Wednesday, July 30, 2014
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Monetary Mystification

NEW YORK – Central banks on both sides of the Atlantic took extraordinary monetary-policy measures in September: the long awaited “QE3” (the third dose of quantitative easing by the United States Federal Reserve), and the European Central Bank’s announcement that it will purchase unlimited volumes of troubled eurozone members’ government bonds. Markets responded euphorically, with stock prices in the US, for example, reaching post-recession highs.

Others, especially on the political right, worried that the latest monetary measures would fuel future inflation and encourage unbridled government spending.

In fact, both the critics’ fears and the optimists’ euphoria are unwarranted. With so much underutilized productive capacity today, and with immediate economic prospects so dismal, the risk of serious inflation is minimal.

Nonetheless, the Fed and ECB actions sent three messages that should have given the markets pause. First, they were saying that previous actions have not worked; indeed, the major central banks deserve much of the blame for the crisis. But their ability to undo their mistakes is limited.

Second, the Fed’s announcement that it will keep interest rates at extraordinarily low levels through mid-2015 implied that it does not expect recovery anytime soon. That should be a warning for Europe, whose economy is now far weaker than America’s.

Finally, the Fed and the ECB were saying that markets will not quickly restore full employment on their own. A stimulus is needed. That should serve as a rejoinder to those in Europe and America who are calling for just the opposite – further austerity.

But the stimulus that is needed – on both sides of the Atlantic – is a fiscal stimulus. Monetary policy has proven ineffective, and more of it is unlikely to return the economy to sustainable growth.

In traditional economic models, increased liquidity results in more lending, mostly to investors and sometimes to consumers, thereby increasing demand and employment. But consider a case like Spain, where so much money has fled the banking system – and continues to flee as Europe fiddles over the implementation of a common banking system. Just adding liquidity, while continuing current austerity policies, will not reignite the Spanish economy.

So, too, in the US, the smaller banks that largely finance small and medium-size enterprises have been all but neglected. The federal government – under both President George W. Bush and Barack Obama – allocated hundreds of billions of dollars to prop up the mega-banks, while allowing hundreds of these crucially important smaller lenders to fail.

But lending would be inhibited even if the banks were healthier. After all, small enterprises rely on collateral-based lending, and the value of real estate – the main form of collateral – is still down one-third from its pre-crisis level. Moreover, given the magnitude of excess capacity in real estate, lower interest rates will do little to revive real-estate prices, much less inflate another consumption bubble.

Of course, marginal effects cannot be ruled out: small changes in long-term interest rates from QE3 may lead to a little more investment; some of the rich will take advantage of temporarily higher stock prices to consume more; and a few homeowners will be able to refinance their mortgages, with lower payments allowing them to boost consumption as well.

But most of the wealthy know that temporary measures result only in a fleeting blip in stock prices – hardly enough to support a consumption splurge. Moreover, reports suggest that few of the benefits of lower long-term interest rates are filtering through to homeowners; the major beneficiaries, it seems, are the banks. Many who want to refinance their mortgages still cannot, because they are “underwater” (owing more on their mortgages than the underlying property is worth).

In other circumstances, the US would benefit from the exchange-rate weakening that follows from lower interest rates – a kind of beggar-thy-neighbor competitive devaluation that would come at the expense of America’s trading partners. But, given lower interest rates in Europe and the global slowdown, the gains are likely to be small even here.

Some worry that the fresh liquidity will lead to worse outcomes – for example, a commodity boom, which would act much like a tax on American and European consumers. Older people, who were prudent and held their money in government bonds, will see lower returns – further curtailing their consumption. And low interest rates will encourage firms that do invest to spend on fixed capital like highly automated machines, thereby ensuring that, when recovery comes, it will be relatively jobless. In short, the benefits are at best small.

In Europe, monetary intervention has greater potential to help – but with a similar risk of making matters worse. To allay anxiety about government profligacy, the ECB built conditionality into its bond-purchase program. But if the conditions operate like austerity measures – imposed without significant accompanying growth measures – they will be more akin to bloodletting: the patient must risk death before receiving genuine medicine. Fear of losing economic sovereignty will make governments reluctant to ask for ECB help, and only if they ask will there be any real effect.

There is a further risk for Europe: If the ECB focuses too much on inflation, while the Fed tries to stimulate the US economy, interest-rate differentials will lead to a stronger euro (at least relative to what it otherwise would be), undermining Europe’s competitiveness and growth prospects.

For both Europe and America, the danger now is that politicians and markets believe that monetary policy can revive the economy. Unfortunately, its main impact at this point is to distract attention from measures that would truly stimulate growth, including an expansionary fiscal policy and financial-sector reforms that boost lending.

The current downturn, already a half-decade long, will not end any time soon. That, in a nutshell, is what the Fed and the ECB are saying. The sooner our leaders acknowledge it, the better.

Read more from our "New Model Central Banking" Focal Point.

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  1. Commenteddouglas ungredda

    Well this description eerely replicates the much feared Keynesian liquidity trap with added booby traps in it making it quite difficult to leave the liquidity t5rap recession zone. As USAs monetary QE kicks in only a part of the generated liquidity really goes into the real economy while most of it is reinvested in derivatives markets (i,e speculative demand balances). This assertion is evidenced by the BIS stats on derivative contracts which stack up as a huge multiple of global GDP if you wished.
    As a remedy then we could argue for increased government spending, as the typical keynesian remedy to get out of the doldrums. However reactivating governement demand is nearly impossible given that government finaces are presently streched to the limit in the USA and in a besieged Europe embarked in fiscal reduction. The lack of policy coordination among these two regions leaves us with anything but a huge race to the bottom combined with a global prisoners dilemma in terms of achieving real exchange rate competitiveness. On the other hand, returning to a gold standard is out of the question given the brutal adjustments reuqired to achieve external internal balance plus the geopolitical implications that the benefit of a comeback of this "barbarous relic" would entail to some gold producing economies that are decidedly against USA, interests.
    SDRs as alternative also requires profound changes in the international monetary system. It for once would help China acquire a greater say in international monetary afairs in exchange for its abandenement of its neo mercantilist policies and practices.

  2. CommentedRobert O'Regan

    We both know that without the gold standard one can manipulate the rate of interest advantageously for specific interest groups ~ c'mon, you have a great reputation.

  3. CommentedSteven Gilbert

    But Joe-

    "...underutilized productive capacity today, and with immediate economic prospects so dismal, the risk of serious inflation is minimal.." Ever hear of Zimbabwe? Argentina? South Africa? Unused capacity will not protect one from the onslaught of major currency debasement. More importantly, given the mega stimilus applied w/o major inflation, only serves to prove how deflationary the economy is.

  4. CommentedAndré Rebentisch

    How could you dare to argue in favour of "stimulus" as long as the interest rates of the affected nations remain in the dead zone? In the current economical situation "Austerity" is nothing but a smear phrase for financial prudence and pacta sunt servanda. The EU treaties said that other member states may not take the debt of others. This fundamental social contract is now broken.

  5. Commenteddalai guevara

    If economic policy of Anglo-America continues at present pace, we will undoubtedly see a further increase of commodity prices. When this is taken to the maximum, we will see as a result economies in the UK think twice about the renationalisation of its entire energy market, as most of its populace will find it impossible to get through the winter.

    Exciting times lie ahead.

  6. CommentedHugo Delgado

    Dear Stiglitz there is an intentional politics of Southern Europe to turn theses countries in the China, Paquistan, other extremely poor labour countries of Europe. Every one knows, it`s an evidence, the politics of austerity have only one result, look to the Argentina case study.

  7. CommentedMark Pitts

    Despite group-think mantras to the contrary, INEQUALITY has been DECREASING as capitalism has spread around the globe. Consider:

    1. In the last 30-35 years almost a billion people (nearly all in capitalist countries) have escaped poverty and entered the middle class. Never have so many people, or such a large percentage of the population, come so far, so fast.

    2. From 2000 to 2015 the number of extremely poor (those making less than $1.25 per day) will be cut in half.

    Don’t believe something just because it is presented as a “fact.”

      Commenteddalai guevara

      Mark,

      all correct, but since 2007 this trend has been reversed. That is what the group-thinkers criticise.

  8. CommentedNathan Coppedge

    A post I made on dimensional economics (I may eventually write a book):

    http://www.hypercubics.blogspot.com/2012/10/precepts-of-dimensional-economics.html

  9. CommentedS.Mahmud Ali

    Contradictory pressures appear to b at play. On the one hand, capitalist models require a focus on increasing share-holders' returns on investment; on the other, the consequences of that focus - cost-benefit analyses based on total factor costs in an increasingly inter-linked, say "globalised," world, require politicians to stress patriotic nationalism with rhetorical demands for returning manufacturing jobs back to the homeland from where cost-benefit analyses had off-shored them in the first place.

    This may be sound election-year campaign rhetoric, but will the candidates - both of them - please show some honesty in pointing out their inability to realise promises to help the voters have their cake, and eat it, too! J

    obs will migrate to where it is cheaper to perform them - if capitalism is allowed to function. If the world's largest economy wishes to operate on principles of much-reviled auturchy, it will possibly no longer remain free-market, or the largest, for very long. Stark choices there, for both the Parties.

  10. CommentedWilliam Hampton

    It seems to me that if a country sends its manufacturing jobs to where there is cheap labor, it will experience a loss of tax revenue. To make up for this loss of tax revenue, you will either need to cut spending, risking a revolt from your people, or get the money from the ones making the extra money from the cheap labor, risking manufacturing moving out completely because they owe no allegiance to a country. I know, that is too simple for an economist to understand.

  11. CommentedMargaret Bowker

    Laying aside the debate on central banks' role before the financial crisis, I cannot agree with Joseph Stiglitz's supposition that their action has proved ineffective. Both the ECB and The Federal Reserve, and other major central banks, have the ability and structure to act swiftly and boldly in appropriate circumstances; and they have done this and a great number of people are grateful. But he is right in saying that mending the debt damage shouldn't make things considerably worse. I was confused years ago to see bailout terms had interest rates attached to them, above cost. As Mario Draghi has said conditionality doesn't need to be punitive. The demanding length of this crisis is partly caused by political leaders in many of the major countries being impeded by not having a sufficient majority, a proper mandate in their own right. Perhaps we would see reduction and growth stimulus going hand in hand if they had. Maybe, even now, the Eurozone, representing one of the more important issues, will come together, put aside the desire to make people atone and take action to make the euro work. Politics created the Eurozone and bound together this swathe of disparate nations, and it behoves it, having found solutions to implement them.

  12. CommentedAndré Rebentisch

    This is not the time for growth, it is the time to restore trust and reliance. That cannot be mistaken for austerity policy options (when the engine is working). We have agreed upon a certain fiscal mechanism and if member states lack discipline we have to reinstate and enforce their agreement unless they comply. "Growth games" can prolong it but harden the fall. How should a nation go for excessive spending while its interest rates are within in the death zone? The Stiglitz convenience choice casts sand in the eyes of desperate people.

  13. CommentedDave Thomas

    Why wouldn't the policy prescription pioneered by Robert Mundell work now? Raising interest rates to attract foreign investment capital that is searching for a sound return under every rock on the planet, and lower marginal tax rates that provided incentives to engage in productive enterprise because producers would keep more of what they produced with lower marginal rates.

    This would provide the investment funds we need and increase the utilization of productive capacity without risking inflation or punishing savers mercilessly as low interest rates do.

  14. CommentedG. A. Pakela

    Deficits and government spending have not been this high as a percentage of GDP since WWII. Why has growth not exploded? Even if state level austerity is subtracted from the amount of federal stimulus, there should still be substantial net fiscal stimulus. Perhaps those fiscal multipliers are significantly less than 1.

  15. CommentedKevin Buzard

    Large public works projects did not end the great depression in the 1930's. In fact, the depression lasted into (and after) the 2nd world war. Somehow, you revisionist historians have managed to alter reality and have convinced many that spending money we don't have on things we don't need will produce wealth beyond our imagination. It didn't work in the 30's, it hasn't worked for the past 4 years and it won't work now. History teaches us lessons. When will you start to learn?

      Commentedsimon long

      government spending is like setting fire to money, we need to withdraw the rewards from activities that don't benefit society, and promote the activites that do. It's ludicrous that 2 % of american society can feed all of america, yet society is still poor.

  16. CommentedPaul A. Myers

    John Maynard Keynes wrote in 1922 (Skidelsky, vol 2, 109):

    "We act as high priests...the heretics must repeat our creed...instead of trying to disentangle the endless coil of impossible debt, merely proposes to confuse it further with another heap of silly bonds."

    Stiglitz has clearly stated the starting point: expansionary fiscal policy and financial-sector reforms. (Why can't our Congress get back to what was once an enshrined Congressional concept: strong local and regional banks. Has everyone sold out?)

    I would like to see a large public works program that builds things. Borrowing dirt cheap money to build public assets seems to me the height of common sense.

    I saw a graph of private sector fixed investment since 2000; what a discouraging picture. But a dollar of public infrastructure investment will attract additional dollars of private investment. Why did pump priming work in the 1930s and now seems a discredited concept? Time turn that graph around. No rise in real wages until that happens.

  17. CommentedProcyon Mukherjee

    If one tracks the S&P 500 stock prices for the last four year period, the three QE programs are distinctly visible in the charts, as around each ‘easing’ program the stocks shot up and the rising trend has been thus sustained. The overall results of S&P 500 also says that the performance has been better over this period, so by all counts the lagging indicator suggests that performance of the top companies in America have been becoming better, the good reason that investors should invest helped by the doze of liquidity has nothing wrong in it.

    But rightly pointed out by Stiglitz, the script has one thing wrong that the leading indicators have very little to offer if one goes by Fed’s own observation that even after three years of unprecedented injection of $1.5 Trillion dollar (till 2015), which is more than 10% of the current GDP, the chances of inflation returning is not very strong.

    The other very alarming thing to watch would be that when eventually the unwinding would have to be orchestrated (when Fed would have to sell the bonds), equivalent amount of balance sheet contraction and commensurate amount of reversal in the credit conditions would leave the daunting task of sustaining demand growth just at the time when inflation is round the corner.

    Stiglitz has referred to small investors and real consumers and home buyers, who in the current scheme of things is the pivot that could turnaround the tide; focusing on them instead of the current euphoria in stocks and commodities would do precious good, but the mysterious world of finance has other ideas that influence the denouements of the future.

    Procyon Mukherjee

  18. Commentedprashanth kamath

    With so much underutilized productive capacity today,

    What underutilized productive capacity? Are you referring to the empty malls and cities of China? Are you referring to Manufacturing units producing dinosaur hunting machines?
    Wake up! there are no dinosaur left on earth. Those machines that can be used in hunting dinosaur are useless now. True, they were useful a few million years ago.
    Who determines what makes "underutilized productive capacity"? Macro economists? Don't be funny!

  19. CommentedRobert Pringle

    Mr Stiglitz argues that monetary policy is unlikely to return the economy to sustainable growth; but the BIS, central banks and most governments say further fiscal stimulus would be dangerous. They may all be right. Is it any surprise that businesses, households and banks sit on their cash? As a result, economies on both sides of the Atlantic remain stuck in The Money Trap. To induce spending and investment to recover spontaneously, and banks to restart vital intermediation, what is needed is a re-writing of the rules of the game, radical bank reform and the construction of a strong monetary order around which expectations can cluster. The focus should be on re-designing institutions.

  20. CommentedZsolt Hermann

    It seems we still keep repeating the same "religious" mantra: "We have to return to growth, we have to stimulate, we have to increase demand..."
    We think there is only one way of life: the constant quantitative growth way.
    But it is not true. This path is totally unnatural, unnecessary, and in truth we do not even want it.
    We have been running in a vacuum, in a self generated bubble, we are trapped in a Matrix.
    The insatiable human ego created this illusion where the constant , infinite profit chase necessitates a cosmic "Ponzi scheme", where people are programmed, brainwashed to chase dreams, products, pleasures they never even thought about before, but a sophisticated media machinery and the subsequent social pressure pushes people into this consumer system.
    This makes everybody unhappy and bankrupt, but now we are like a chronic drug addict or alcoholic who simply cannot stop even he dies.
    Even in the life of a person there is the phase of exponential growth, development, but it slows down, and then comes the time of maturation where the quantitative growth, change is changed to qualitative change.
    In our evolution we have exhausted the quantitative growth phase, humanity has evolved into a global, interconnected, interdependent network, and this human network is locked into a closed, finite, living natural system.
    There is simply no more opportunity to expand, grow in a quantitative way.
    If in the human body exponential growth continues beyond the age of maturity it is called cancer. And untreated cancer kills the whole body and itself with it.
    Humanity in its present form is a cancer in the vast system of nature. And at the moment we are on our way to destroy the whole system and ourselves with it.

  21. Commentedjames durante

    We're stuck. There must be an increase in aggregate demand. This can happen in the following ways and won't for the following reasons:

    1. significant increase in wages; but record corporate profits result largely from holding down wages, and there is certainly no champion of unions in the u.s. elite class (neither obama nor romney)

    2. significant investments in infrastructure; but the government is tapped out. Sure, borrowing costs are low but debt is over 100% of gdp (if we count social security trust funds)

    3. a return to 1940's-1960's progressive and redistributive tax policies; but while that might not be political suicide in terms of voters it certainly is in terms of donors

    4. export driven growth; but in what area? there is no prospect for this realistically

    Capitlaism has worked perfectly over the last tree decades to transfer value from workers ho create it to shareholders and the managerial and ownership classes. The resulting inequality is a reflection of capitalism's success. But the ultimate result is crisis. Any clear-eyed account of history tells this story and repeats it.

      CommentedMark Pitts

      Despite group-think mantras to the contrary, INEQUALITY has been DECREASING as capitalism has spread around the globe. Consider:

      1. In the last 30-35 years almost a billion people (nearly all in capitalist countries) have escaped poverty and entered the middle class. Never have so many people, or such a large percentage of the population, come so far, so fast.

      2. From 2000 to 2015 the number of extremely poor (those making less than $1.25 per day) will be cut in half.

      Don’t believe something just because it is presented as a “fact.”

  22. CommentedJ. C.

    Mr. Stiglitz,

    If you reduce the world to US and Europe you are very right. But in fact what the US keeps doing is a exporting its problems to the rest of the world and to all those who trust in dolars as a value reserve. Mostly developing countries.

    You say no inflation problem: ask developing countries, which have seen prices of basic products double or triple in a few years. Of course this is not a problem in the US where consumption basket is composed of more elaborated goods, but it is in africa or LatAm, mostly for poor people.

    Central Banks in those countries are haveing tremendous problems to keep competivity with the US without creating inflation problems.

    This "currency war" in which we are getting into is and will be a problem in the future, maybe not for the US, but it will surely be for those who one way or the other will pay for its problems.

    Ask China and Brazil only to quote some of the big ones...

  23. CommentedVirgil Bierschwale

    Very true.
    Problem I see is that until we can reverse what these three groups of people are doing in America and Europe, it will not get better.

    http://keepamericaatwork.com/?p=207649

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