by Dirk Ehnst
At this point, however, we seem to have a broad convergence. As I read them, the market monetarists have largely moved to an expectations view. And now that we’re almost four years into the Lesser Depression, I’m willing, out of a combination of a sense that support is building for a Fed regime shift and sheer desperation, to support the use of expectations-based monetary policy as our best hope.
I still believe that the chances of success will be a lot larger if we have expansionary fiscal policy too; but by all means let’s try whatever we can.
And we are back at the old QE discussion. It is Richard Koo in the red corner, vs Paul Krugman in the blue corner. Let me quote from the referee’s game manual, sponsored by Goldman Sachs:
The key mechanism through which the shift from the baseline scenario to the nominal GDP target with QE boosts the economy is a reduction in the real long- term interest rate. This occurs via three channels:
1. Lower nominal long-term interest rates via a delay in the onset of rate hikes. As monetary policy needs to stay on hold for longer to reach the nominal GDP target, the first funds rate hike is pushed out to 2016, lowering the long-term interest rate. This, in turn, boosts growth and pushes down the unemployment rate.
2. Higher inflation expectations and thereby lower real rates. The reduction in the unemployment rate pushes up inflation and expectations of future inflation, which lowers the real long-term interest rate further.
3. A lower term premium. In the third scenario, the asset purchases further reduce long-term interest rates by lowering the term premium. In our scenario the purchase of $21⁄2 trillion of additional assets lowers the long-term interest rate by about 60bp.
So, this is it. These are the steps that must be successfully taken to get back to the long-term growth path. Let me point out that #2 depends critically on #1 and that #3 is a policy not connected to the other two.
Step 1. is something I find unrealistically optimistic. By now, everybody should expect the US interest rate to be stuck at around zero for many years. I don’t know how much the announcement of a continuation until 2016 will change the sentiment. As I see it, the economy is plagued by a demand side problem. Firms don’t see where future demand will come from while people are repaying debt (deleveraging). That is why they don’t invest. Cheaper interest rates won’t make a difference to them. After all, we had low rates for three years now without any significant rise in investment. And look back at the time from 2001-2008: low interest rates, but not much investment. Before the crisis hit, there was the jobless recovery. It must be very much doubted that low interest rates play any significant role in a depressed economy like today’s.
Step 2. means there are cumulative processes at work. If step 1. succeeds, then it will continually succeed. This does not have much meaning. Growth processes are always like that.
Step 3. is the QE part. Richard Koo had a presentation on this in 2010. In his book “The Holy Grail of Macroeconomics” he considered QE to be the Greatest Monetary Non-Event. This slide shows why:
Alan Blinder quotes a research paper on Japan in his own paper on QE (pdf link):
A survey of empirical research on the effects of Japan’s QE programs by Ugai (2006) concluded that the evidence “confirms a clear effect” of the commitment policy on short and medium-term interest rates but offers only “mixed” evidence that “expansion of the monetary base and altering the composition of the BOJ’s balance sheet” had much effect.
OK, one out of one. As Blinder explains, though, QE in the US drove down interest rate spreads, not long-term rates. So it remains very doubtful whether QE will deliver the push to the economy that is needed. After all, QE1 and QE2 were not putting the economy back on the track in terms of economic growth. Commercial and industrial loans did not exactly skyrocket:
One is left with the impression that the whole case for a nominal GDP target is based on dubious assumptions and mixed evidence at best. The case for fiscal policy is much more clear-cut. Targeting nominal GDP is OK with me, as Paul Krugman says, why exclude the fiscal side? As it stands, it is a lender’s strike. Investors want to see aggregate demand rise, and not expect that it rises. Only then you get back to talking about credibility and confidence and all those things. Since we are in a situation which resembles the Great Depression, I am not aware that any country escaped from that event by changing expectations. Two things did it: exiting the gold standard (which gave you control over the interest rate and money supply), and ramping up fiscal policy. I wish there were another way.
Articles by Dirk Ehnst
Deficits, Debt and Dysfunctional Policy-Making by Elliott Morss
Interest Rates, Consumption and Savings Rates by Michael Pettis
Credit, Demand and Unemployment by Steve Keen
Mistaken Monetary Policy Lessons from Japan? by John Muellbauer and Keiko Murata