Monetary Policy – Surgery Needed

Current monetary policy is still primitive and will remain so without making use of new measures such as macroprudential policies

Monetary policy has come a long way but it is still in its initial stages of development.  Serious shortcomings mean that the tools of monetary policy are still rudimentary just as those of medicine were crude in the past.  In the same way that leeches would be prescribed for every ailment in medieval times, central banks have tended to rely solely on interest rates to manage the economy.  The tendency to “reach for the leeches” is still with us even though the global financial crisis has highlighted the flaws inherent in this approach and a range of new techniques for managing the economy have been made available.

Learning some hard lessons

Doctors often did more harm than good in antiquity due to a lack of understanding of the workings of the human body.  With our knowledge of the economy also deficient in places, economists may be guilty of causing similar damage.  Hubris led economists to believe that booms and busts could be eliminated but their faith was shown to be spectacularly misplaced.  Despite this, economists have been slow to adjust their view of the world even though their remedies are proving both ineffective and costly.

The global financial crisis and its aftermath have taught us a few valuable lessons.  The limitations of using interest rates to moderate the business cycle (both before and after recessions) are now apparent.  Higher interest rates do little to temper lending when both bankers and borrowers want more debt.  It is also becoming clear that different sectors of the economy react to interest rates in different ways.  Consumers have shown themselves willing to take on excessive debt in order to spend or to buy property.  On the other hand, businesses cannot always be enticed to borrow for investment when the economy is weak. 

The limits of monetary policy have been laid bare by the faltering economic recovery.  Low interest rates and cheap cash have spurred on some lending but not the right type to generate sustainable economic growth.  Households have taken on debt to buy property (which mostly just increases prices) rather than businesses or the government borrowing to make the economy more productive.  Surplus funds have also built up prices in the stock market which, while somewhat beneficial in the short term, will create problems down the line.  The abundance of cash in the financial system may also reduce the effectiveness of central banks’ control over interest rates. 

For a better world

Monetary policy needs to continue to develop as economists learn more about the economy and how it reacts to different policies.  Manipulating interest rates is a blunt instrument that is applied across the whole economy.  Interest rates need to be raised eventually but it seems rash to do so in response to distortions in certain sectors.  An early interest rate hike has been proposed as a countermeasure to the booming UK property market.  Yet, this is like chopping off an arm to treat an infected finger.

A more measured approach would be preferable but will take time to realise.  Techniques such as minimally invasive surgery have been developed in medicine over many years and economists should aim for similar progress in monetary policy.  Disparities between policies in theory and practice mean that trial and error will be necessary.  Using a still sickly economy to trial new policy options may seem reckless.  Yet experimentation is the main route to breaking fresh ground even in medicine where there are actual lives at risk.  Forward guidance is an example of a policy which seemed useful in theory but whose application was fraught with issues.

A wider range of policies would help deal with problems now and in the future with greater effectiveness.  These two goals can be achieved by the Bank of England trialling the much-discussed macroprudential policies such as caps on mortgages and other limits on property lending.  Having a greater range of options allows for better tailoring of policy while targeted measures enable greater freedom in setting interest rates to reflect the overall economy.  Just as modern medicine has had to advance beyond leeches, future monetary policy will need to progress past what we currently have and such an evolution will only happen as a result of taking bold actions today.

Monetary Policy – Losing its Power?

With the finance sector already awash with cash, we can no longer rely on central banks to help us out of trouble

After having worked like a charm for a long time, monetary policy now seems to be losing its mojo.  The source of power for central banks mainly comes through their tricks of printing money and controlling interest rates.  With many governments mired in debt, it has only been the wizardry of central banks that has stood between us and a greater tragedy.  It is of great concern that the capabilities of the once almighty central banks to manipulate the economy are under threat from the large amounts of liquidity in the financial system.  The spells with which central banks hold sway over the economy may amount to little more than illusion when there is already lots of cash around.

Where has the magic gone?

The power to create money seems nothing short of sorcery; however, the rise of digital cash means that it is in fact easier than ever.  Central banks have even lost their monopoly over generating electronic cash with normal banks able to pull off the same trick by making loans.  It was thought that control of interest rates would be sufficient to steer the economy through any ups and downs.  Yet central banks left interest rates too low in line with their narrow focus on keeping inflation in check and banks were free to churn out loans at an unprecedented rate.  The prices of assets such as property have surged upward as a result but only until the inevitable crash in prices.

Central banks stepped in with record low interest rates and new policy tricks such as quantitative easing.  Yet these measures lack potency considering that cash was already cheap and in abundance.  Both banks and businesses hoarded cash – the former worried about their own survival while the latter had few investment options available due to the weak economy.  To add to this, many emerging markets such as China had been building up massive reserves since well before the global financial crisis. 

With the international financial system already flooded with cash, it has been no surprise that monetary policy has not worked as well as expected.  It has been like trying to use sweets to modify the behaviour of a child that lives in a candy shop.  Instead of being much help, the extra funds from central banks have seen the financial markets deformed and distorted as if suffering from some form of voodoo.  Some emerging markets have also suffered from this black magic with their banking sectors unable to handle the volume of cash on offer.

Nothing up their sleeves

Central banks have been looking to develop new powers to influence different sectors of banking.  The Bank of England has been given greater scope to deal with a runaway property market.  Yet, the central bank seems ill at ease with its new policy options, such as restrictions on mortgages, and prefers to rely on its old act of manipulating interest rates.  If central banks no longer have the power to bewitch the economy, it will be tougher to clean up after a crisis like the one we have just been through.

This shifts the goal of policy to stopping problems forming rather than merely attempting to limit the ensuing trouble.  Restricting the dark arts conjured up by banks will be essential to preventing future disasters.  The fairy-tale time when we could believe in the magic of central banks may have passed – we will need to rein in the wicked elements of the economy now that there is nothing to save us from potential misfortune.

Inflation – More friend than foe

Inflation plays the role of the bad guy in economic theory but this may change now that we are faced with a greater threat to the economy

Inflation has been cast as a villain by economists but it could be a source of salvation.  Rising prices are often seen as one of the main evils in an economy – they push up the cost of living and eat into savings.  This may be the case in a normal economy but may not hold true considering that things are far from normal.  Instead, it might be that the high levels of debt weighing down the economy prove to be a greater menace.  In an ironic twist of fate, it is inflation that may prove to be our best weapon in our fight against high levels of debt.

I’ll be back (as the good guy)

Villains can turn into heroes with a twist in the storyline.  Just think of Arnold Schwarzenegger’s character in the second Terminator movie.  The havoc wrought by inflation in the past is almost on the same scale of a cyborg from the future but it has left economists with an innate fear of its return.  Inflation has been tamed and no longer poses the same danger to the economy having been the focus of monetary policy for decades.

It was the global financial crisis that led to a new peril.  Interest rates that were kept too low along with creativity in the banking sector set the scene for a surge in the amount of loans.  The problem of excessive debt was made worse by policies designed to bring the economy back to life.  Monetary policy has left interest rates at record lows while also resulting in a flood of liquidity in the financial markets through quantitative easing.  This combined with government policy to revive the housing market has seen a dramatic rise in the volume of mortgages.

As we have seen with government spending, a large burden of debt can result in cutbacks which damage an economy.  If consumers are also saddled with debt, the resulting limits on consumer spending have serious implications for economic growth.  Debt is not only bad for borrowers but the resulting sluggish economy dims the prospects for everyone else as well.

More inflation now to save the future

While not a new technology sent from the future, something as simple as inflation could be one way of alleviating the burden of debt on both consumers and the government.  Inflation helps by increasing the size of the economy relative to any debts.  If wages increased along with inflation, households would also have more money for repayments of their loans and the greater tax revenue will be a boost for the government. 

There are a range of measures (including one preferred by Your Neighbourhood Economist) which could be used to nudge inflation upwards in a controlled manner while also adding momentum to the economic recovery.  Many economists would recoil from the idea of higher inflation almost as fast as they would run from a cyborg.  But this has more to do with economists being stuck in the past than the destructive powers of inflation.

There are some negatives to factor in but the overall effect of increased inflation would be positive.  Inflation will eat into our spending power through higher prices for many of the things that we buy.  However, spending on everyday items takes up a smaller portion of the earnings of borrowers compared to paying off debt.  Even though a policy of allowing more inflation would be biased towards those with debt, everyone would benefit from a more vibrant economy.  As the Terminator movies have taught us, our current actions shape our future and a little more inflation would be a small price to pay to bid hasta la vista to our burden of debts.

Stock Markets – Calm for now

Following a rising stock market is an easy way to make money but share prices can only defy gravity for so long

Something strange is in the air among investors – a pervading sense of calm.  Volatility in financial markets has dropped off while stock prices are near record highs.  These conditions seem out of place at a time when there are a number of reasons to be jittery - the economic recovery is far from assured and central banks are set to raise interest rates.  The buoyancy of the financial markets says more about the habits of investors than the actual state of the economy. 

One defining feature of investing is that it can be easier to make money by following trends rather than fighting against market momentum.  The only problem is that the trends become a force in themselves and can push prices too far either up or down.  This effect can only be temporary as markets must revert back to normality at some point.  This leaves investors caught between making money when times are good and making a getaway before profits are wiped out.  This day is drawing closer.  Your Neighbourhood Economist can’t predict when it might happen, only that a reckoning is likely to be just around the corner.

It’s complicated

Financial markets are notoriously hard to read.  Theory tells us that the prices of shares are based on a combination of all available relevant information.  Yet one of the most pertinent reasons for buying or selling is the past price movements.  Financial assets are one of the few things that we buy more of as the price rises and are more likely to sell when the price falls.  This can often override other considerations such as whether a company is expected to see its profits grow in the future.  Base instincts such as greed and fear can also take over and distort our investment decisions.

The tech boom and bust just over a decade ago was a classic example of this.  Investors threw money into start-ups whose ability to generate revenue was questionable.  You did not even have to believe that the Internet would revolutionize business, just that others would and that these others would keep buying so that you could make a tidy profit and sell up.  Thus, prices often deviate from what shares in a company might actually be worth depending on the likelihood that someone else might be willing to pay more for the shares sometime in the future. 

This is not to say that money cannot be made by holding onto shares in profitable and well-managed firms.  Yet such an investment policy will only work out in the long term with the timing of when to buy and sell also being crucial.  The bulk of investors, however, are not trading in shares over the long term.  Professional investors looking after other peoples’ money tend to actively buy and sell to take advantage of short-term trends.  This proactive approach is also used justify (and amplify) their considerable fees despite often being unable to outperform market benchmarks.

Actually, it's even more complicated

Gauging where shares might be heading is further complicated by the current expansive monetary policy.  An abundance of cash in the financial system means that people wanting to buy financial assets are never far away.  Pushing share prices to unrealistic values is just one example of how monetary policy is creating problems.  Policy makers need consumers in an optimistic mood to get spending up and creating extra wealth through the stock market is one of the few ways of getting us in a more cheerful mood.  It can only provide a short-term boost and might work in the opposite direction when this policy is reversed.  The jolt from the inevitable interest rate hike which is likely to disrupt the market calm may result in more than just some investors losing their easy gains.

Economic Recovery – Reasons to be Pessimistic

The economy seems to be picking up so why are economists still so dour?

Economists are not known for being moody but many are depressed when it comes to the state of the global economy.  This seems out of place at a time when economic recoveries in some countries are showing signs of taking hold and stock markets are setting record highs.  The mood among economists was already negative after being caught out by the global financial crisis.  Are economists right to be worried or just hung up on past mistakes?

Why so glum?

My father inquired, after a recent post on my blog, why my views had to be so downbeat.  Given that much of the business cycle is driven by the sentiment of consumers and businesses, his line of thinking was that the economy would jump back to life if we could all just be more positive about the future.  People would spend more while companies would invest and take on more workers.  All we would need is economists to tell us that everything will be alright.

The problem is not that economists are always a grumpy bunch.  The problem is the opposite – that economists have been overenthusiastic in the past.  This optimism was fuelled by a belief that economic theory could provide a route to a steady rise in prosperity.  Instead, economists have been chastened as a result of their previous ideas being proved wrong by the global financial crisis.  The crisis has also focused minds on what can go wrong.  Now, even periods of prosperity are seen to have a darker side and to create the seeds for trouble in the future.

Grumpy for a reason

It may just be the case that economists are caught in a crisis of confidence.  There is a core belief among economists that markets have the ability to correct themselves.  This means that any periods of weak economic growth should only last until the economy gets back on its feet again.  There is much data on the economy to get excited about.  Consumer spending is up, buoyed by the job market recovering faster than expected.  The worst of the crisis seems to be behind us and stock markets reflect this new upbeat outlook.

Yet, economists have learnt their lessons and know better than to place too much trust in the data.  Behind the numbers lurks a less cheerful story.  Investment by companies is low with few businesses seeing opportunities to expand despite balance sheets laden with cash.  One reason for this is that labour productivity is weak.  This means that the extra earnings for companies from employing more workers are likely to be poor.  Low labour productivity also implies that wages are not likely to rise much which raises concerns about whether households will struggle to pay off rising levels of debt.  A lack of new innovations suggests that investment and productivity may not improve for a long time to come, prompting talk of prolonged stagnation.

When the markets are not functioning normally, it is typically the government that steps in to correct any problems.  However, the governments in many countries have been more hindrance than help.  Mismanagement of government finances, slow and timid responses to crises, and a lack of forward-looking policies are common complaints.  With voters lacking genuine alternative political parties, politicians have become engrossed in petty political positioning rather than constructive policy making.  Managing the economy has been left to central banks which has caused its own problems. 

This is why Your Neighbourhood Economist is one of many who struggle to find reasons for cheer.  It would be great to be caught up in the euphoria that has taken hold of the financial markets but economists have been burnt too badly to get carried away.  Only time will tell if the gloom among economists is warranted.

Drowning in Debt – Need Help

We are being pushed into borrowing our way back to economic growth but staying afloat also involves selling off our future

The last thing a drowning man needs is more water but this is how policy makers have chosen to react to the global financial crisis.  The global financial crisis came about due to consumers being allowed to take on too much debt in the past.  Yet, the policy response has been to push for greater borrowing by lowering interest rates and feeding money into the banking system.  Higher debt now can only mean greater repayments in the future.  This would be acceptable if a swift return to economic growth was on the way but this seems too optimistic.  Instead, while the economy is getting a temporary boost now, growing levels of debt are being forecast to depress the economy for years to come.

Cheap loans anyone?

The debt and water analogy works on many levels.  In the same way that water is essential for life to flourish, debt is needed for an economy to grow.  Yet, like water, too much debt can be as bad as not enough.  The appropriate level of debt depends on the pace of economic expansion.  Rapid economic growth will create greater demand for loans as business opportunities arise and asset prices rise.  Like a garden requires watering when the weather is hot, a booming economy can absorb more debt as the money generated through the loans makes it easier to fund debt repayments. 

The opposite is also true.  It is desirable to have fewer loans as an economy cools since paying off debt is tougher.  It seems a strange time to convince people to rack up more debt but that is what central banks are pushing for.  This is because the tools of monetary policy work by reducing the cost of money (through lower interest rates or printing more cash) when the economy is floundering.  Such policies make sense when assuming a rapid recovery in economic growth but even economists are pessimistic about the prospects for the global economy.

The other bail out option is for the government to ramp up spending through increased borrowing.  This is the typical response to dampened economic growth but concerns about high levels of government debt have limited the capacity for such a fiscal stimulus.  This has resulted in monetary policy having to take on the bulk of the heavy lifting in getting the economy moving again.  Businesses have typically not made use of the cheap credit on offer through the low interest rates (except to buy back their own shares).  It is the increased debt taken on by households that has been the main driver of economic recovery but this is neither balanced nor sustainable. 

Debt – paying the price

It is the role of policy makers to create an environment for encouraging economic growth.  Tough choices are necessary when few options are available but relying on households to pile up more debt seems irresponsible and short-sighted.  The ratio of earnings to house prices is on the rise at a time when wages are standing still.  This means that consumers will be saddled with debt repayments for longer (especially if house prices stagnate as is probable) and this will depress consumer spending in the future.  It seems a poor trade-off even at a time when the economy is underwater. 

This policy seems even dafter when considering that consumer debt is mostly unproductive.  Buying a house off someone else does not add anything to the economy (while spending on renovations does help a bit).  On the other hand, if the government were to borrow and spend more on education or infrastructure, this would increase the output capacity of the economy.  Yet, this sensible alternative is being dismissed even though investors are no longer shunning any government with excessive debt and interest rates on government debt are near record lows for many countries. 

It will ultimately be people like you and me who pay the price.  Our spending power is being put at risk at a time when the government’s own finances are drained and businesses are not putting their balance sheets in jeopardy.  It is likely to remain tough for many people to keep their heads above water and an economy saturated with debt may not provide much help.

Economics – more religion than science?

Economists claim to offer salvation but the tenets of economics need reforming before we can be saved

Economics is sometimes like a religion in that its adherents keep the faith irrespective of evidence to the contrary.  The global financial crisis has tested the conviction of many economists but few seem ready to renounce their previous beliefs.  This might seem strange with a discipline that aims to be more like a science but there are factors which mean economics relies more on faith than on facts.  Considering the positions of power held by economists, we can only hope that the moment of revelation is not too far off. 

In Markets We Trust

Economics claims to offer a path to the Promised Land.  The role of God is assumed by the concept of the invisible hand which prophesies that markets will bring about the most favourable outcomes in terms of output and prices.  One of the most sacred beliefs in economics is that we must defer to the invisible hand as much as possible.  Economists help this along, with central banks keeping down inflation while governments open up their economies to global markets.   This ushered in over two decades of unprecedented economic progress until financial turmoil struck like a plague in 2008. 

Yet, despite the economic Armageddon that followed, economists have remained stubbornly tied to the same creed.  The response to the financial crisis has relied on the traditional tonic of lower interest rates with newer orthodoxy calling for the use of quantitative easing when conventional measures did not work.  Central banks have stuck with these policies despite the resulting growing distortions in the financial markets which would be anathema for economists in normal times. 

Believing in false idols

One element which makes economics more like a religion and less like a science is that it is difficult to prove when someone is wrong.  Scientific theories can be tested by experiments carried out in laboratories or similar places where the conditions can be kept in check.  Economic hypotheses cannot be proven in such controlled environments.  The sheer volume of transactions by consumers and firms means that there may be any number of reasons behind a certain outcome.  The impossibility of isolating specific cause and effect relationships means that truths in economics can only be subjective. 

This means that economists can piously hold onto their previous ideas on how the economy works despite any evidence to the contrary.  Economists tend to become wedded to their ideas as they hone them over many years in long careers in academia.  Any newcomers to economic are also indoctrinated into the existing dogma with little scope for breaking out of the mould.  The current generation of economics students have risen up in arms against being taught theories that have little relevance to economic events.

One of the more old-fashioned ideas that economists cling to is a fear of inflation.  The full range of tools for monetary stimulus has not been available as central banks have been adamant that inflation should not be allowed to get out of control.  This stems from psychological scars in the minds of economists due to damage done by inflation in a bygone era (the 1970s).  Europe has suffered the most under this economic fanaticism and has had to deal with the added difficulties of the Eurozone crisis with few policy options available. 

It is not a coincidence that the global economy and economic theory are both stagnating at the same time – economic deliverance for us all may depend on a second coming of economics in a more practical form.