Stephen King: Let's admit that rate cuts will not end the crisis, printing money will
Monday 16 February 2009
Chugger chugger chugger chugger"... yes, it's the sound of the printing press. With UK interest rates down to 1 per cent and US interest rates at zero, it's no longer possible to pretend that rate cuts alone will bring this economic crisis to an end. In the monetary sphere, something else needs to be done. Central bankers can no longer be content merely focusing on the price of money: in real, inflation-adjusted terms, they no longer have any influence. They also need to act on the quantity of money.
Any talk of the printing press, though, rings alarm bells. "You're trying to inflate your way out of the crisis ...you're robbing pensioners of their hard-earned wealth... you're following the policies of Mugabe's Zimbabwe." These are the typical accusations.
The accusations are wrong. Their existence, though, underscores the need for policymakers to explain very carefully why actions should now focus on the quantity, rather than the price, of money, and why these actions will go some way to cushion the downside risks now confronting the global economy.
The case for printing money does not rest on the idea of creating inflation by stealth. It rests solely on the idea that there is now tremendous downward pressure on both demand and prices globally. The current economic downswing is unlike any other in the post-war period. It is closer in spirit, if not yet in magnitude, to the 1930s Depression. And the Depression was associated with a world of monetary shortage and falling prices.
Deflation is the devil's work. Both Irving Fisher and John Maynard Keynes understood this very well in the 1930s, although they had different views of the mechanisms that threatened immense economic hardship. For Fisher, the problem was associated with the impact of deflation on real debt levels. Given that nominal interest rates cannot fall below zero (because cash, by definition, has a zero nominal interest rate), a period of deflation with zero interest rates will raise both real debt levels and real interest rates. This is very bad news for companies, which typically borrow to invest. Deflation paves the way to collapsing profits and scuppered investment. It's also bad news in our modern-day economies for those householders who have borrowed hugely to live in houses they will be ill-equipped to pay for.
For Keynes, the problem was associated more with the "stickiness" of nominal wages. The general idea is straightforward. If prices fall faster than wages, real wages will increase. Put another way, real profits will fall. If social convention prevents wages from falling too far, the chances are that companies will be forced to lay off workers in their thousands.
Either way, deflation is pretty much bad news all round. Some argued in the 1930s that deflation could pave the way to recovery by raising the real return on cash, thus creating higher wealth and income for cash savers. This was the so-called "real balance" effect, but it didn't work then and it's unlikely to work now, given that people's savings nowadays are tied up in stocks and property, all of which have lost huge amounts of value in recent years.
By raising the real return on cash, deflation leads to perverse incentives in capital markets. People are rewarded for hoarding cash. By doing so, though, nominal demand falls even further, leading to even more cash hoarding. Savings are no longer channelled into the capital markets. They, instead, end up stuffed under the mattress. The perception that cash is in short supply, a natural response to the credit crunch, needs to be dealt a fatal blow: printing money is part of the answer.
To win the "printing money" argument, though, policymakers should offer a strategy and framework within which the printing press can be used. After all, whether conventional or otherwise, monetary policy has the capacity to influence an economy not just directly but through its influence on people's expectations.
The first part of the strategy must be to drop all the "unconventional" language. It leaves people with the sense that our central bankers are engaged in experimentation. They can afford to be more confident than that. They should simply say that, at all times, monetary policy can be used to influence either the price or quantity of credit. As a group, central bankers are a pretty conventional bunch: they shouldn't be pretending to be offering the economic equivalent of nose-piercings and tongue studs, or thinking they should be heading off to Glastonbury or Burning Man. At their age, it's unbecoming.
The second part of the strategy should be to explain, precisely, how monetary policy operates on the quantity of credit and why, given the experience of recent years, it is essential to do so at all times. At the press conference following the release of the Bank of England's Inflation Report last week, Mervyn King, the Governor of the Bank of England, noted that "for many years central banks debated as to whether their short-run operating instrument should be the overnight interest rate in the market or whether it should be the monetary base... central banks have always being buying assets... in order to either target the overnight rate or the monetary base".
This, though, doesn't go far enough. At zero rates, a further reduction in the overnight rate simply cannot be achieved: there is, therefore, no choice other than to influence the monetary base. And, in a recession, boosting the monetary base offers no guarantees that broader measures of money supply will, in fact, expand because, within the private sector at least, there's an absence of willing borrowers (everyone's too busy hoarding money). The Bank of England may have turned itself into a lender of last resort for the economy as a whole, but a successful printing press also requires a borrower of last resort, likely to be the government.
The underlying problem is simply that the Bank of England, like other central banks, has been unable to exert very much influence on the transmission mechanism of monetary policy: too little credit expansion currently despite very low interest rates while, back in the boom years, too much credit expansion despite relatively elevated interest rates. Longer-term, a coherent plan to influence the quantity of credit – perhaps in the form of a counter-cyclical capital ratio for the banks – would be a useful reform.
Finally, a strategic framework is needed to allow the printing of money without the threat of hyperinflation. Fortunately, such a framework already exists, at least in theory. It's called price level targeting. One of the big weaknesses of inflation targeting is the acceptance of bygones as bygones. If the level of prices and wages drops 10 per cent, the typical inflation targeting regime simply requires inflation to go back to target. But as both Fisher and Keynes would have argued, a sustained drop in the price level when interest rates are already at zero leads to lasting real economic damage. A price level target takes past inflationary errors much more seriously: if prices and wages have fallen too far, they need to go back up again. Inflation, temporarily, needs to go back above target. This is not a descent into Mugabe-style madness: instead, it's an approach which both justifies the printing of money and imposes strict limits on the amount of additional money to be printed. It should be adopted forthwith.
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