As we all know, the Central Banks (CBs) have tried to strengthen the economy since the start of the crisis by increasing the supply of liquidity.
This is derived from Milton Friedman’s theories, who said that when an economy falls into a recession for too long, or a deflation situation, it was sufficient for the central bank to increase its supply of hard cash (in other words, not temporary loans or repos) for demand to recover and inflation to return to its normal level.
It’s what he recommended for Japan in one of his last articles, when that country began to have deflation problems (Reviving Japan, 1998). It’s worth highlighting some of the paragraphs, because the article is brilliant, although, unfortunately, unsuccessful.
There is no limit inasmuch as the Bank of Japan can increase its money supply if it wants to do so. More growth will have the same effect as always. After more or less a year, the economy will expand more quickly; production will rise, and after another delay, inflation will moderately increase. A return to the conditions of the end-1980s would rejuvenate Japan and would help support the rest of Asia.
It’s pure monetarism, pure Friedman. Unfortunately, the crisis in 2008 showed us that the theory is false. The global CBs decided to attack the crisis by using this theory. And it’s not that its implementation destroyed the economies, but it failed to pull them out of their lethargy. A hopeful status quo was achieved, but the hope was continually being transferred to the future, in the case of the ECB, a point which F. Coppola analyses in his blog.
In the graphic below, we see how successive expected rises in the Fed Fund rates are continually frustrated, during the crisis and in the aftermath of the next 10 years. This is reflected in the forward rates implied by future contracts. The red line is the effective rate.
Like an obsessed Sisyphus, the markets, encouraged by the CBs, were predicting interest rates would rise. And afterwards, inevitably, the reality of the economy made them fall again. This is what Coppola calls the CBs’ lack of credibility.
Because at the same time, the CBs were encouraging, with their much vaunted “Forward Guidance” – one of the last monetary policy tools included in the box. Forward Guidance has achieved little more than the CBs official declarations, which years ago hardly consisted of one paragraph and now they need pages and pages, in the hope the markets “assimilate” the lesson on what the BC wants, but doesn’t always achieve. As the above-mentioned author says.
“One mistake after the other, the markets predicted rate rises which then didn’t happen.” And as far as the CBs’ credibility is concerned: “There’s a much more serious open question. On the one hand, the markets have their own vision of where they believe rates will head and they hope the ECB will follow this path. On the other hand, the ECB refuse to do what the markets expect. This is a sign of its independence. After all, a central bank which simply does what the markets expect has no more real independence than a central bank which simply does what the politicians tell it do.”
The problem is that the rest of the economy has not responded to the call (we will see later that there is very special factor influencing this lack of response). For its part, money supply has not multiplied as expected. It has been stored in the commercial banks’ safes and they have not lent enough money to fuel a recovery. Money in circulation comes from bank lending and there has been no sign of this. But the CBs have continued to expand their portfolio of bonds and other financial instruments. And now they need to start to reduce this portfolio to “normalise” monetary policy, at the same time as interest rates recover a level compatible with this normalisation…The bad thing is that the economies, if they have recovered some dynamism, don’t show any signs of normalisation. In fact, Peter Praet, a member of the ECB’s executive board, makes a prediction which somewhat undermines his own house:
“It’s expected that rates will remain at their current levels for a prolonged period of time, and beyond the horizon of our net asset purchases.”
It’s the same for the Fed, as we can see in this graphic courtesy of the FT and Coppola:
In short, the CBs, via their Forward Guidance for strengthening their decisions on interest rates and asset reductions, have given a nod to the markets, a nod which doesn’t appear to amount to more than accepting what the markets themselves were saying. The (monetary) authority’s authority can’t last long if it claims that it’s the one creating the situation.
But let’s look at the lack of response from the real economy to such monetary incentive.
Why? We can talk about various reasons, like the absence of real investment, which has also caused the desired productivity to collapse. This is closely linked to austere fiscal policy, in a context of a drop in private demand, tangled up in its problems of Debt Deflation. On this point, Coppola has the following comment:
“There is another possible reason why the ECB may feel obliged to keep rates “lower for longer” in the foreseeable future. Fiscal and associated monetary tightening cause deflation (look at the UK in the 1920s or Germany at the beginning of the 1930s) and the Eurozone fiscal pact controls the fiscal policies throughout the region. As a result, the ECB feels obliged by the fiscal stance to maintain a loose monetary policy. I would personally call this fiscal control, which might seem strange given the ECB’s famous “independence”. But if tightening monetary policy causes delflation due to a persistently excessive fiscal stance, the ECB has no option but to compensate for this with monetary policy.”
But what is really a little frightening is the increasing trend towards a declining demography in the developed countries, especially in Europe. When the population is definitely decreasing, monetary policy is less effective. The reason for this is that it’s the population who supports demand in the first place, but supply as well. Yearly GDP is more than just a function of employment and capital. The trick obviously is that it should not be simply an additional function – so many people employed plus so many tons of capital. There needs to be a residual factor called productivity which is what makes the final production a bigger margin than the sum of the factors of production. And although this factor may be difficult to measure and to know how to compute it in the function, the important thing is that every year this margin can be seen because its result can be accounted for. Unfortunately, this productivity has disappeared off the scene.
In short, we have receding demography, productivity which has disappeared (which shows the demand factor has an influence on productivity) and a fiscal policy aimed at consolidation. And all this weakens monetary policy, as we have seen, continuing to demonstrate that the CBs are not really independent.
The central banks are still powerful. They can make the financial markets rise or plunge them into the doldrums. The liquidity created and tied up in the commercial banks has inflated the financial markets. A small but unexpected rise in the official interest rate could cause an earthquake in the bond market or in the stock market. But this is not the real economy. It’s certainly an increasingly bigger part of the economies’ GDP, but there is increasing doubt over its social usefulness. The CBs should scrutinise the financial system and its systemic risks more closely. Some indicators show that these have decreased in certain aspects, but in others the same doubts exit and the same sensation that the flight of a butterfly in China could spark another catastrophe.