Monetary Policy Creates Financial Instability?

A Benjamin Cole post

Paul Krugman may be persona non grata in my house, but I must begrudgingly admit when the NYT blogger makes a good point:

“Let me also add that if it’s really that easy for monetary errors to endanger financial stability—if a deviation from perfection so small that it leaves no mark on the inflation rate is nonetheless enough to produce the second-worst financial crisis in history—this is an overwhelming argument for draconian bank regulation. Modest monetary mistakes will happen, so if you believe that these mistakes caused the global financial crisis you must surely believe that we need to do whatever it takes to make the system less fragile. Strange to say, however, I don’t seem to be hearing that from (John) Taylor or anyone else in that camp.”—Paul Krugman.

Krugman plays a little fast and loose here, and also ignores University of Chicago scholar John Cochrane, who has in fact called for major reforms, such as bank lending 100% backed by equity. No more 30-to-one leverage.

And inflation did sag after 2008, indicating monetary policy was too tight, as Market Monetarists have said. There was a “mark on the inflation rate,” such as Western economies sinking into deflation. I noticed that mark.

Still, Krugman has a point. We keep hearing monetary policy is too loose, and have heard that for 30 years. Yet the developed world is in deflation or close, led by Japan. Then we had a global financial collapse.

So, the record suggests the inflation-hysterics have it exactly backwards. If monetary policy has threatened financial stability, it has been because it has been too tight. We are in ZLB now—that is not a sign of decades of easy money.

Krugman has a point about banks, too. How is it in the U.S. we have such a feeble financial system? Why has the right-wing no interest in measures that would create strong banks? Being “against Dodd-Frank” is not a policy. If Dodd-Frank is no good, then embrace John Cochrane, or please devise a policy that would make for strong banks.

And, as I always say, print more money.

Because, not printing more money will have unintended and unforeseeable but catastrophic consequences on financial stability. Well, you can take out the word not, but the insanity level remains unchanged.

Jerome Powell, “monetary expert”

Powell gave a speech: “Remarks on Monetary Policy”:

The Committee said that it will want to be reasonably confident that inflation will move back to 2 percent over the medium term. On a 12-month basis, headline inflation in February, as measured by the personal consumption expenditures price index, stood at 0.3 percent; meanwhile, core inflation, which excludes volatile energy and food components, was 1.4 percent. These low current readings are partly a consequence of two transient shocks–the dramatic decline in oil prices and the effect of the appreciation of the dollar on import prices. Before those shocks, both headline inflation and core inflation were running at about 1.5 percent. When the effects of these shocks pass, I expect that inflation will return roughly to those earlier levels and then rise gradually to our 2 percent objective over the medium term as labor and product markets tighten further.

He´s an “expert” because:

1 He believes (as most in the FOMC) that interest rates are a pretty good indicator of monetary policy)

2 He believes (as most in the FOMC) that inflation is a “price phenomenon” (i.e. likes to reason from a price change)

3 He believes (as most in the FOMC) that there are “long and variable lags” in the effect of monetary policy

As the chart shows, from the “get go” on the 2% inflation target in January 2012, inflation has been mostly falling below the target, It was around 1.5% in mid-2014, just before the oil price fall and dollar appreciation. But it was also 1.5% 18 months before that, in early 2013.

Powell speaks_1

Powell speaks_2

If he paid attention to better indicators of the stance of monetary policy (like NGDP growth and (less precisely) core inflation) he would have difficulty believing that inflation will “turn up”.

Powell speaks_3

Powell also brings up the effects of financial crisis:

All else equal, a decision to return interest rates to more-normal levels implies that the economy is nearing its capacity. The financial crisis did significant damage to the productive capacity of our economy, and the damage was of a character, extent, and duration that cannot be fully known today…

Let us take a brief look at the implications of severe financial crises for economies generally. Studies document that severe financial crises around the world have typically left behind large and sustained reductions in the level of output.5 The recent crisis is no exception, and figure 1 shows such an effect for the U.S., U.K., euro-area and Canadian economies since 2008. The underlying pattern is an interesting one. Economists and policymakers have tended at first to view a decline in output as a cyclical shock to demand and to realize only gradually over time that a crisis has done substantial and lasting damage to the productive capacity of the economy.

The charts in the link to his figure 1 refer to real GDP (RGDP). If he were smart, he would have checked that pattern against the (monetary policy induced) nominal GDP (NGDP) pattern. He would have found that for those countries the NGDP pattern is the same, all having let NGDP drop significantly below trend.

If he really wanted to get to the bottom of the issue, he would have tried to find out how the crisis evolved regarding countries, like Australia, Israel and Poland, which did not let NGDP fall below trend. “Miraculously”, those countries did not experience a recession (fall in RGDP).

If he did all that, he would have to conclude that the “substantial and lasting damage to the productive capacity of the economy” rests heavily on the shoulders of the Fed and its misguided monetary policy!

That, however, will never happen. As Bernanke has indicated in the title to his forthcoming book, as the “leader of the pack” he had the “Courage to Act”!