Column: Can monetarists revive the global economy?

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October 5, 2015 12:24 AM

Central Banks, by funding development activity, can do what govts are unable or unwilling to do using fiscal policy.

During the first 30 years after 1945, economists had a simple division in terms of policy instruments. Fiscal policy was effective and had to be actively used for keeping the economy out of recession and perhaps secure growth as well. Monetary policy was thought to be passive and ineffective. This was the Keynesian orthodoxy. Then along came the Monetarists and reversed the ordering. Fiscal policy, especially budget deficits, was nothing but harmful. If monetised, deficits caused inflation. Monetary policy was the effective weapon as long as money supply was under control.

There were huge controversies, many battles of equations and estimates but eventually the Great Moderation came about by the 1990s. Fiscal policy had to have a medium-run perspective, telling the agents what the government planned to do, and above all, avoid surprises. Budgets had to be balanced over the cycle and the debt-GDP ratio had to moderate.

After 15 years of the Great Moderation, the global economy fell apart, generating the biggest contraction (at least, among the developed economies) which has now lasted seven years. Fiscal policy has been absent as an active ingredient of the recovery (except perhaps for Obama’s first stimulus of $850 billion). It is monetary policy which became innovative. Bernanke had written his PhD thesis on the Great Depression and the failures of the Fed. So, he initiated quantitative easing (QE) which was really very aggressive and extensive Open Market Operations. The Bank of England followed (Mervyn King, Bank of England Governor from 2003 to2013, and Ben Bernanke once had offices in the same corridor at an Ivy League university). Japan had been doing something similar for a decade and even ECB, expected to be an old-fashioned monetarist, has followed.

We have had many years of near-zero interest rates. As we saw, the aged is reluctant to leave the comfort zone of near-zero interest rates. But it is hard to see where the money has gone. It has not entered the economy and caused income growth or inflation. The old link between money and nominal income has broken down. The best one can say is that all this money may have prevented the economy from doing worse than it has done.

All through the earlier 50 years, we had debates about the transmission mechanism from money to the real economy. We thought we had settled it in the Great Moderation. Now, we are back to that question. Why did all that money not enter the real economy and cause inflation or a boom? After all, we have Central Bankers worried that inflation is too low, way below the target of 2%. Can the transmission be directed where money can do some good?

This is now the theme of a new political debate partly sparked off by the new Left-wing leader of the Labour Party, Jeremy Corbyn. He has advocated a People’s QE. The idea is that the Central Bank, rather than buying bonds on the open market, will direct the money to infrastructure project such as home-building and roads, energy conservation schemes, etc. There has been a reaction against this. Mark Carney, the Governor of the Bank of England, has said it will be inflationary, though he failed to explain why. Or since Central Bankers are wishing inflation were higher, what is wrong with increasing the rate of inflation towards its target level of 2%?

The idea that instead of buying government or corporate bonds, the Central Bank should set up and fund a development bank is being mentioned in the context of the Eurozone as well. The ECB, for example, may buy the bonds of a national development bank (the Anglo Saxons don’t believe in them but the Europeans love them). The development bank then can do what in the old days fiscal policy used to be able to do—finance investment. The Central Bank can, thus, do the fiscal activism governments are unable or unwilling to do using fiscal policy.

There are debates going on, especially as to whether Central Banks would lose their credibility if they are seen to be indulging in off-the-balance-sheet spending. It is the Eurozone, where there is no central government to speak of, where this issue is most live. But the ECB is also a very young Central Bank. It has done some wonderful things to relieve the crisis in the Eurozone. It has to be careful with its credibility.

It is uncertain whether the ECB will go along this route. The near-term outlook for income growth is so depressed that markets may treat such activism on the part of a Central Bank benignly. But that is a hope rather than an expectation. Given how febrile the economic climate is, the final outcome may be inaction rather than innovation. The absence of fiscal policy on the part of the government is difficult to replace easily. We may be in a low level equilibrium for a while yet.

The author is a prominent economist and Labour peer

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