July 12th, 2014
in Op Ed
by Edward Harrison, Credit Writedowns
Last week, I wrote a fairly comprehensive piece laying out some of the macro issues around the Fed and other central banks' ultra-easy monetary policy. The gist of that piece was that, due to the political economy, monetary policy is now seen by policy makers as a good way to 'steer' the cyclical economy through peaks and troughs. Fiscal policy, while used effectively during the depths of crisis in 2008 and 2009, is largely off the table.
I would make the case that monetary policy is wholly inappropriate as a tool for steering against cyclical ups and downs exactly because it only has a secondary impact on the real economy and must act through the credit markets. As such, monetary policy is always about increasing credit in order to affect the real economy and, thus, is always at risk of creating financial instability. Does that mean it can't be used? My answer is below.
I am going to make this a longer-form piece to cover both the analytical framework here as well as the current issues being debated. This piece is an outgrowth of the ongoing controversy created by the BIS' latest warning about ultra-easy monetary policy and the defense of easy money proffered by those who see it as the only mechanism available to support economic growth and full employment.
History of the Political Economy
When the global economy collapsed into Depression in the 1930s, policy makers and economists ushered in a sea change in thinking about economics, economic policy, the financial system and financial regulation. The laissez-faire of the pre-Depressionary period was out and heavier macroprudential regulation was in. Classical economics ceded ground to Keynesianism as government intervention became de rigueur.
Eventually, however, during the 1960s the Bretton Woods global monetary system began to come apart, and with it the economic consensus. The Bretton Woods system collapsed in 1971 when the United States ended gold convertibility under President Richard Nixon. And within two years the global economy was hit with the first of two oil price shocks. The result from these two events was high inflation, uneven economic growth and high unemployment.
During this inflationary period, the West witnessed tremendous social unrest, bordering at times on anarchy. In the UK, for example, the RPI index twice peaked over 20%, shares dropped over 90% in inflation adjusted terms, and civil unrest and strikes were nearly daily. I would call it an inflationary Depression of a magnitude similar to the Great Depression's deflationary one. For policy makers, it was a frightening period that broke the economic consensus and ushered in monetarism and neo-liberalism as the new economic paradigms to follow.
The key here is that using fiscal policy to steer the economy and heavy government control and intervention were out. Instead, the primacy of monetary policy with first money supply and then interest rate targeting as well as structural reform toward laissez faire were in.
The Asset-Based Economy
The result of the shift toward cyclical monetary policy steering was an asset-based economic model because monetary policy is dependent on credit markets for its transmission mechanism.
The fiscal agent adds net financial assets to the private sector by deficit spending. The issuance of government IOUs to the private sector without a corresponding offset in terms of taxation means net financial assets flow into the private sector as a result of fiscal policy. Net financial assets can also flow out of the private sector, when taxes exceed spending when the government has a surplus.
The central bank is never permitted to add net financial assets to the system. It can only conduct asset swaps as it does with quantitative easing, swapping base money for existing financial assets and changing private portfolio preferences for the types of liabilities it buys and sells and changing risk premia and term premia throughout the economy.* (*UPDATE: Stephanie Kelton notes to me in response here that interest on excess reserves at the Fed creates net financial assets in the private sector. So, I should not have said never. I would call this a quasi-fiscal operation though.)
Having said that, the principle way central banks conduct monetary policy is through interest rates. They raise or lower rates based on inflation, employment or economic growth. And these rates alter the supply and demand for credit generally and shift demand between different sectors of the economy or asset classes of the capital markets depending on private risk preferences. When the Fed sets rates below the prevailing yield and above the prevailing risk preferences for sectors, investors are forced into riskier asset classes to chase yield. At the same time, debtors can be enticed to leverage up based on lower debt service costs, something we now see in the US household sector with zero rates leading to generational lows in household monthly debt service costs.
This is the essence of monetary policy: it's all about credit. And to the degree that monetary policy has any impact on the real economy, it is because credit has increased and debt service costs have decreased.
The result of using monetary policy to steer the economy cyclically then is an asymmetric policy that has debt levels growing on a secular basis through economic cycles. The economy becomes an asset-based economy by dint of the fact that growth becomes correlated to the ability to increase credit and leverage on a secular basis, using rising asset prices as collateral against that increased credit. When I took a brief look at the Asset-Based Economy at economic turns after the Great Financial Crisis, the policy asymmetry was clear. In every single sector of the US economy except the government sector increases in debt associated with cycle trough monetary stimulus was not unwound at the peak over a full three decades.
Now we are in a deleveraging cycle that, despite the present cyclical upturn, I believe will continue through more cyclical downturns such that economic growth will be poor and deleveraging will dominate the macro outlook for years to come. The attempt by the Fed and other monetary agents to steer the economy without the aid of fiscal policy and credit writedowns and to resist this private sector deleveraging trend will lead to severe crises during those downturns. Zero rates won't fix this. No amount of quantitative easing will fix this. Instead, these policies will skew capital allocation to higher risk and higher yield sectors of the economy, pumping up asset prices, creating higher leverage and leading to more credit writedowns at cyclical downturns.
Note: This is excerpted from a longer article available only to paid premium content subscribers at Credit Writedowns.
Disclosure: Econintersect Managing Editor John Lounsbury was formerly a regular contributor and an assistant editor at Credit Writedowns.