Leave Monetary Policy to the Market !

On EconLog, Scott Sumner leads us to a mind-blowing January 31st, 2009 article from The Economist. Here’s an excerpt from that article:

THE European Central Bank (ECB) believes it deserves a break. In a flurry of activity it took its benchmark interest rate from 4.25% in early October to 2% by mid-January. Its president, Jean-Claude Trichet, has hinted that interest rates will be kept at 2% when the bank meets on February 5th, though it may act again in March. But the euro-area economy is deep in recession and inflation is falling rapidly. Why delay?

The rationale for holding off seems a bit muddled. One worry is that once interest rates fall too far, it will be hard to lift them again. Low rates make risky assets look cheap, so policymakers may hold off from raising them for too long, for fear of derailing a recovery based on rising asset values. But this is more a plea for wiser policymakers than a case against reducing rates.

Another reason for caution, voiced by Mr Trichet, is to avert a “liquidity trap”. This ambiguous bit of jargon usually refers to situations, such as when interest rates fall to zero, where orthodox monetary policy can no longer affect demand.

Trying to avert the liquidity trap by not loosening monetary policy is the most hilarious thing I’ve heard in a long time – and Scott Sumner is accordingly outraged:

That’s an EC101 level error. If the Economist magazine is right, and this was the motive, then the Great Recession in Europe was partly caused by an almost unbelievable level of ECB incompetence. Lowering rates to zero with easy money does not make a liquidity trap more likely, it makes it less likely. A liquidity trap is often assumed to occur when the actual market interest rate is stuck at zero. Actually, it’s a situation where the Wicksellian equilibrium interest rate is zero or below. What Mr. Trichet doesn’t seem to have understood is that lowering the policy rate of interest with an expansionary monetary policy actually tends to raise the Wicksellian equilibrium rate, making a liquidity trap less likely. This is just basic EC101.

The article in The Economist illustrates again why monetary policy shouldn’t be left to central bankers and why Market Monetarists call for Futures Targeting, where the central bank pegs the price of futures on NGDP, inflation or whatever else constitutes the monetary policy target. This way, the market, not central bankers, would set both the level of the monetary base and short-term interest rates. Monetary policy would be endogenous and fully market based.

Milton Friedman once said that money is much too serious a matter to be left to the central bankers.

Milton-Friedman

The conduct of monetary policy by the ECB during the Great Recession should convince even the last sceptics that handing over monetary policy from central bankers to the market is the sensible thing to do.

The Root of the Root of the Perverse Incentives in the Banking Sector: the Wrong Monetary Policy Regime

As I have described before, the banking sector is a mess – or as Mervyn King put it: “Of all the many ways of organising banking, the worst is the one we have today.”

At the root of the problem are explicit and implicit government guarantees for bank debt. These constitute a subsidy of debt financing and provide an incentive for banks to minimize equity to asset ratios. Razor-thin capital ratios again incentivize banks to take on excessive risk. At some point excessively risky investment behavior will produce heavy losses and lead to a solvency crisis.

Government guarantees for bank debt do not only stand at the beginning of this causal chain – they also stand in the way of a solution to the solvency crisis. Undercapitalized banks do not necessarily need to engage in credit rationing. The much simpler solution would be to issue more capital. But the taxpayer subsidy for debt has made capital artificially expensive relative to debt. Hence, banks are reluctant to issue more capital and the solvency crisis drags on.

So, if the government abolished deposit insurance (which is, of course, not insurance in the true sense of the word but simply a government guarantee) and also announced that there would be no bailing out of creditors any more in the future, would this eliminate the perverse incentives in the financial industry?

Without being accompanied by certain changes in the institutional environment (described below) such an announcement would simply not be credible and hence not effective: there are, at the moment, banks that are (potentially) “too important to fail”. Hence, the government has a strong incentive to renege on its promise and rescue such banks in the event of a crisis.

Anticipating this too-important-to-fail problem facing the government, the creditors of such banks will be content with relatively low risk-premiums. Again, the capital structure irrelevance principle will not hold and the banks will still be able to reduce their weighted average cost of capital by increasing their leverage to astronomical levels.

Without first solving the too-important-to-fail problem, the government cannot credibly commit to not bail out failed banks. But is there a solution to this problem at all?

The failure of a sufficiently large bank (or several banks) may well cause a massive negative shock to aggregate demand that cannot be offset by conventional monetary policy (i.e. by cutting the nominal safe interest rate). The economic cost associated with such an outcome (especially the cost in the form of a potentially significant rise in unemployment) may well be deemed too high to be politically acceptable.

The fact that the central bank’s power to offset negative aggregate demand shocks by cutting the safe nominal interest rate is limited (namely by the zero lower bound) is the main argument put forward to rescue failed banks with taxpayers’ money.

However, while there is obviously a limit to reductions in nominal interest rates, there is no limit to the extent to which the central bank can increase the money supply. That was Milton Friedman’s point when he complained about the failure of US monetary policy in the 1930s.

Of course, it is not enough to just increase the money supply. In order for the expansion of the money supply to increase aggregate demand, markets have to believe the increase of the money supply will be permanent. In short: the central bank has to commit to temporarily higher inflation (NGDP growth) in the future.

A fixed inflation target cuts off the Friedmanite money expansion route to boosting aggregate demand at the zero lower bound. If the central bank does not commit to deviate from its inflation target, market participants know that the central bank will collect the newly printed money again as soon as the economy is not subject to the aggregate demand shock any more. Hence, the effect of the monetary expansion on spending will be negligible.

The problem is that at the moment central banks across the world have a fixed inflation target, which means that the central bank’s power to offset negative aggregate demand shocks caused by the failure of sufficiently large banks is limited by the zero lower bound, which is again the root of the too-important-to-fail problem.