Thursday, December 1, 2011

Is monetary accommodation becoming a dogma?

When history of the tumultous period of the Great Recession will be written, central bankers will be among its dominant characters. All along the crisis, across the world, monetary policy has been the predominant and preferred choice to fight both financial market instability and boost aggregate demand.

In a recent blog post, Brad DeLong echoed this view when he advocated further massive expansion of the Fed's balance sheet and committing to a target nominal GDP growth. He writes,

"The Federal Reserve might be able to spark a real economic recovery by... announcing that it is going to keep short-term Treasury interest rates low not just as long as the economy is depressed but even afterwards when the economy has recovered and when it would normally be raising interest rates: that it is going to keep short-term Treasury interest rates low until it generates an inflationary boom, and that you had better start building capacity now to serve your customers during that inflationary boom or your competitors will do so and take your profits...

If I were in the hot seat, I would follow the Jan Hatzius plan: (a) take the Fed's balance sheet up to $5T over the next two months, and (b) say that if that turned out not to be enough to get nominal GDP growth to a path that will return it to its pre-2007 trend within three years, that I would then keep interest rates low and take the Fed's balance sheet even higher until it did."

A similar debate is being played out across the Atlantic in Europe. With the Eurozone economies grappling an existential crisis, there have been calls for the ECB to emulate the Federal Reserve and indulge in aggressive monetary policy to stabilize financial markets. A leading advocate of such measures, Wolfgang Munchau wrote,

"The European Central Bank must agree a backstop of some kind, either an unlimited guarantee of a maximum bond spread, a backstop to the EFSF, in addition to dramatic measures to increase short-term liquidity for the banking sector. That would take care of the immediate bankruptcy threat."

More specifically, in addition to advocating a fiscal union, he favors unconventional quantitative easing and issuance of large enough joint-and-several liability eurozone bonds. On same lines, James Surowiecki has called for the ECB becoming the lender of last resort for the embattled European economies,

"If the European Central Bank were to commit publicly to backstopping Italian and Spanish debt, by buying as many of their bonds as needed, the worries about default would recede and interest rates would fall. This wouldn’t cure the weakness of the Italian economy or eliminate the hangover from the housing bubble in Spain, but it would avert a Lehman-style meltdown, buy time for economic reforms to work, and let these countries avoid the kind of over-the-top austerity measures that will worsen the debt crisis by killing any prospect of economic growth."

The suggestions of DeLong, Munchau, and Surowiecki are representative of policy prescriptions on both sides of the Atlantic calling for aggressive measures to restore economies to their pre-crisis normal. The monetary policy bias is very distinct.

As I have blogged earlier, advocates of such policies suggest them more out of desperation than from any strong conviction. There is a strong urge to throw everything and the kitchen sink at the intractable problem and hope that something will click. Brad DeLong himself writes,

"How well would it work? We don't know. Are they worth trying? I certainly think so..."

While all such accommodatory policies will surely contribute towards backstopping losses and stabilizing the markets, there are two important questions. One, given the circumstances, how effective will be such policies? Two, what are the costs - direct and secondary market distortions - associated with this?

A honest assessment of both these questions will raise disconcerting answers. The severity of the crisis, on both sides of the Atlantic, means that the magnitude of monetary accommodation - liquidity injections and indirect debt guarantees - required to meaningfully and sustainably stabilize the financial markets is beyond the abilities of most central banks and governments.

Further, the secondary market distortions that are certain to be set off by such sustained and extra-ordinarily large monetary accommodation will certainly challenge global financial market stability. It will perpetuate many of the bad practices that contributed towards the sub-prime era financial market excesses - regulatory arbitrage, TBTF, mis-pricing of risk etc. This monetary accommodation and flood of liquidity has the strong likelihood of generating another round of resource misallocation in the financial markets. It will also expose the emerging economies to the vagaries of massive cross-border capital flows, with all its attendant adverse consequences.

Much of the academic debate that feeds into policy making has been on exploring alternatives to get the economy back to its pre-crisis normality at any cost. This line of thinking glosses over questions about whether the old normal is itself desirable. There is a strong case that the quarter century of Great Moderation, with its low unemployment rate and inflation coupled with high growth rates, was the result of a fortunate confluence of favorable factors. The dynamics generated by China and the emerging economies, a big wave of trade and financial market liberalization, and dramatic productivity improvements generated by advances in information technology contributed to the Great Moderation.

The past 15 years, atleast since the late nineties, has been an era of unprecedented complementarities. The emerging economies saved to cheaply finance consumption and deficits in many parts of the developed world. Cheap exports of consumer durables and non-durables served to keep inflation low across the world. The consumption boom in developed economies also kept up the demand for commodities from many developing countries. It was over-optimistic to imagine that these forces would maintain their momentum forever.

In the process of this era of extraordinary stability and growth, several distortions and imbalances had become institutionalized into the world economy. The monetary-pump-prime-your-way-out of recession fails to acknowledge that the efforts to restore normalcy would serve to perpetuate many of the same distortionary trends and policies that fuelled the crisis. For example, there is enough evidence that the ultra-low rates have benefitted the remaining big financial institutions, who have used the opportunity to grow even bigger and pose even greater systemic risks.

Apart from resolving the extant problem, every crisis is also an important opportunity to wring out the excesses of the bygone era that was in the first place responsible for the crisis. In this case, the later can be done both by letting those responsible pay for their recklessness and greed (after all this is the primary incentive formation and disciplining mechanism of capitalism) and by refining regulatory policies to pre-empt such future failures. Unfortunately, influential opinion makers across the world have been focussed more on exploring options to get the economy back to its pre-crisis normal instead of doing the hard problem solving to get things back to a more efficient and desirable "new normal".

Update 1 (3/12/2011)

In a move to ease Eurozone's debt squeeze, the Federal Reserve, ECB, BoE, BoJ, SNB, and Bank of Canada announced that they would reduce by about half the cost of a program under which banks in foreign countries could borrow dollars from their own central banks, which in turn get those dollars from the Fed. The banks also said that loans would be available until February 2013, extending a previous deadline of August 2012. This move effectively makes the Fed emerge as the global lender of last resort, lending dollars to foreign central banks so as to ease credit markets there. The move is intended to free up liquidity and ensure that European banks have funds during the sovereign debt crisis and keep borrowing costs down for consumers and firms.

These are loans between central banks rather than loans to individual foreign banks, there is very little risk to US taxpayers. However, in the face of ECB's reluctance to buy debt of the most beleaguered Eurozone economies and work as the risk absorber of last resort, this is the closest that the Fed can get to effectively doing ECB's job and purchasing foreign government debt itself.

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