It seems that different people have drawn different lessons from the credit crunch and global recession. Many have pointed to the Fed’s easy-money policy as a major culprit. Not so the chief economist of the International Monetary Fund, and the leading light of mainstream “new Keynesians,” Olivier Blanchard. His recipe for avoiding future calamities of the kind recently witnessed is for monetary policy to be even looser and inflation rates even higher, as expressed in a recent Wall Street Journal interview.
The reason for this seemingly paradoxical policy recommendation is that a higher inflation rate would ensure a higher nominal policy rate, which in turn would make it possible for the Fed (and other central banks) to cut interest rates even more, in percentage points, than what was done this time around. As Blanchard explains,
Now we realize that if we had a few hundred extra basis points to rely on, that would have helped. We would have had to rely less on fiscal policy. So it would have been good to start with a higher nominal rate. The only way to get there is higher inflation.… Policy makers have generally chosen a 2% [inflation rate target]. But there was no very good reason to use 2% rather than 4%. Two percent doesn’t mean price stability. Between 2% and 4%, there isn’t much cost from inflation.… If I were to choose inflation target today, I’d strongly argue for 4%.
If such a policy goal was in place during the boom years of the 2000s, it would mean that real interest rates — which were already negative for more than two years — would have been even lower, borrowing money would have been even cheaper, credit growth even more rapid, and asset prices appreciating at even-faster rates. In other words, monetary policy would have amplified both the boom and the bust to an even larger degree than what we just experienced.
Blanchard’s record of being able to diagnose the health of the economy and to give sound macroeconomic recommendations is hardly stellar. In 2008, just weeks before the collapse of Lehman Brothers, he wrote the now-infamous paper “The State of Macro,” concluding that “the state of macro is good.” For this he was targeted as an object of ridicule alongside Chicago School economists Robert Lucas and Eugene Fama in Paul Krugman’s much-debated 2009 New York Times article “How Did Economists Get It So Wrong?”
As it turns out, the state of macro wasn’t so good after all — a realization Blanchard feels the need to come to grips with in his latest paper, “Rethinking Macroeconomic Policy,” published by the IMF this month.
In it he admits the wrongful thinking he and his colleagues were responsible for before the crisis, stating that “the great moderation lulled macroeconomists and policymakers alike in the belief that we knew how to conduct macroeconomic policy. The crisis clearly forces us to question that assessment.”
His paper seeks to “review the main elements of the precrisis consensus” and to identify where the mainstream profession went wrong, what tenets still hold and, tentatively, outline what should be the way forward for creating “a new macroeconomic policy framework.” This is all good, it seems. The crisis has revealed the crying need for a thorough revision of the basic tenets of mainstream macroeconomics. However, the conclusions drawn by Blanchard from recent experience are, if anything, just as wrong as the ones drawn before the crisis.
Blanchard starts out with emphasizing that mainstream macroeconomists and policymakers somewhat naively relied upon monetary policy to “stabilize” the economy, saying that “we thought of monetary policy as having one target, inflation, and one instrument, the policy rate. So long as inflation was stable, the output gap was likely to be small and stable and monetary policy did its job.” (Emphasis added.)
This myopic focus on “price stability,” or more precisely, moderate and constant year-on-year growth in consumer prices, made policymakers blind to other possible pitfalls, such as the surge in credit and the rapid growth in asset prices, and the concomitant misallocation of resources led on by distorted price signals. According to the mainstream view, stable consumer prices were tantamount to a stable economy:
Stable and low inflation was presented as the primary, if not exclusive, mandate of central banks. This was the result of a coincidence between the reputational need of central bankers to focus on inflation rather than activity … and the intellectual support for inflation targeting provided by the New Keynesian model. In the benchmark version of that model, constant inflation is indeed the optimal policy, delivering a zero output gap … which turns out to be the best possible outcome for activity given the imperfections present in the economy. (emphasis added)
In other words, new Keynesian thinking, based upon the idea that it should be the government’s task to stabilize the growth in prices and output, was in large part what gave rise to the monetary mistakes in the period preceding the financial crisis. The measure used to achieve “the best possible outcome for activity” in the economy is constant inflation according to some arbitrary standard, in the United States set as an implicit target of 2 percent per year, a target Blanchard now thinks should be revised upward.
Also, and importantly, new Keynesian thinking is based upon the “rational expectations” notion, which was incorporated into macroeconomic models after the “new classical” critique of postwar Keynesianism made its impact on the economics profession in the 1970s and early ‘80s. The new Keynesian view holds that as long as actual inflation does not diverge from inflation expectations, and as long as inflation expectations are stable, the economy will perform at an optimal level — “delivering a zero output gap,” as Blanchard puts it.
The output gap is the divergence from the assumed optimal and desirable growth in GDP, given available resources and technology. A zero output gap would, according to this view, also imply that the unemployment rate is at its “natural” or equilibrium level.
In other words, constant price growth at a targeted rate would seem to give us the best of all worlds: predictable inflation, optimal economic growth, and the lowest desirable level of unemployment. The only thing that could undermine this rosy scenario is an “external shock” that upsets the economy and moves output and employment away from its optimal level.
The main task of policy makers then, would be to dampen these shocks through “counter-cyclical policy,” thereby closing the output gap. Up to the full-blown crisis of 2008, this was mainly done by adjusting the Fed’s policy rate to influence the targeted economic aggregates.
The assumption outlined above is the reason why central bankers and mainstream macroeconomists put such great emphasis on the need to “stabilize inflation expectations” through establishing what is usually referred to as a “nominal anchor” for monetary policy. Fed Vice Chairman Donald Kohn makes the case for price stability as follows:
Our objective is to promote maximum sustainable employment and stable prices over time. These goals are enshrined in law, and they also make sense in economic theory and practice. Central banks are uniquely suited to promoting price stability, and they contribute to maximum employment and growth over time by eliminating the uncertainties and distortions of high and unstable inflation.
It also follows from this view that it really doesn’t matter how high inflation rates are — up to a certain level where the costs associated with changing prices become too high — as long as the inflation rate is stable.
The main problem with this view is that it does not take into account monetary aggregates, especially credit growth in the economy, which only affect consumer prices unevenly and with a certain time lag. In the meantime, credit growth can, and often will, lead to unsustainable asset bubbles and other economic distortions.
Price Stabilization Leads to Asset Bubbles
There is no reason to believe that a certain fixed percentage of consumer-price growth is in any way optimal, or that inflation expectations are all that matters — the bubble and crash of the 2000s has made that perfectly clear.
“This myopic focus on ‘price stability’ made policymakers blind to other possible pitfalls, such as the surge in credit and the rapid growth in asset prices, and the concomitant misallocation of resources led on by distorted price signals.”In an environment of strong growth, both domestically and on a global scale, a rise in productivity will put downward pressures on consumer prices. Without monetary tinkering by the government, the normal course of events should therefore be for consumer prices to fall as the economy grows (because the same amount of money is pursuing more goods and services). In such an environment, however, the central bank cuts interest rates to stimulate inflation figures, in order to approximate the formal or informal inflation target.
Once interest rates are cut, the central bank can keep them there for a long time, due to both domestic productivity growth and cheap imports from abroad, which puts even more downward pressure on consumer prices. This has been the case with goods from China and other emerging markets during the decade leading up to the crisis.
This leads to the paradoxical situation that the better things are going in the economy, the more the central bank will expand the money supply and keep interest rates low, and the larger is the potential for huge imbalances in the financial sector. In other words, the current monetary-policy regime ensures that the better things are going in the economy, both domestically and globally, the more likely is an asset boom and bust.
A Recipe for Disaster
Low interest rates, combined with optimism about the domestic as well as the global economic outlook, and the potential gains coming from rising asset prices in new and exciting markets — such as the recently expanding US subprime market and strong emerging economies — made the perfect environment for a financial bubble to take place. On top of this was the tacit guarantee, implied by the very framework of the monetary policy regime, that the central bank would always make sure the economy was growing through a commitment to rate cuts and monetary expansion at the first sign of an economic slowdown and reduced price growth, or even the very possibility of such an outcome.
Furthermore, through its “preemptive” stance toward any remote chance of trouble in the financial sector being transmitted to the “real” economy, the Fed created a guarantee to investors that a severe drop in asset prices would always be cushioned — the infamous “Greenspan [and later on, Bernanke] put.”
It turns out that the very “success” of the Fed in coming to the rescue, both for the financial sector as well as the economy at large, during the period that central bankers like to refer to as the “Great Moderation,” in large part created the conditions that led to the subprime bubble and financial crisis because it created a false sense of security. Blanchard gives credence to this idea in his paper. The result was the underpricing of risk on a grand scale and the encouragement of highly geared investment activities in the years leading up to the crisis.
These investment strategies were further encouraged by poorly designed regulations, such as international capital standards (the Basel rules) that deemed mortgage-backed securities and other similar debt instruments as safe as US government securities as long as they were graded triple-A by the government-mandated rating agencies. On top of this house of cards was a highly politicized US housing-finance system, creating even more distortions and moral hazard.
This was a recipe for moral hazard writ large. In other words, this was a recipe for disaster. And what have mainstream macroeconomists learned from the recent financial fiasco?
A Lesson Not Learned
Blanchard is probably typical of the prevailing view; he is the leading textbook writer in introductory and intermediate macroeconomics as well as being the chief economic expert of the IMF. It does not seem like this guiding light of macro gives us much hope of policymakers being able to forestall any future similar events. Blanchard’s diagnosis, as mentioned, boils down to the view that monetary policy in the years leading up to the crisis followed a trajectory that took us dangerously close to too little inflation. As he explains,
There was an increasing consensus that inflation should not only be stable, but very low (most central banks chose a target around 2 percent). This led to a discussion of the implications of low inflation for the probability of falling into a liquidity trap: corresponding to lower average inflation is a lower average nominal rate, and given the zero bound on the nominal rate, a smaller feasible decrease in the interest rate — thus less room for expansionary monetary policy in case of an adverse shock. The danger of a low inflation rate was thought, however, to be small.
To Blanchard, then, the real danger for the economy is too little inflation, because low inflation makes it more difficult for the Fed to conduct a massive monetary stimulus in the case of a severe downturn. As Blanchard puts it, “Higher average inflation, and thus higher nominal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions.”
What is missing from this story is the fact that it is easy monetary policy, following from this kind of thinking and the associated policy goals, that creates the need for such a monetary stimulus in the first place. Loose monetary policy creates unsustainable booms that eventually must come crashing down. So this whole line of reasoning really doesn’t make any sense.
The historical analogy that is usually put forth to give credence to the Fed’s actions is, of course, the daunting experience of the depression of the 1930s. In that era, the US money supply, according to Milton Friedman and Anna J. Schwartz, contracted by around one third in the three years following the peak of the business cycle in 1929. Donald L. Luskin, chief investment officer of Trend Macrolytics, succinctly explains the Fed’s rationale:
The Fed makes its policy decisions under extreme uncertainty and therefore must err on the side of avoiding unacceptable risks even if that means deliberately taking on acceptable risks. To the Fed, deflation is an unacceptable risk. Most economic historians, including Ben Bernanke, believe that deflation was the greatest single cause of the Great Depression.
Several things come to mind when assessing this fear of deflation. Most importantly, the Great Depression actually came about as a direct result of the low interest rates and monetary expansion of the 1920s, which were partially caused by tinkering with the international monetary system (after its collapse in connection to World War I).
As Murray Rothbard explains, the Fed cut interest rates and expanded the money supply in order to help the United Kingdom erect a deeply flawed quasi-gold standard. Once interest rates were cut, however, the strong productivity growth of the 1920s made sure that this monetary expansion did not translate into consumer price inflation. In fact, the whole period up to the Great Crash of 1929 witnessed stable prices not unlike what was seen in the United States during the boom years of the 1990s and 2000s. However, in all three episodes, low interest rates and credit expansion spawned an unsustainable investment boom that eventually came crashing down.
The very same thing happened in Japan in the 1980s. Both the interwar US economy and the 1990s Japanese economy then experienced a “lost decade”: their policy mistakes exacerbated the downturn that followed in the wake of a financial crisis. The same could easily happen to the United States this time around as well.
So the real lesson from both of these stories should obviously be for the central bank to avoid excessively expansionary monetary policies at any cost.
“In an environment of strong growth, a rise in productivity will put downward pressures on consumer prices. Without monetary tinkering by the government, the normal course of events should therefore be for consumer prices to fall as the economy grows.”The exception would of course seem to be the Keynesian “liquidity trap” in a severe downturn like the one witnessed in the US today and the one of the 1930s. However, the liquidity trap explanation is highly implausible, even though the temporary downward spiral of deleveraging and credit contraction surely is a painful experience, and one that makes it harder for the central bank to “stimulate” the economy. But this misses the point: why not avoid such a severe credit crunch in the first place by avoiding the credit bubble that gave rise to it?
Mainstream policy makers, though, find it hard to grasp this insight because of their views on how monetary policy affects financial conditions and real variables in the economy. They see the interest rate mainly as a policy instrument to achieve price growth at a constant rate and to indirectly stabilize output and employment. This is why they didn’t take into consideration monetary aggregates, including credit growth, when they made policy decisions.
The notable exception to this rule, though, is the European Central Bank (ECB), which operates on the basis of a “two-pillar” policy, i.e., it looks at both consumer prices and monetary aggregates. Springing out of the former West German central bank, the Bundesbank, the ECB’s legacy is one of tighter money than the central banks of most other industrialized countries (even though the ECB’s policies were also looser than they should have been in this period). This stemmed from the fact that the German monetary-policy makers dreaded having not one but two hyperinflationary episodes during the 20th century (both following in the trail of Germany’s engagement in world war). Thus, European policy makers were much more alert to the dangers of rapid monetary expansion than were their deflation-scared American counterparts.
The Chimera of Price Stability
While he admits to wrongful thinking in the precrisis years, Blanchard, unfortunately, does not seem to have learned the right lessons from the recent panic and recession, although some obvious insights are starting to dawn upon him. To begin with, he states that “stable inflation may be necessary, but is not sufficient.” The problem, however, is how to measure prices, since, according to Blanchard himself, “no single index will do the trick.” Furthermore, the assumed relation between stable price growth and a stable economy isn’t as clear cut as once believed:
What is clear, however, is that the behavior of inflation is much more complex than is assumed in our simple models and that we understand the relationship between activity and inflation quite poorly, especially at low rates of inflation. (emphasis added)
The most obvious reason why this is so is that there is no reason to believe that some artificial price index should remain stable or grow at a stable rate. As mentioned earlier, productivity gains at home and cheap imports from abroad would imply falling prices. This kind of benign deflation is also referred to as “good deflation” by monetary economist Michael Bordo. Based on the ungrounded fear of such deflation, policy makers hold interest rates at very low levels, even to the extent of making them negative in real terms, i.e., lower than the inflation rate. And low interest rates give rise to highly unstable investment activities that will influence the rest of the economy as well, both when asset prices rise unduly and when they come tumbling down.
At least mainstream economists and policymakers are taking this lesson to heart, giving new impetus to the case for deflating a bubble before it gets out of hand. In Blanchard’s words,
as in the case of the precrisis 2000s, both inflation and the output gap may be stable, but the behavior of some asset prices and credit aggregates, or the composition of output, may be undesirable (for example, too high a level of housing investment, too high a level of consumption, or too large a current account deficit) and potentially trigger major macroeconomic adjustments later on.
However, the intimate links between low interest rates, rapid credit growth, and asset bubbles seem hard to grasp for those making or recommending policy. Since the focus of the new Keynesians is still on what the government should do in order to respond to “shocks,” they tend to place great emphasis on the need for government maneuverability in times of crisis, rather than on preventing financial imbalances from occurring in the first place. This is why Blanchard suggests increasing the rate of inflation: it will give room for more drastic rate cuts should a new severe crisis arise. But this asymmetrical policy stance — cutting interest rates at the first sign of trouble, but never increasing them when asset prices are inflated by cheap credit — creates a highly unstable environment for investments.
“The current monetary-policy regime ensures that the better things are going in the economy, both domestically and globally, the more likely is an asset boom and bust.”For those who fail to see the links between easy money and unstable asset booms and busts, the solution to financial instability seems to lie wholly within the realm of regulation. Blanchard, echoing the ideas of Fed Chairman Bernanke, thinks that the “policy rate is a poor tool to deal with excess leverage, excessive risk taking, or apparent deviations of asset prices from fundamentals.” And, in accordance with the views of Greenspan and other Fed officials during the boom years, Blanchard thinks that “even if a higher policy rate reduces some excessively high asset price, it is likely to do so at the cost of a larger output gap.”
The solution then is for the central bank to be in charge of financial regulation, to monitor the financial sector for systemic risk, and to take corrective actions through regulatory tools. However, the Fed was able neither to identify the last financial bubble nor to reign it in before it got out of hand. This should make us think twice before expanding the Fed’s mandate as Bernanke has advocated doing during the last year or so.
Also, there is little reason to believe that better regulation would prevent a future crisis, since the true cause of any credit boom is monetary expansion by the central bank. Any reform of the financial system should start out from this simple fact.
Also, Blanchard’s thinking displays the common fallacy of treating developments in credit markets and asset prices as wholly separate from what is going on in the “real” economy, as if investment decisions and the allocation of capital are somehow unrelated to the workings of the economy. He also clearly displays the new Keynesian’s lack of understanding of the nature of asset booms and busts.
William White, former chief economist of the Bank for International Settlements, points out that “the prevailing paradigm of macroeconomics allows no room for crises of the sort we are experiencing,” adding that “this crisis provides evidence that the simplifying assumptions on which much of modern macroeconomics is based were not useful in explaining real world developments.”
White was among the few economists working within the mainstream institutional orbit who actually predicted the financial crisis. He did so based upon his “Austrian”-influenced understanding of the dynamics of boom–bust cycles. As he writes in a recent paper,
In contrast to the Keynesian framework, Austrian theory assigns critical importance to how the creation of money and credit by the financial system can often lead to cumulative imbalances over time. These imbalances, which ultimately come down to investments that do not end up profitable, eventually implode in the context of an economic crisis of some sort. In today’s terms, unusually rapid monetary and credit growth over the past decade or so led to asset price increases that seemed to have little to do with fundamentals. (emphasis added)
Low interest rates and rapid money growth lead to resources being allocated differently than they otherwise would have been. Once the boom ends, this misallocation is revealed, and a necessary readjustment of economic activity and resource allocation has to take place.
Keynesians’ myopic focus on economic aggregates, and their policy goal of stabilizing prices, output, and employment, makes them somewhat oblivious to the basic facts of economic life and leads them to a whole range of policy errors with painful long-term consequences. This — not some superficial revision of the existing dominant paradigm — should be the main lesson from the financial crisis.
