No Excuse for Inaction
by Adam S. Posen, Peterson Institute for International Economics
Op-ed in Reuters
August 31, 2011
It is past time for monetary policy to be doing more to support recovery. The Jackson Hole conference has come and gone, and no shortage of excuses was provided for central banks to hold their fire—even though most economists acknowledged the grim outlook for the advanced economies.
Too much attention has been paid, however, to the failings of fiscal policies and to the shortfall from effects of earlier quantitative easing. Further asset purchases by the G-7 central banks are needed to check not just a downturn, but the lasting erosion of productive capacity and of debt sustainability—especially when even justified fiscal and financial consolidation is undercutting short-term recovery. Easier monetary policy will increase the odds of other policies improving, and those policies' effectiveness when they do.
It is also past time to stop fearing inflationary ghosts. There is no credible threat of sustained higher inflation in the advanced economies that should restrain central bank action. The rate of wage growth is tepid and compatible with price stability, at most, even in Germany; the inability of wages to keep up with recent real price shocks underscores the ongoing downward pressure from labor market slack. Consumption was driven down by fiscal tightening and household retrenchment as much as oil prices, and those forces will be ongoing. Had consumer confidence not been weakly footed to begin with, the oil shock would not have had such an impact.
Commodity prices have since demonstrated again that they go down as well as up, and thus monetary policy should not react to their short-term gyrations (and deceleration in Western growth will likely send them further downwards). Credit and broad money aggregates are barely growing and current account deficits are slowly shrinking, so no asset price bubbles will emerge. Importantly, interest rates on long-term G-7 government bonds display no consistent rise in inflation expectations, no matter how the data is parsed.
Some of us had seen this coming. This is what happens to economies following a financial crisis, particularly when the crisis hits simultaneously across integrated markets. That is why I began advocating more quantitative easing (QE) in the UK a year ago. Yet even if some believe that the recent setbacks reflect new developments—rather than just long-run vulnerabilities (fragile Central European banking systems, dysfunctional American fiscal politics, British over-dependence on the financial sector) exposed by the crisis—that still should be enough to downgrade any plausible prior forecast for growth and inflation to where additional monetary stimulus is called for on its own terms.
Just because a downturn is expected does not mean its course is inevitable, and some of the present prospects' severity certainly still can be usefully offset. The lesson from past post-crisis recoveries, whether from the late 1930s worldwide, the late 1990s in East Asia, or the 2000s in Japan is that aggressive monetary easing can ease the process of real adjustment and limit its lasting damage to economies and to people. Insufficient monetary stimulus, let alone premature tightening, makes fiscal and financial problems worse, and raises prospects for dangerous political reaction to policy failure.
True, the quantitative easing measures undertaken by the world's central banks since late 2008 have not created a strong, sustained recovery. I warned in October 2009 that mechanistic monetarism could not be relied upon, that the stimulus from the stock of assets kept on central banks' balance sheets would diminish faster than many expected, and thus that the only way central banks would know that they had made sufficient asset purchases was when the sustained recovery of domestic demand was achieved. That is an argument for G-7 central banks to purchase more assets, while removing any fears of overshooting with such purchases. It is not a reason to give up on the effort.
The evidence is clear that the Bank of England's and the Federal Reserve's asset purchases had a positive significant effect on consumption, on the relative prices of riskier assets, on credit availability, and on liquidity in the financial system. If the improvement was insufficient, because the response to a given injection was less than some hoped, increase the dose.
There are no negative side-effects to speak of from greater asset purchases, beyond some politically induced nausea (which central bankers simply have to suffer through). In the 2-1/2 years since QE began to be felt in earnest, the trade-weighted pound has been flat and the trade-weighted euro has fluctuated but is within 5 percent of where it was. The trade-weighted dollar is down 10 percent since January 2009, which is not that much all considered, and some if not most of that decline is due to downward revisions in the US outlook, leaving little due to QE I or II.
Thus, all the claims of gold bugs and defenders of undervalued exchange rate pegs that QE was debasing the currencies of activist central banks have been proven unfounded. We should talk about asset purchases as what they are: mega-supplements for economies with a severe temporary deficiency of vitamin D (for demand). In other words, there are limited economic side effects because asset purchases are not at all unconventional for central banks, as many monetary theorists and historians have pointed out. The only exception is the scale required, which is determined by the size of deficiency.
Yes, inadequately restructured financial systems and real estate markets do inhibit the transmission of monetary stimulus by whatever means, as well as constraining growth directly. Further monetary easing, however, makes it easier at the margin for deserving borrowers to get around the impairment of the banking system, and for banks to raise the higher capital they definitely require. Were elected governments to undertake the desirable reform of banks and resolution of real estate overhangs, central bank provision of liquidity would ease the uptake of risky lending that followed—with positive feedback on the effectiveness of monetary policy in turn.
Similarly, fiscal mismanagement does offset monetary efforts to reduce interest rates and anchor inflation expectations. Whenever central banks go beyond lecturing, however, into threats of withholding stimulus to try to compel elected officials into fiscal rectitude, they fail. That is what the Bank of Japan mistakenly and futilely tried during the 1990s; that kind of structural failure is arguably a major source of the euro area's underlying difficulties.
The appropriate response by monetary policy to the fiscal situation is to ease so as to keep recession from sabotaging fiscal consolidation or making budget disputes intractable. In any event, monetary policy in the G-7 has to take as given that the major economies will undertake fiscal contraction at an average annual rate above 1.5 percent of GDP for the next couple of years—and when integrated economies simultaneously move fiscal policy in the same direction, the multipliers on that policy increase.
When you are the goalkeeper, there is no excuse for inaction, even if it is embarrassing when some shots do get past you, and even if your teammates fail to play defense. Additional monetary stimulus is the last line of defense for the advanced economies today. G-7 central banks should purchase more assets if we are to have any hope of our economies ever catching up.
Adam S. Posen is an external member of the Monetary Policy Committee of the Bank of England and senior fellow at the Peterson Institute for International Economics. The opinions expressed are his own.