Deep down, many economists are deadly afraid of the power of monetary policy
This past weekend I reread Doug Irwin´s marvelous article on Cassel and the Great Depression. In many ways it´s like “back to the future”. Just call Keynes Krugman (PK) and Cassel Sumner.
Take this passage from history and you´ll see that the current playbook is the same!
In a January 1929 article on the League of Nations gold inquiry, Keynes found himself coming around to Cassel’s view of the international gold problem. Keynes (1981 , 776) wrote that “Professor Cassel has been foremost in predicting a scarcity” of gold, adding that “I confess that for my own part I did not, until recently, rate this risk very high.” However, he continued,
“recent events and particularly those of the last twelve months are proving Professor Cassel to have been right. A difficult, and even a dangerous, situation is developing . . . .there may not be enough gold in the world to allow all the central banks to feel comfortable at the same time. In this event they will compete to get what gold there is – which means that each will force his neighbor to tighten credit in self-protection, and that a protracted deflation will restrict the world’s economic activity, until, at long last, the working classes of every country have been driven down against their impassioned resistance to a lower money wage.”
[NotePK in 1997 on Japan: Now as a general rule modern economies are not supposed to suffer from prolonged periods of inadequate demand. There is usually nothing easier than increasing demand: just have the central bank (i.e., the Bank of Japan) increase the money supply, or have the government spend more. Why, then, has Japan suffered from low demand for more than half a decade? Well, there are some structural reasons. Japanese consumers still consume an unusually low fraction of their income, which means that companies must correspondingly be persuaded to maintain a high investment rate if the economy is not to have too little demand. The problem is aggravated because the troubles of the banking system have restricted the flow of credit. So to push demand high enough to get the economy back to more or less full use of its capacity would require a big stimulus. Still, why not provide that stimulus?
The standard answer goes like this: interest rates are already very low, so the Bank of Japan has done all it can. Meanwhile, the government has a severe fiscal problem, so it cannot increase spending or cut taxes. There is, in short, nothing to be done except pursue structural reforms and hope for an eventual turnaround. This answer sounds hard-headed and responsible. In fact, however, it is based on a completely false premise – the idea that the Bank of Japan has reached the limits of what it can do.
The simple fact is that there is no limit on how much a central bank can increase the supply of money.
As Keynes stated in late 1931, after Britain left gold, “I am not confident . . . that on this occasion the cheap money phase will be sufficient by itself to bring about an adequate recovery of new investment. . . . . If this proves to be so, there will be no means of escape from prolonged and perhaps interminable depression except by direct State intervention to promote and subsidize new investment” (Keynes 1982, 60).
In the General Theory, Keynes repeated his skepticism of monetary remedies to a depression. He argued that “for my own part I am now somewhat skeptical of the success of a merely monetary policy directed towards influencing the rate of interest . . . it seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimal rate of investment. I conceive, therefore, that a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment” (Keynes 1973 , 164, 378).
Because Keynes judged the stance of monetary policy largely if not exclusively by interest rates, with low rates indicating to him monetary ease, he became skeptical of the value of monetary policy as a stabilization tool when nominal rates were so low.
[Note: PK in 2014: Just to be clear, I have supported QE in both Britain and the US, on the grounds that (a) central bank purchases of longer-term and riskier assets may help and can’t hurt, and (b) given political paralysis in the US and the dominance of bad macroeconomic thinking in the UK, it’s all we’ve got. But the view I used to hold before 1998 — that central banks can always cause inflation if they really want to — just doesn’t hold up, theoretically or empirically.]
By contrast, Cassel (Sumner) never lost faith in the power of monetary policy to improve economic conditions. When the Federal Reserve began a program of open market purchases in early 1932, Cassel wrote in October of that year that its scale was inadequately small and it “should have been on a far larger scale. The fact that no tangible results have as yet been gained does not in the least invalidate the efficacy of the method.”
[Note: the “far larger scale” came a few months later when in March ´33 FDR delinked from gold and the dollar depreciated. The changes were instantaneous].
I don´t think Keynes or Krugman despise (or hate) monetary policy. In fact, they believe it´s ´powerless in certain circumstances. On the other side the policymakers, the guys responsible for implementing monetary policy, also are fond of saying that monetary policy is powerless (when interest rates drop to zero). In this they are following Keynes who thought interest rates defined the stance of policy.
But the real reason is that, as policymakers they are afraid of the “beast” under their care.
The evidence for that claim is abundant!
Throughout the “Great Inflation” Arthur Burns argued that inflation was a nonmonetary phenomenon (Unions, Oligopolies, Oil Producers, etc.). Inflation was a “bad outcome”, so we can understand Burns´ plea of “I´m not responsible”.
But that is true even when the “outcome is good”. In his memoirs (Age of Turbulence p. 190) Greenspan says he didn´t “feel responsible”:
“To judge success in containing inflation, central banks look to changes in inflation expectations implicit in nominal long term interest rates. Success is evident when long term rates slip in the face of aggressive monetary tightening. But as I recall, during most of our initiatives to confront rising inflation pressures, aggressive tightening was unnecessary. Even a slight“tap on the brake” induced long term rates to decline. It seemed too easy, a far cry from the monetary policy crises of the 1970s…”
In 1999, Bernanke “advised” Japan
How to Get Out of a Liquidity Trap:
Contrary to the claims of at least some Japanese central bankers, monetary policy is far from impotent today in Japan. In this section I will discuss some options that the monetary authorities have to stimulate the economy. Overall, my claim has two parts: First, that—- despite the apparent liquidity trap—-monetary policymakers retain the power to increase nominal aggregate demand and the price level. Second, that increased nominal spending and rising prices will lead to increases in real economic activity. The second of these propositions is empirical but seems to me overwhelmingly plausible; I have already provided some support for it in the discussion of the previous section. The first part of my claim will be, I believe, the more contentious one, and it is on that part that the rest of the paper will focus. However, in my view one can make what amounts to an arbitrage argument —-the most convincing type of argument in an economic context—-that it must be true…
But when the time came for him to listen to his own advice he “got the chills”!
Maybe the best example comes from a FOMC meeting in November 1937. Board Member and Board Chief-Economist John Williams (probably no relation to today´s John Williams, president of the San Francisco Fed) said, regarding the possibility of undoing the previous rise in reserve requirements):
At the November 1937 FOMC meeting John Williams, a Harvard professor, member of the Fed board and its chief-economist said:
We all know how it developed. There was a feeling last spring that things were going pretty fast … we had about six months of incipient boom conditions with rapid rise of prices, price and wage spirals and forward buying and you will recall that last spring there were dangers of a run-away situation which would bring the recovery prematurely to a close. We all felt, as a result of that, that some recession was desirable … We have had continued ease of money all through the depression. We have never had a recovery like that. It follows from that that we can’t count upon a policy of monetary ease as a major corrective. … In response to an inquiry by Mr. Davis as to how the increase in reserve requirements has been in the picture, Mr. Williams stated that it was not the cause but rather the occasion for the change. … It is a coincidence in time. … If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn. It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground.
It seems “being afraid” is in their DNA. This is Tim Geithner in 2008:
The argument that makes me most uncomfortable here around the table today is the suggestion several of you have made—I’m not sure you meant it this way—which is that the actions by this Committee contributed to the erosion of confidence—a deeply unfair suggestion.
… But please be very careful, certainly outside this room, about adding to the perception that the actions by this body were a substantial contributor to the erosion in confidence.
So saying “we´ve done all we could” or “we are out of ammo”, is the safe bet!
PS And Woodford´s New Keynesian Bible is just “Interest & Prices”. Money has “disappeared”!
Arthur Burns was ignorant and arrogant. Pritchard used to read his correspondence with him in his Money and Banking class.
The Federal Reserve, under Chairman William McChesney Martin Jr., re-established stair-step case functioning (and cascading), interest rate pegs (like during WWII), thereby using a price mechanism (like President Gerald Ford’s: “Whip Inflation Now”), and abandoning the FOMC’s net free, or net borrowed, reserve targeting position approach (quasi-monetarism), in favor of the Federal Funds “bracket racket” in 1965 (presumably acting in accordance with the last directive of the FOMC, which set a range of rates as guides for open market policy actions).
Using interest rate manipulation as the monetary transmission mechanism is non sequitur. Interest is the price of loanable funds, the free market’s clearing price of credit. The price of money (the Fed’s bailiwick) is the reciprocal of the price-level, as represented by varied and specialized price indices
Using a price mechanism (pegging policy rates), has assured the bankers that no matter what lines of credit they extend, they can always honor them, since the Fed assures the banks access to costless legal reserves, whenever the banks need to cover their expanding loans – deposits (legal reserves supplied after the fact - emasculating the Fed's Open Market power).
We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was entirely about ("taking away the punch bowl").
The effect of tying the FRB-NY trading desk's Open Market policy to a remuneration rate (or any other market-based interest rate), is to supply additional (and excessive, and costless interbank demand deposits) to the banking system whenever loan demand, or investment opportunities, expand (when the banks began in earnest to buy their liquidity, instead of following the old fashioned practice of storing their liquidity
It's the single biggest error that makes economics a dismal science. Economics is an exact science.
It's stock vs. flow. If monetary savings equaled investment there wouldn't be a problem. But the Japanese save more and keep more of their savings impounded in their payment's system. Their deposit insurance is unlimited for transactions based accounts. I.e., from the standpoint of the system, not any individual bank, all bank-held savings are frozen, destroying the velocity of circulation.
It is axiomatic. The only way to activate or liquify monetary savings, from an accounting perspective, is for their owners, saver-holders, to spend/invest either directly or indirectly entirely outside of the banks.