A paper investigating the roots of current crisis published by former Bank of International Settlement economist William R. White now at the US Federal Reserve at Dallas comes largely with the perspective of the Austrian Business Cycle Theory (ABCT).
One may interpret that Austrian economics may have “infiltrated” the US Federal Reserve or that this could also mean the the Fed have become more open to out of the box ideas [hat tip Zero Hedge; bold emphasis mine].
Here is the abstract:
In this paper, an attempt is made to evaluate the desirability of ultra easy monetary policy by weighing up the balance of the desirable short run effects and the undesirable longer run effects – the unintended consequences. The conclusion is that there are limits to what central banks can do. One reason for believing this is that monetary stimulus, operating through traditional (“flow”) channels, might now be less effective in stimulating aggregate demand than previously. Further, cumulative (“stock”) effects provide negative feedback mechanisms that over time also weaken both supply and demand. It is also the case that ultra easy monetary policies can eventually threaten the health of financial institutions and the functioning of financial markets, threaten the “independence” of central banks, and can encourage imprudent behavior on the part of governments. None of these unintended consequences is desirable. Since monetary policy is not “a free lunch”, governments must therefore use much more vigorously the policy levers they still control to support strong, sustainable and balanced growth at the global level.
Some of my favorite segments of the study
1. Mr. White challenges the “Wealth effect” or the Financial Accelerator (I made short comments here and here) principle espoused by US Federal Reserve Chief Ben Bernanke
the argument that higher “wealth” (generated by lower rates causing rising asset prices) will lead to more consumer spending also needs serious reevaluation. While not denying the empirical robustness of this relationship in the past, the argument suffers from a serious analytical flaw. Lower interest rates cannot generate “wealth”, if an increase in wealth is appropriately defined as the capacity to have a higher future standard of living. From this perspective, higher equity prices constitute wealth only if based on higher expected productivity and higher future earnings. This could be a byproduct of lower interest rates stimulating spending, but this is simply to assume the hypothesis meant to be under test.
As for higher house prices raising future living standards, the argument ignores the higher future cost of living in a house. Rather, what higher house prices do produce is more collateral against which loans can be taken out to sustain spending. In this case, however, the loan must be repaid at the cost of future consumption. No “wealth” has in fact been created. In any event, as noted above, house prices in many countries have continued to fall despite lower policy rates. This implies that the need for “payback” can no longer be avoided by still further borrowing.
2. Mr. White amplifies the view the capital markets may have been largely influenced by central bank actions, which not only increases risk exposure by the central bank itself, but likewise signify that current policies may have gone beyond the objectives of central banks. Also, current actions by central banks may have been interfering with or influencing the fiscal dimensions of government.
Ultra easy monetary policies, whether very low policy rates or policies affecting the size and composition of their balance sheets, can also have unintended and unwelcome implications for central banks themselves. Some of these effects are more technical. First, with very low policy rates, the likelihood rises that normal intermediation spreads in private markets will fall so far that these markets will collapse. The central bank may then find itself as the “market maker of last resort”. The current interbank market might fall into this category. Moreover, a similar experience in Japan in the 1990’s indicates that restarting such private markets is not easy.
Second, deeper questions can arise about central banks operating procedures in such an environment.
Third, with central banks so active in so many markets, the danger rises that the prices in those markets will increasingly be determined by the central bank’s actions. While there are both positive and negative implications for the broader economy, as described in earlier sections, there is one clear negative for central banks. The information normally provided to central banks by market movements, information which ought to help in the conduct of monetary policy, will be increasingly absent. Finally, with policies being essentially unprecedented, wholly unexpected implications for central banks (as with others) cannot be ruled out.
Beyond these technical considerations, the actions undertaken by AME central banks pose a clear threat to their “independence” in the pursuit of price stability. First, as central banks have purchased (or accepted as collateral) assets of lower quality, they have exposed themselves to losses. If it were felt necessary to recapitalize the central bank, this would be both embarrassing and another potential source of influence of the government over the central bank’s activities. Second, the actions of central banks have palpably been motivated by concerns about financial stability. Going forward, it will no longer be possible to suggest that monetary policy can be uniquely focused on near term price stability. Third, by purchasing government paper on a large scale, central banks open themselves to the criticism that they are cooperating in the process of fiscal dominance.
3. Low interest rates may incentivize a further delay in reforms, which increases the market, credit, interest rate and political risks.
A more fundamental effect on governments, however, is that it fosters false confidence in the sustainability of their fiscal position. In the last few years, in spite of rising debt levels, the proportion of government debt service to GDP in many AME’s has actually fallen. Citing as well the example of Japan, many commentators thus contend that the need for fiscal consolidation can be resisted for a long time. Koo, Martin Wolf of the Financial Times, and others are undoubtedly right in suggesting that a debt driven private sector collapse should normally be offset by public sector stimulus. What cannot be forgotten,however, is the suddenness with which market confidence can be lost, and the fact that the Japanese situation is highly unusual in a number of ways.
What is clearer is that exiting from a period of ultra easy monetary policy will not be easy. In this area, the Japanese experience over the last two decades is instructive. Central banks using traditional models will hesitate to raise rates because growth seems sub‐normal. Further, the recognition that higher short rates might cause longer rates to “spike”, with uncertain effects on financial stability, will also induce caution. Governments will also firmly resist higher rates, because they might well reveal that the level of government debt had indeed risen to unsustainable levels. Further, on the basis of recent experience, the entire financial community (with its formidable capacity for public communication and private lobbying) will oppose any tightening of policy as too dangerous. Their motives in this regard are questioned below.
Presumably a sharp enough increase in inflation would lead to a tightening of policy. However, by then a lot of further damage ‐ not least to the credibility of central banks – might well have been done.
The entire paper here:
Dallas Fed QE
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