Pushing on a string and similar notions on monetary policy ineffectiveness

As interest rates in the developed economies approach the zero bound, we must begin to ask ourselves how effective monetary policy can reasonably be in these circumstances. And if policy is to be effective, which policy tools will be most advantageous to use? Or are we just pushing on a string here?

In plain English: central banks are running out of bullets and the deflation bogeyman seems to be right on our doorstep. Can they even stop him from ripping our house to shreds and sending us into depression?

In 1990, when the Japanese were faced with this question, they felt confident that they had the solution. Anna Schwartz and Milton Friedman wrote the well-regarded book “A Monetary History of the United States, 1867-1960” , which argued that the Depression was due in large part to a restrictive monetary policy by the Federal Reserve. Therefore, the Japanese were prepared to act: initiating massive interest rate cuts and fiscal stimulus for five full years.

However, Marshall Auerback has argued persuasively that these measures were insufficient. When the Japanese economy recovered after 1994, many felt the coast was clear. A consumption tax that hit the middle class hard ensued. By 1997, Japan fell into recession and started to suffer consumer price deflation — all made worse by the Asian Crisis. Japan’s relapse was a repeat of the U.S.’s own relapse in 1937-38.

By 2001 the Japanese realized their error as the industrialized world suffered recession and stocks fell below 8,000. The Bank of Japan went on a massive monetary stimulus, the likes of which we had never witnessed to reflate the economy — to little effect. The Japanese had waited too long to begin quantitative easing (QE). To be sure, the carry trade (where Japanese retail investors, companies, and foreign speculators borrowed in Yen and invested abroad in higher yielding currencies) limited the policy’s effectiveness. But, most economists agree that the enormous lag between 1990 and 2001 was deadly.

Present Fed Chairman Ben Bernanke is one of those economists. He was particularly critical of the Japanese and their ineffective policy response. Soon after the Japanese began their experiment with quantitative easing, he delivered his famous “printing press” speech on how a central bank could fight deflation (The Federal Reserve was also worried about deflation, leading to a 1% Fed Funds rate).

Therefore, the main takeaway here was that the Japanese erred in not being aggressive enough, quickly enough. The Japanese should have cut rates sooner and more aggressively and instituted QE more quickly thereafter.

I would like to challenge that notion on two counts. First, I believe that quantitative easing should have been the preferred policy tool from the start if the desire was to reflate the economy. Second, I am unsure that monetary policy is particularly effective in the aftermath of a financial crisis due to credit writedowns. and a reluctance to lend by banks as well as debt overhang and balance sheet repair in the private sector.

A central bank has a number of weapons in its arsenal. Traditionally, the principal weapon has been interest rate policy. However, one must ask whether lowering the rate of interest in the aftermath of a bubble can induce damaged banks to lend or overburdened debtors to borrow. In 1993 Japan, as property prices collapsed and bank capital dwindled, only few would borrow or lend as debt levels were high and Japanese banks were mistrusted domestically and abroad due to their thin capitalization. Similarly, today, we await hundreds of billions of dollars more in bank credit writedowns and a tidal wave of corporate bankruptcies. Few will lend in this environment. Few will borrow irrespective of the rate of interest.

Moreover, the idea is to reflate the economy not to induce excessive risk-taking or bad loans. Lowering interest rates makes low-risk, low return investments unattractive and increases the appetite for risk. It also distorts investment decisions causing investment in unprofitable projects that would not be undertaken in a different interest-rate environment — projects that will be written down at a late date.

Why not just start quantitative easing from the word go? If the central bank chairman said that they were going to flood the economy with money and push up inflation to unbearable levels, I guarantee you people would start to spend and credit markets would ease. To be clear: this is inflationary, but it represents a best worst choice pick between deflation and bubble-inducing interest rate reductions. To my mind, a dose of quantitative easing and government spending on under-invested economic sectors would induce lending and prop the economy while the private sector repaired its collective balance sheet. Moreover, with a steep interest rate curve, banks would be likely to recapitalize their balance sheets more quickly. Unfortunately, this train may have already left the station. The Fed is pushing on a string.

Have we learned from Japan’s mistakes or just made new ones of our own?


Originally published at Credit Writedowns and reproduced here with the author’s permission.