Death To The New Monetary Consensus And Quantitative Easing
L. Randall Wray
Over the past decade and a half a new approach to macroeconomics was developed. In a
sense, it integrated the old Bastard “Keynesian” ISLM model that we all learned in
intermediate macroeconomics with a Monetarist-inspired “Taylor Rule” for formulating
monetary policy and a dynamic “Phillips Curve” to determine inflation. We do not need
to go deeply into the technical details. What is important is that it relegated fiscal policy
to the backburner and brought monetary policy front and center. Unlike Milton
Friedman’s monetarism, the Fed would not adopt a money growth rule, but rather would
focus directly on inflation. Adjustment of the fed funds rate would allow it to keep
inflation in check.
On this view, policy does not work directly but rather indirectly through influence on
market expectations. Hence, the word “consensus” has a dual meaning: first it refers to
the “consensus” among macroeconomists that the aforementioned integration brings the
various approaches under one big tent. The second refers to the Fed’s attempt to achieve
a consensus of market participants and policy makers on the goals of policy.
The consensus idea is that inflation slows growth so it must be diligently fought. The Fed
will keep inflation expectations low, inflation will be low, and growth will be robust. But
in truth, every link in that sentence is a delicious illusion. The Fed supposedly manages
expectations by convincing markets that it controls inflation, and so long as it controls
expectations it can control inflation. But if it cannot control expectations it cannot
manage inflation and all bets are off. What a flimsy reed upon which to hang public
policy!
And in any case, why should low inflation generate robust growth? Because—well,
because the Fed says it will, contrary to all evidence. There are, quite simply, no
plausible theories or empirical studies that show that the low-to-moderate inflation rates
common in the developed post-war world affect growth rates. Chairman Greenspan
simply made the (false) claim so often that it was picked up by the media, by policymakers, and by economists without any justification. Like almost everything Greenspan
ever claimed, it is just dead wrong.
Returning to the obsession with control over expectations, out in the real world,
expectations alone cannot govern any economic phenomena: inflation expectations will
determine actual inflation only if those with ability to influence prices act on those
expectations. And inflation below the high double digits has never proven to be a barrier
to economic growth. Let us take the current experience as an example. We have moved
on to QE2, an application of the NMC that will have the Fed engage in another round of
asset purchases.
Helicopter Ben is supposedly injecting trillions of dollars of money into the economy to
create expectations of inflation—to counter the deflationary real world forces. And many
wingnuts actually ARE expecting inflation—running around like Chicken-Littles, buying
gold and screaming about hyperinflation and collapse of the dollar. And, yet, no inflation.
Why not? Because those who might have pricing power—corporations and organized
labor—cannot create inflation. Workers cannot increase their wages given massive global
unemployment, and firms cannot increase prices in the face of competitive pressures. So
no matter how strong is the will to believe, it has no purchase against the facts of
experience.
The wingnuts will be proven wrong. The Fed cannot create inflation. It is within the
power of the central bank to lower the price of reserves—the overnight rate--as close to
zero as it wants. It can also lower longer term rates on assets it is willing to buy, but there
is a nonzero practical limit to that based on what Keynes called the square rule (as long
term rates fall, the dangers of capital losses should they rise easily swamp any yields).
Quantitative easing supposedly pumps money into the economy to generate spending in
order to create expectations of inflation. But all it really amounts to is substituting
reserves for treasuries on bank balance sheets—lowering their interest earnings. QE
won’t work because:
(1) additional bank reserves do not enable or encourage greater bank lending;
(2) the interest rate effects are small at best, and are swamped by private sector
attempts to deleverage;
– The best estimate based on NYFed work: QE2 will lower long term rates
by18 basis points
(3) purchases of Treasuries are simply an asset swap that reduces the maturity of
private sector assets, but does not raise private sector incomes; and
(4) given the reduced maturity of private sector portfolios, reduced interest
income could actually be deflationary.
But we knew all that—Japan has been doing QE for 20 years, trying to create
expectations of inflation in the face of deflationary headwinds. Twenty years later, they
still have falling real estate prices, deflation, and no recovery (indeed, the worst economic
collapse of any of the major developed nations since the crisis began).
As they say, history doesn’t repeat itself but in this case it rhymes nicely. Only insanity
would lead us to follow Japan’s path while expecting different results. Japan relied
mostly on monetary policy to generate recovery. It allowed its financial institutions to
hide bad assets. It refused to deal directly with insolvencies and collapsing real estate
prices. True, its budget deficit expanded, but this was mostly a passive response to
destruction of tax revenue. So far, the US is adopting exactly the same policies—but it
(arguably) suffering to a much greater extent due to massive and pervasive fraud.
And Washington is not only looking the other way, it is actually promoting fraud to allow
the banksters to try to generate another bubble. In short, the public policy response has
been (mostly) based on the theory that we need Money Manager capitalism and that the
only hope is to generate another bubble.
It won’t work. Financialization is the problem, not a sustainable economic strategy. We
need to turn instead to an updated Keynesian-Minskian New Deal based on jobs, growing
wages, consumption—especially public consumption, constrained and downsized
finance, and greater equality. Monetary policy also has to be downsized, while fiscal
policy has to play a bigger role. Not fine-tuning but a positive and permanent presence to
counter and guide and supplement the private purpose. It is an audacious hope at this
point.