Are central banks running out of steam?
To paraphrase a well-worn political expression, ‘It’s fiscal policy, stupid’
I have been inundated lately with requests from readers to explain the recent evolution of monetary policy practices happening here and around the world.
I admit, it's all very confusing, and all I can do is quote from Alice in Wonderland, "Curiouser and curiouser." Like Alice who 'forgot how to speak good English', central bankers have forgotten how to do good policy.
So what went wrong? If blame has to be laid at someone's feet, I would lay it at the feet of bad economic models, on two fronts.
First, the macroeconomic models used by most mainstream economists are not representative of modern economies.
In a speech at Princeton University on September 24, 2010, former Fed Chairman Ben Bernanke admitted as much: "the standard models [used by economists] were designed for these non-crisis periods."
In other words, most models used by mainstream economists have nothing to say about the current situation, and therefore nothing to propose in terms of policy.
Second, over the last three decades, these models downplayed the role of fiscal policy, as a consensus emerged that economic growth comes first and foremost from monetary policy.
Fiscal deficits were thought to lead to inflation and higher interest rates. Yet the huge fiscal spending in 2009 led to neither higher inflation nor higher interest rates, which have remained at historical lows.
These models encouraged politicians, economists and central bankers to leave all the economic responsibility with monetary policy.
The only problem with this approach is that it did not work. In fact, it made things worse. What's more, economists don't seem to have learned much from the 'disastrous decade', as many are calling for even more monetary stimulus.
Consider the evolution of monetary policy since the crisis. Since the crisis, monetary policy has relied on two planks: quantitative easing (QE) and, more recently, negative interest rates — both policies sharing similar characteristics.
Quantitative easing, which was championed as a sure policy to rescue our failing economies, was based on the idea that banks did not have sufficient liquidity to make new loans.
If banks could lend more, the economy would pick up (hence, no need for fiscal policy).
In 2009, then Governor Ben Bernanke stated "The idea behind quantitative easing is to provide banks with substantial excess liquidity in the hope that they will choose to use some part of that liquidity to make loans or buy other assets."
Well it did not work. The only affect of QE was to inflate the asset market (that's another story).
So central banks moved on to the next great idea: negative interest rates, which are in fact an implicit admission that QE failed. Yet negative rates are also based on the notion that banks are liquidity-constrained. Central banks now want to force banks to lend their excess reserves by taxing these reserves.
Central bankers believe banks will want to avoid having to pay for deposits at the central bank, and lend those reserves.
Yet, this has backfired as well.
In Switzerland, where negative rates were introduced over a year ago, banks are holding more reserves than before. While they accept to pay the tax, they have passed on these extra costs to borrowers by raising lending rates.
So negative rates have led to higher lending rates! Moreover, excluding real estate loans, lending activity to the private sector has actually gone down, not up.
So like QE, negative rates don't seem to be working. And now, some very prominent people are promoting the next big idea: monetary financing, better known as "quantitative easing for the people."
It has been heavily promoted by Adair Turner, a member of the UK's Financial Policy Committee and popularized by Martin Wolf of the Financial Times.
Essentially, the central bank would simply print new money and finance all fiscal deficits. In some other versions, it would print money and give it directly to households.
There is a common thread running through all these ideas: desperation. I have called this 'Hail Mary Economics.' Just recently Mark Carney warned: "The global economy risks becoming trapped in a low growth, low inflation, low interest rate equilibrium."
The former Bank of England Governor, Mervyn King, also recently said another financial crisis is "certain" if reforms are not implemented – echoing something I wrote here in November 2014.
It's time to get rid of these bad economic models, and go back to the ones that have worked well in the past. My own model tells me that monetary policy does not work at low interest rates, and that we must rely on fiscal policy.
To paraphrase a well-worn political expression, 'It's fiscal policy, stupid.'
Louis-Philippe Rochon is Associate Professor, Laurentian University and Co-Editor, Review of Keynesian Economics.