from final consumer outlays in the marketplace. 
     
    Demand is always paramount in successful business planning and commitment decisions.  If sufficient demand is not expected to exist, it matters not what the expected costs will be.  “Sufficient” demand, of course, covers all costs plus and expected after tax profit margin. 

     Supply-siders approach the demand side of the equation on a “trickle down” basis; build the plants and produce the goods, and demand will take care of itself.  Supply creates its own demand. 

    Unfortunately, we do not live in that kind of world.  The proposition is simple.  An economy such as ours which is geared to mass production requires concomitant mass consumption.  Payrolls must be sufficient to buy the goods and services produced – at the asked prices. 

    Only in the frictionless world created by the mathematical model builders are the asked prices in equilibrium with consumer spendable income.  In the real world, there is always a purchasing power deficiency gap of varying proportions.  This is just another way of saying that to have high levels of production and employment, we need not only a vastly more competitive price structure, we also need a steady but slightly inflationary monetary policy (prices increase c. 2-3 percent annually), and a tax policy that contains some elements of compulsory income redistribution – downward.”  LJP Ph.D, economics, Chicago 1933