Tag Archives: monetary policy

The Alice in Wonderland world of low interest rates

When interest rates go close to zero, it is possible that central bankers might just slip down a rabbit hole and discover that what used to be up might now be down.

There is a growing chorus of people arguing against central banks using low (even negative) interest rates to stimulate the economy.  One of the reasons that people point to is that when interest rates are low, cutting them further induces savers to save more.  The logic is that there are two offsetting effects a) a price effect — the lower return on savings makes people more inclined to consume today rather than wait for tomorrow; and b) an income effect where the fall in people’s income from lower interest rates induces them to have to save more today to satisfy their future spending needs.  Economists nearly always assume that the first effect (known as the substitution effect) outweighs the second effect (the income effect). This traditional assumption implies that the supply of savings in an economy is positively correlated with the interest rate.

But when this standard assumption does not hold, and the income effect more than completely offsets the substitution effect. In this case the supply of savings in an economy becomes negatively correlated with the interest rate.  It seems most likely that this could happen when interest rates start to get close to or below zero.  Figure 1 illustrates two savings supply curves, one for each of our two cases.

Figure 1

Fig 1

Whether the traditional assumption about the income effect holds or not when interest rates start to get close to zero is important for policy makers. To see why think about how monetary policy normally works.  Suppose that investment demand is shown as in the figure, and that the equilibrium real rate of interest is r0 (i.e. the rate of interest that equates savings supply with investment demand at A).

Now suppose that the economy looks like slipping into recession. The central bank sees signs of weakening demand for goods and labour. So the central bank intervenes and cuts interest rates below r0.  When it does this, there is an excess demand for investment over savings, which stimulates spending and boosts the demand for goods and labour.  Recession avoided. Good job central bank.

But now suppose that things are different and that investment demand is much lower. Indeed most economists believe that the equilibrium rate of interest has fallen in the last 20 years because of a shortage of good investment opportunities (i.e. a fall in investment demand).  This would shift the investment demand curve in Figure 1 to the left leaving Figure 1 to look like Figure 2 below.

Fig 2

In Figure 2 we see that in the traditional case, the new equilibrium interest rate is lower corresponding to the new equilibrium at point B. If the economy now started showing signs of recession, the policy prescription would be no different  than before — cut rates.

But if the non-traditional assumption held, then things get more complicated. Investment  demand and savings  supply now intersect twice at C1 and C2 and there are now two equilibrium interest rates associated with the two equilibria C1 and C2. But only the one associated with the higher interest rate (C1) is a stable equilibrium.  By this  we mean an equilibrium at which if the economy started to show signs of slipping into  a recession, the central bank could cut interest rates and thereby  create an excess of investment demand over savings supply and help to stimulate the economy to avoid recession. If the equilibrium was at C2 instead and the economy showed signs of recession. A cut in the interest rate in this case would cause savings to rise by more than investment and the recession would get worse, rather than being alleviated. This is the case that some economists are worried about.

The possibility that the savings supply curve might actually be backward bending (i.e. exhibit the non-traditional shape) means that there could  be a constraint on central banks abilities to prevent a recession and prices from falling.  Even if the economy is at an equilibrium like C1, the possibility of the negatively sloped savings supply curve limits the ability of central banks to make deep cuts to the policy rate for fear of driving the rate too low below C2 and creating a deflationary spiral.

Before ending this post, there are two last points to consider. First, it is possible that the slow fall in investment demand and rightward shift in savings supply that the world has witnessed in the last 20 years may continue (especially in countries where populations are starting to age dramatically, like Japan and Europe and even China).  In which case, it might be possible that there is no intersection between investment demand and savings supply (at least not at full employment, which we have been implicitly assuming in this post).  Second, it might be that at really low (say negative) interest rates, investment demand becomes infinitely elastic.  In which case, eventually the central bank could still achieve its goals of maintaining inflation and avoiding if it was willing to go negative enough.   Regardless, the simple analysis here is meant to highlight just one thing, that the economics of monetary policy could soon be much more complicated than one thought.


The ceiling can’t hold us: What to expect on D-Day and why it’s more likely than you think

TH woke up this morning with that catchy tune “the ceiling can’t hold us” and thought how apt it is to describe the behaviour of the US congress, which may soon recklessly drive the global economy into yet another financial crisis by choosing not to lift the US debt ceiling before October 17 (D-Day). It also got TH thinking about what would actually happen if no agreement is reached and congress actually failed to act, and how we might end up in that situation.

To think through, it is helpful to imagine what would happen if nothing else happened except that the  debt ceiling is reached and the government loses the ability to issue new debt. First, the US government shutdown, which is underway at present, would have to sharply accelerate to constrain expenditures to avoid new borrowing. The sharp acceleration will have all sorts of macro consequences, the most notable of which would be a sudden contraction in US GDP growth and loss of jobs. The more interesting and worrisome complication is that because certain expenditures can’t just be constrained or stopped, the US government will probably have to default on some liabilities.

Sovereign default is never good; especially for people who are holding the debt that the government defaults on.

So imagine that there you are on October the 16th (the date when congress votes (or doesn’t vote) to raise the debt ceiling. And as the votes come in, it becomes clear that you are holding debt that is due to be redeemed in the next few days and will therefore most likely be defaulted on. You are holding the hot potato. Of course you try and sell it, as does everyone else.  The price of the debt plummets; you wished you had sold the day before. Of course in reality, many people wouldn`t have been as optimistic as you, and would have sold the day or week before.  There will be a point where bond selling along with the various uncertainties will cause markets to start behaving badly. Something a kin to a run starts. Liquidity dries up, short-term interest rates spike, banks stop making loans, and so on.  You know the drill.  Something like what happened when Lehman Brothers was forced to default. It would be nothing short of a financial and economic calamity that could make the Lehman Brothers moment look good.

But that scenario assumes nothing else happens.  And of course something will.  The US Federal Reserve will have its “whatever-it-takes” moment and intervene to avoid disaster.  The simplest way would be for it to stand ready to buy any US Federal government debt, including (and most importantly) the debt that the government is about to default on. It would effectively take on the debts for the US treasury even the debt on which the government is in arrears on.  This would effectively amount to a new (fourth) round of quantitative easing – QE4

Some will no doubt worry that this will be inflationary.  It need not be.  The US Fed does not only have to issue money in exchange for those dodgy US Treasuries.  It can issue its own bonds instead. In practice it would probably to a bit of both.  The problem is that this will affect the well-being of the financial system in general, raising the overall costs stemming from the excessive reliance on monetary policy. But for now, calamity avoided.

Phew, so now you breathe a sigh a relief. You don’t need to panic now.  You can just wait until D-Day and for the Federal Reserve to come to the rescue.  The trouble is that you are not the only ones that can do the calculus.  The members of the US congress can too.  The fact that the situation has gone this far shows that congress is already willing to overburden the US Fed. The question is how much further they are willing – how much larger are the nips of liquidity going to get?

As the famous Mental As Anything song goes:

Started out, just drinkin’ beer
I didn’t know how or why
Or what I was doin’ there
Just a couple more
Made me feel a little better
Believe me when I tell you
It was nothin’ to do with the letter

I ran right out of beer
I took a look into the larder
No bones, nothin’
I’d better go and get somethin’ harder
Back in a flash
I started on a dash of Jamaica rum
Me and Pat Malone
Drinking on our ow-ow-ow-own

Woh-hoh-oh, the nips are gettin’ bigger
Woh-yeah, the nips are gettin’ bigger
Wo-hoh-oh, the nips are gettin’ bigger
Yeah-eah-eah, mmm they’re gettin’ bigger


How to balance inflation on the end of your finger

Five years after the  beginning  of the financial crisis, there are still a lot of people trying to come to grips with monetary policy and inflation. Here is an analogy that TH thinks might (usefully) help make monetary policy setting seem less like rocket science and more like child’s play.

Imagine that you have a stick balancing on the end of your index finger.  It’s a nice straight stick, about a metre or so long – perhaps a pool cue made for a child.  The stick is unstable, it could fall any which way, but for the sake of this thought experiment, imagine that it can only fall forwards, away from you, or backwards towards you.

If you are standing still and are lucky, you have it perfectly balanced, but at any moment, some random event could cause the still to fall forwards or backwards. If you do nothing, the force of gravity will quickly cause the pace at which the stick falls forwards or backwards to increase.  If the stick starts falling forwards, your natural instinct will be to push your finger away from you so that the base of the stick gets out in front of the top of the stick and halts the stick from falling over. With some skill, you’ll soon have it well-balanced on the end of your finger again.

By now, you have a pretty well-developed model in your mind of that stick.  It is also a pretty good model of (the Wicksellian cumulative process of) inflation and monetary policy. Where the bottom of the stick is and what it is doing (remember it can’t go sideways, only backward or forward) tells you about the nominal rate of interest; closer to you is a lower rate of interest, further away from you  is a higher rate of interest.  The top of the stick tells you about inflation – if it is falling forwards, inflation is increasing, backwards and prices are falling.  Clearly there is going to be a relationship between interest rates and inflation – you can play with the model in your head – or get a stick and try it out for yourself. The model has some pretty good predictive power. Try pulling the (virtual) stick towards you (cut interest rates) and what see happens to inflation.  Anyway, before going further you need two simple equations that might help to better convert our balancing stick into a model of inflation:


which simply says that the real rate of interest on a financial investment (a loan) is the nominal rate of interest (i.e. the interest rate on loans, which we will assume to be the same as the policy rate set by the central bank) minus the inflation rate, p*.

The other equation is


In this equation, R is the natural rate of interest – it is the rate of return on physical investments – from building a house or a factory.  The equation says that inflation is a function of (which is what the f stands for) the gap between the natural rate of interest and the real interest rate expected to be earned on a financial asset.  If r is less than R, so that it is profitable to borrow money and buy a real investment (a house or a factory), then the increased demand for goods such as these will cause the inflation rate to rise.

Let’s return to our stick analogy. Suppose you have the stick perfectly balanced on your finger.  It’s not falling forward or backward.  The base of the stick is right under the top. You are standing still. Remember that top of the stick tells you about inflation.  Since the top of the stick is not moving, inflation is currently zero. The real rate of interest is therefore equal to the natural rate of interest (this comes from the information summarised by Equation 2).  If you expect things to stay this way, or at least that the chances of the stick falling forward in the future to be the same as it falling backwards, then the expected rate of inflation would be zero too. And since the expected rate of inflation is zero, it is also the case that the nominal rate of interest must just equal the real rate of interest, which, as we said, is equal to the natural rate of interest.   Got it?     p* =0 and  p=0, so from Equation 2, R=r and from Equation 1, r=i, so i=R too.

Now all the hard work is done, try doing the same thought experiment again.  Imagine that you pull your finger towards you just a bit so that you pull the base of stick from under the top. This shock causes the nominal rate of interest and consequently the real rate of interest to fall below the natural rate and stimulates people to borrow and invest. It drives up demand in the economy and prices start to rise – i.e. inflation goes up.  The top of the stick starts falling forward.  Quickly, people start to realise that, unless something is done soon, there is going to inflation in the future.  The higher expected inflation means that, given the nominal rate of interest, the real rate of interest (real cost of borrowing) is now even less than before, which further fuels an increase in investment and inflation.   The process feeds on itself in a vicious circle, creating a process of accelerating inflation and the stick is soon accelerating rapidly towards the floor.

The inflationary process can be stopped by pushing forward on the bottom of the stick – this is analogous to increasing the interest rate.  Just as you would have to push the bottom of the stick forward to get in front of the top to stop its fall, to make the real rate of interest equal to the natural rate of interest and set inflation back to zero, the increase in the interest rate will have to overshoot the rate of increase in prices. For example, if the shock has caused inflation to increase from 0 to 5%, then the increase in the nominal rate of interest – the policy rate – will have to be more than 5%.  This is because of the effect of inflation expectations.  Just like the stick has some momentum, so do expectations about future inflation, and the policy rate must increase by enough to offset not only the current rate of inflation but any expectations that are forming based on the current behaviour of the economy about future inflation.

So what does our simple model tell us about current monetary policy? TH reckons it tells us quite a lot. First, monetary policy, like balancing a stick on your finger, is more of an art than rocket science. You don’t need to know the laws of physics to balance the stick, you just need practice. There are also different styles too.  Some stick balancers (read inflation-targeting central bankers) could prefer slow graceful adjustments to the policy rate – that allows for longer periods of inflation away from the central bank’s target (Australia says inflation will be around 2 to 3 percent, on average, over the course of the cycle, which could be up to 10 years!). Others might prefer swifter, sharper policy adjustments and more stable prices.    Both could work. We could call the two types of policy reactions  as Type I and Type II. Australia would be a Type I inflation targeter.

Expectations about inflation

As you might have guessed, expectations about future inflation are also important in this model.  Suppose that the central bank has a zero inflation target, and people are firmly convinced that the central bank will keep inflation close to zero, then an inflationary shock won’t need such a swift or large interest rate response from the central bank because it won’t need to offset the stimulatory, self enforcing  effect of inflation expectations causing a reduction in the real interest rate and stimulating demand.  To make their life easier, central bankers will continuously remind you of their inflation objective to do what they can to keep you convinced that inflation expectations are “well-anchored.”

The zero lower bound on interest rates and forward guidance

You can do the inflation thought experiment for deflation too. Imagine that the stick starts falling towards you.  What do you do? The obvious thing is  to pull the base of the stick towards you and cut interest rates. With some manoeuvring, the deflation will be halted.  But what do you do if you can’t pull the still towards you.  If there was nothing else you could do, then there would be a deflationary spiral and you would have lost the stick. But of course there are other things you can do.  Suppose you were once a quick reacting (Type I) central bank that kept inflation close to target with swift and large if necessary interest rate responses.  Now you only have a little bit of lee-way, maybe to cut the interest rate to zero from say, 2%.  One trick is to switch type from a Type II central banker into a central banker that prefers slow and small adjustments (Type I).  If you don’t tell people that you have switched to Type II from Type I monetary policy, they may mis-read a small interest rate cut for policy ineffectiveness. Those deflationary expectations could start getting away from you, reinforcing the downward spiral.  So what do you do? You provide guidance to the markets that you are going to stay “low for long”, possibly until some condition outside of the control of the central bank like unemployment is met, and remind them of your inflation target to keep inflation expectations well anchored. This has become known as forward guidance. TH prefers Open Mouth Operations.

The zero lower bound on interest rates and quantitative easing

But interest rates are not the only game in town.    Everyone knows that printing money (aka quatitative easing) is inflationary right?  So another way to prevent deflation when you can’t pull back on the stick is to print money.  This will create the expectation that there will be some inflation, which will lower the real rate of interest for borrowers and stimulate demand.  Effectively, it’s finding a way to push on the top of the stick.  Again, by helping to anchor inflationary expectations (in this case offsetting expectations about deflation), quantitative easing can give help make the interest rate tool more effective at the lower bound.

Monetary policy to increase inflation with rational expectations

As noted above, inflation expectations are important in this model .  The momentum in the stick, which keeps it falling forward or backwards, even after some policy response, is a proxy for what economists call adaptive expectations. It simply means that people form expectations, at least partly, on the basis of what happened in the past.   What would happen if they were fully rational or forward looking? In that case, then things might be a bit topsy turvy. For example, suppose that the central bank announced a new inflation target of 10% (up from 0).  If the natural rate of interest was 3%, then, if everyone fully believed that the central bank would hit is target, starting a year from today (or tomorrow at annualised rates), all the central bank would have to do is INCREASE interest rates immediately to 3+10 = 13% to create inflation.  Using our stick analogy, the central bank would announce a new inflation strategy, which would stimulate demand and get the top of the stick moving forward, and then simultaneously start walking forward, pushing on the bottom of the stick.  The central bank would then just keep on walking forward at a constant pace that was analogous to constant increase in prices of 10% (perhaps ten steps a minute), with the top of the stick perfectly aligned with the bottom.

If you are quick, you might wonder whether the model with adaptive expectations could ever be consistent with the model with rational expectations.  After all, in the adaptive expectations case you cut interest rates to create inflation, in the rational case you raise them.  The answer is relatively simple, once you think of monetary policy as just balancing a stick on your finger.  After all, you know that you could, with practice initiate a process where you went from standing still while balancing the stick, to walking forward at a constant pace of 10 steps per minute. First you would cut interest rates, get inflation moving and soon adaptive expectations would learn that you were serious about targeting 10% inflation. Once you were advancing forwards at close to 10 steps per minute, you would tighten policy by pushing forward on the stick to alleviate the acceleration created by gravity and momentum. It might require a bit of back and forth, but eventually you’ll achieve  your goal.  You understand this, and so do market participants who seek to learn to come to rational conclusions through adaptive means.  All you need to know is that, in addition to cutting rates to increase inflation, you can raise them in the future to prevent accelerating inflation. So long as you know that, you will quite rationally understand that you can raise inflation by cutting interest rates.


Wicksell and Open Mouth Operations

According to Knut Wicksell (one of TH’s favorite economists) this is how you conduct monetary policy in an economy that relies purely on banks to generate money in the economy.

simply in a proper manipulation of general bank-rates, lowering them when prices are getting low, and raising them when prices are getting high.

He came to that simple conclusion in 1906 after writing a brilliant book on the subject some years before. And although it sounds obvious, it was somewhat “out there”. Why? Because Wicksell was arguing that in a world where the government had no control over the amount of money being produced in society, it could still determine the price level. At the time it was radical and foresighted – money was tied to gold, and national central banks often didn’t even exist.

Anyway, this is (briefly) how the idea works.  When you borrow money, you care about the real cost, which is the interest rate minus the inflation rate that you expect over the term of the loan (and a negligible interaction term that we’ll ignore).


where r is the real rate of interest (which is what you care about), i is the interest rate you pay on the loan, and p is the expected inflation rate.  If the interest rate is 5% and the inflation rate is 3%, then the real cost of borrowing is only 2%.   The lower the real rate of interest, the more borrowing that will take place  and the greater the level of aggregate demand and the more expansionary monetary conditions are.

There are two ways to implement monetary policy in this framework. The first is to do what Wicksell suggests.  Suppose, just for illustrative purposes, that prices are falling and people expect that to continue so that p is negative.  Then, the real cost of borrowing will be above the nominal rate and rising, so firms and households that are borrowing to buy goods and services, will tend to borrow less.  To prevent a fall in aggregate demand (which would just add to the process of already falling prices — Wicksell’s cumulative process), the central bank must cut interest rates to get the real cost of funds down.  That is fairly straight forward.

But suppose the central bank can’t cut rates because, say, they are already close to zero, what then? Well, in this framework, the only other variable that the central bank can tweak is the expected inflation rate.  And they can do this, through what is known as “open mouth operations” (a play on “open market operations”, which is a traditional way that central banks can implement monetary policy, and a term that was coined, TH believes, in a Reserve Bank of New Zealand discussion paper in the mid 1990’s but he can’t find it – though it has since become somewhat common amongst monetary economists).

How do open mouth operations work?  Well, the central bank just tells you what you should expect in terms of inflation. That’s it! And so long as you believe them, it should work in pretty much the same way as a cut in interest rates (Torrens knows that this is probably not quite true, but for now he’ll roll with whatever flack he gets).

This raises an interesting question.  Why don’t central banks engage in open mouth operations more fully?  There have certainly been some efforts to do something similar – central banks pay careful attention to their monetary policy statements because they  know that markets pore over them for tid bits that will help them to understand what to expect in the future. The Fed, has stated that it expects to maintain an exceptionally accommodative until mid 2015, while highlighting that if monetary policy wasn’t accommodative, inflation would be too low.  But the efforts at conditioning expectations fall short of directly conditioning inflation expectations altogether. See Jim Haley’s musings here.

It’s somewhat understandable when there is a mandated inflation target that binds the hands of a central bank, but that is not the Fed? Couldn’t the Fed simply say (hypothetically – TH doesn’t know what the right numbers are) that it will keep monetary sufficiently loose so that inflation can be expected to rise to say 4% over the next 2 years, after which, if the output gap has closed, it will tighten monetary policy to bring inflation back down to its target?   The effect of telling people that once the economy was operating at its potential it would reduce inflation would simply signal that it would tighten policy once conditions were right, so surely no problem there. This would be a bit like price level targeting or nominal GDP targeting, but without the central bank tying the inflation outcome to the growth of potential GDP, something that the central bank has no control over.

I guess one reason might be a time consistency type argument.  What happens if in 2 years Inflation is at 4%, and due to some unforeseen circumstances, the economy is still in the hole? Then the central bank has two problems – inflation and unemployment.  And, indeed, this could soon be the predicament that the ECB will find itself in. And it is a predicament that no inflation targeting central bank wants — recession and inflation. Euro area inflation is currently 2.5%, which is above its target of 2% (though technically the ECB does not really have an inflation target – it just aims to keep inflation below, but close to 2%). And this leaves the ECB in an awkward position because, since it has a defacto inflation target and inflation is above target, people will start to expect that inflation will fall.  This means that the real interest rate will rise if not offset by a further interest rate cut, which could lead to a further fall in aggregate demand. That most certainly will lower inflation, but it will hurt growth, and boost unemployment. So maybe the ECB should just say that it expects that inflation to rise further as the economy comes out of recession and that the rise will be reversed thereafter.  That would be better than the alternative of leaving markets unsure of what to expect – after all uncertainty is currently killing growth.

The euro area currency crisis – time for local currency solutions … and a serving of wedges

Brixton has one, Toronto has one and now Bristol does too (hat tip JH). They all have local currencies. These currencies are really scrip, and like the Austrian “worgl”, which has been discussed numerous times in this blog, they circulate in parallel to the official currency and are designed to boost demand in the local economies in which they circulate.

Just a thought, isn’t it also time to boost local demand in Greece, Portugal and Spain too? There are no other policy tools left that can directly boost demand in these economies (wage restraint is assigned to boosting supply, fiscal policy to reducing demand and achieving external balance, but nothing is assigned aiding the process by boosting demand see earlier post here).

The arguments for local currencies in the euro periphery are straightforward. First, ECB policy is set to maintain euro area price stability. By design it is currently too tight for the periphery. Engaging in additional quantitative easing in the periphery is just sensible monetary policy. And local currencies essentially do just that.*

Second, local currencies are mercantilistic. Normally mercantilism is a bad thing. But when you are stuck with a way over-valued local currency and an unsustainable trade deficit, mercantilism is really just what you need. Local monies work like this: they are currencies that are accepted by local merchants and trades people (places like bakeries and so on), but they are not widely accepted to by goods that are traded across jurisdictions. The reason is that although you can freely convert the official currency (say the euro) into a local currency (say the Spanish spud) at a rate of one euro for one spud, when you convert back, you only get 0.9 euros per spud. This convertibility “wedge” does two things. First, it makes the local currency a bit of, well … a hot potato. People who want to get euros to buy TVs will tend to try and spend their spuds as fast as they can and save any euros that they happen to already have or get in change. That spending will tend to go on locally made services rather than imported goods. Secondly, the convertibility wedge makes buying goods from outside the local jurisdiction more expensive for those who receive spuds. In popular macroeconomic parlance, the convertibility wedge helps to rotate demand away from imports towards local goods, which in turn reduces the trade deficit.**

Third, if it is successful, the Spanish spud could be expanded to the whole economy and eventually, but not necessarily, be used to smooth an exit from the euro.

Let’s face it, Spain is already in the fryer. They need to try something new. The youth unemployment is over 50% (likewise for Greece), paying the unemployed in Spuds to deliver local services, which have been heavily cuts due to austerity measures, can’t really hurt can it? Even if it is a ridiculous idea, how much worse could it be? OK the project would need to be managed by someone sensible, but there is no shortage of smart Spaniards around (except maybe in Spain – apparently a lot are emigrating). The idea shouldn’t be limited to just Spain. Perhaps the Athens argo, the Dublin Dubliner, Milano Money … . TH reckons it’s an idea whose time has come. And here’s the other thing, they don’t have to wait for national politicians (though they should be considering them) but can be implemented in small towns or big cities too. Go on Madrid, now is the time to try.

* This is really just an extension of an old argument by Paul Krugman .

** As Nick Rowe explains, people are always itching to get rid of the cash in their pocket, but in this case they are particularly keen to get rid of spuds. The rate at which they spend could also be increased by making the currency a depreciating currency — see earlier posts on “the worgl”.

QE3 and the Assignment Problem

The US Federal Reserve recently announced its third round of quantitative easing – i.e. loosening monetary policy by increasing the supply of money. It got Torrens Hume thinking about whether monetary policy was really the right tool and whether US monetary policy might be too loose. There are many ways of thinking about the problem, but TH was reminded of one of the most important classes he had in his undergrad international economics course on the assignment problem. We talked about it once before (here).

In its simplest form, the assignment problem says that if you have two policy objectives you need two policy instruments. Understanding this simple bit of Dutch inspiration was pretty important when the global economy was on a system of fixed exchange rates. This was because it meant that if you were trying to maintain external balance (i.e. balance in the balance of payments – basically net exports – to avoid a crisis that required a visit from the men in black at the IMF) and internal balance (full employment) then you needed two policy tools – monetary and fiscal policy. Monetary policy was best suited to fixing the exchange rate, leaving fiscal policy to maintain full employment.

All that came to an end about 30 (well actually 29) years ago when Nixon nixed the Bretton Woods system, and, in doing so, drove the world towards a system of mostly floating exchange rates. Countries like Australia, which finally adopted a floating exchange rate in the 1980s and Canada, which pretty much had one from day one, found that now the market automatically adjusted the exchange rate to maintain full employment, leaving policy makers free to choose whether to assign fiscal or monetary policy to the maintenance of internal balance.

Fast forward to today. Pretty much every advanced economy has decided to assign the job of maintaining full employment solely to monetary policy – thus leaving fiscal policy to achieve other objectives: mostly social objectives such as income redistribution, education, health and so on. And to ensure that they did their job free of political influence, governments went further made their central banks independent and gave them explicit targets (such as inflation targets) to pursue. With the exchange rate free to adjust monetary policy no longer had to be coordinated with fiscal policy, it just had to respond to it – if the government deemed it fit to spend more on schools, roads and so forth, the central bank could simply offset the expansionary effect with a tighter monetary policy. Likewise fiscal contraction could be offset with monetary expansion.

The trouble is that the US doesn’t have a fully flexible exchange rate. It has some hangers on, most notably China. This means that to a certain extent its exchange rate is effectively fixed. But the US behaves like it has a flexible exchange rate: its central bank is mandated to maintain full employment not external balance. As a consequence, it is setting a loose monetary policy. Because the exchange rate can’t respond vis-a vis the China’s of the world the adjustment tends to fall on other economies, the US dollar tends to depreciate against those that it can (e.g. the Aussie and Canadian or Brazilian) currencies, but not against the fixers (e.g. China). This means that the monetary policy tend to help US exports to the former group of countries, but encourage imports from the latter. Since monetary policy is targeted at internal balance the effect on external balances is not clear.
That leaves the US with a problem. It has a partially fixed exchange rate and the monetary policy tool is being assigned to internal balance. But no policy tool has been assigned to maintain external balance. It’s just flapping in the wind, determined partly by monetary policy, partly by the whims of policy makers in the rest of the word that tinker with capital controls, fix exchange rates and just generally intervene with the global economy, and partly by some troublesome market distortions too.

Perhaps the US needs to assign a policy tool to maintain external balance. US Fiscal policy is “stranded” at the moment – caught between the need to control the growth of the US government debt and do so without causing another recession. Arguably, the US could use fiscal policy tools to encourage a “fiscal devaluation” – changes in taxes and subsidies that raise the prices received by producers and paid by consumers of goods relative to services to bring about a structural transformation of the economy. This would tend to reduce the trade deficit and encourage investment in manufacturing, which could help boost growth. But this sounds a bit like central planning and it’s not obvious that it will work in practice.

And speaking of Europe …, OK we weren’t, but now that we are, the assignment problem is even more relevant for them. Nearly all the Europeans governments external and internal balance problems of some sort. The periphery have exceptionally high unemployment and are mired in recession as well as having current account deficit problems. But policy tools that they have at their disposal are limited. They all have high debt levels and many (especially in the periphery) can’t use fiscal policy. None of them have monetary policy instruments (because the ECB only sets a euro-wide monetary policy) nor a flexible exchange rate. So how will they achieve internal and external balance? What two instruments do they have at their disposal? TH reckons this problem explains why the regulators are going so easy on periphery banks, which are able to create credit and support the local economies. But then what policy instrument do you assign to financial stability? TH has a head ache now. He’s going to bed.


Could easy US monetary policy cause a widening of global imbalances?

Torrens had a nice day today – he got to peruse through some really interesting policy pieces – and for one reason or another, it got him thinking about whether US monetary policy, for which the well known Dire Straits tune seems aptly titled, could spill over to the rest of the world, and if so, how.

Apart from the psychological effects of getting the lyric “money for nothing” into the heads of Specie-Flow readers around the world, there are a variety of channels through which US monetary policy is generally thought to affect another country and these are associated with the exchange rate regime. Here are the traditional explanations. If the US shares a fixed exchange rate with another country with a closed capital account, like China, then an expansionary monetary policy in the US will stimulate US spending, including spending on imported Chinese goods, which in turn makes China’s trade surplus larger. This then requires greater amounts of foreign exchange intervention by the Chinese government to maintain the fixed exchange rate, which in turn creates inflationary pressure in China (the specie flow mechanism). If, however, the country has a flexible exchange rate and an open capital account, then the expansionary US monetary policy causes US interest rate to fall, which generates a capital outflow to the other country (as money flows in search of yield), and a depreciation of the US exchange rate. The weaker dollar tends to boost US exports to and weakens US demand for goods from such countries. It also might cause asset prices to get inflated in the foreign economy, which could be be a create additional financial risks.

So, everything else taken as given, it is likely, that US policy is expansionary for China and contractionary for, say Brazil. This is the mainstream view out there.

But TH wondered whether there were other linkages. He is sure that there are many, but here is one that came to mind. He probably read it somewhere, but doesn’t remember where; so apologies in advance if that is the case.

The linkage he has in mind is via the global banking system. Since international interbank markets often depend on the borrowing having high quality, liquid US dollar assets as collateral, US monetary policy, which affects the value of these assets, will affect international banking via these markets. So it seems reasonable to think that an easing of monetary policy that increases the supply of the most highly liquid US dollar assets will affect international borrowing conditions as well as US domestic borrowing conditions.

For countries with open capital accounts that are net borrowers from the rest of the world (such as, say, Australia and Canada), US monetary easing thus amounts to a credit easing policy, which causes these countries to increase their borrowing from the rest of the world. Since the borrowing is likely to result in a capital inflow (which causes the foreign currency to appreciate as capital flows in) and an increase domestic expenditure (as the borrowed money gets spent). These two effects tend to have offsetting effects on the foreign economy. So, in Australia, for example, the overall effect of the US monetary policy is to create increased indebtedness with the rest of the world (i.e. a larger current account deficit), without much effect on inflation.

But what about surplus countries, those like Germany, for example, that are net lenders to the rest of the world? What is the effect on them? Well countries like Australia have to borrow the money from somewhere, and, effectively, the US credit easing policy makes it easier for their banks to lend to the rest of the world. These countries experience the opposite effect – a capital outflow, which reduces domestic spending by diverting money that would have gone into the domestic economy abroad, and a depreciation, which increases their exports.

Thus, loose monetary policy in the US, could be exacerbating the global imbalance problem, or preventing it from rectifying itself as it should. It’s not clear how big this problem is. And it is certainly only one of many distortions that are currently messing up international banking and capital flows, but it could be a distortion that policy makers need to think about. And, who knows, perhaps they already are.