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.

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