After the Global Financial Crisis, there has been a lot of re-thinking about Monetary Policy, as one might expect. In fact, in light of the magnitude of the failure, re-thinking efforts have been much less than proportional. There are many, many, different strands of thought, and personally, I do not have clarity on what needs to be done. Furthermore, the situation is rapidly changing, so that a solution for today would not be a solution for tomorrow. The fundamental problem is private sector creation of money, and nobody wants to discuss this elephant-in-the-room. But there may be a good reason for this unwillingness — with the financial sector is firmly in control of the US Government, and the Euro area, it does not seem politically feasible to think about radical alternatives. The goal of this post is just to summarize a paper of Stiglitz expressing his post-GFC thoughts on Monetary Policy — without much in the way of comments and discussion. The full paper itself is linked at the bottom of the post.
Summary of Joseph Stiglitz paper on monetary policy:
- In response to GFC 2007-8, massive programs of QE (quantitative easing) have been launched all over the world. While these actions may have prevented another Great Depression, economic growth and employment has not been restored to pre-crisis levels.
History of Evolution of Thinking at Central Banks
- Monetary policy had been based on the quantity theory of money (QTM) MV=PQ, which posits a stable relationship between the quantity of money, and the GNP. However, starting in the 1980’s this equation became unstable – Velocity fluctuated erratically, and none of the measures of money showed any stable relationship to important real and nominal variables like the GNP, and even the interest rate.
- This failure of QTM should have prompted a deeper investigation of monetary theory, and reasons for its failure, but it did not. [Stiglitz is unaware of the research of Richard Werner, which explains the failure, and provides and alternative: The Quantity Theory of Credit]
- Instead of investigating WHY the quantity of money failed to have stable relationships with macroeconomic variables, Central Banks shifted to the use of interest rates as the main instrument for monetary policy.
- Post Crisis experience has led the problem that interest rates have hit 0%, but the economy has not responded in the manner expected – cheap credit should have led to borrowing for investments, stimulating production, and borrowing for consumption, stimulating demand and lifted the economy out of the recession. However this has not happened.
- In light of this experience, current thinking is that monetary policy has become ineffective because we have hit a liquidity trap at 0% interest rate. We cannot take it down further. Some efforts are being made to create negative interest rate policy in the hopes of breaking through the liquidity trap.
Stiglitz’s proposed solutions:
- The key variable which drives the economy is the supply of credit to investors and consumers. This supply, provided by private banks, does not respond in a systematic or mechanical way to either the quantity of money produced by the central bank, or the interest rates. This problem does not have much to do with 0% interest rate floor. What we need to do is to target the flow of credit directly, if we want to have an effective monetary policy.
Errors of conventional theories, models, and policies.
- Conventional macro models assume perfect information and liquidity, which makes banks unnecessary. Using a more realistic model with liquidity constraints, credit rationing and asymmetric information, Greenwald & Stiglitz (G&S) show that credit provision by banks depends on their net worth, perceptions of risk, and the regulatory framework.
- In abnormal situations like post-GFC, these other factors which affect the provision of credit by banks, can overwhelm the normal channels by which monetary policy operates, rendering it ineffective. To restore effectiveness, Central Banks must go outside the conventional channels, and utilize macro and micro prudential regulations.
- Even if Central Banks succeed in increasing supply of credit provided by private banks, this may fail to have desired effects of stimulating production and consumption. This happens when credit is provided for non-productive activities like lands and stocks, which increases their prices without creation production or consumption. Cheaply available money can flow to harmful speculative activities, instead of productive investment.
- Lowering interest rates to fight recession creates a jobless recovery (as observed in USA). Lower costs of capital lead firms to substitute machines for labor.
The problem is that we are asking too much from a single instrument. But most governments have eschewed using this broader set of instruments.
- Using aggregated macroeconomic models hides the distributional effects of monetary policy. Stimulus using monetary policy hurts the poor and the laborers, and enriches the wealthy, leading to increasing inequality.
CONCLUSIONS FOR PART 1:
- Conventional theories of how money works, which are the basis of monetary policy today, have been discredited. The transmission channel for conventional tools – interest rates, Open Market Operations, Reserve requirements – is very weak, and can be interrupted or disrupted by outside factors.
- Managing a complex economic system requires as many tools as one can manage; the single minded focus on short term interest rates as the instrument and inflation as the target substantially limits the possibilities for effective interventions by the Central Bank.
PART 2: Creation of a RADICAL New System which circumvents all of these problems.
- The total amount of credit creation should be directly under government control. This credit can then be allocated or auctioned to banks – banks can no longer create credit, unless they acquire/purchase the right from the government. In turn, the government can put conditions on allocating credit to banks to ensure that it is lent out for productive investments only, and not for speculation. Electronic money can ensure that the system works, since all money and credit creation can be monitored.
- In open economies, fluctuations in the exchange rates and in balance of payments create tremendous costs. These can be managed by a trading chit system which stabilizes the trade deficit or surplus at a pre-determined level. Every exporter is issues a trading chit equal in value to his exports. Every importer must acquire trading chits in order to be able to import. Since the value of export chits necessarily equals the value of import chits, this system will have exactly balanced trade with no surplus or deficit. If economic conditions dictate running a deficit, the government can issue 20% extra chits, over and above export earnings – this would stabilize the trade deficit, and hence also the exchange rates. This is of tremendous value in stabilizing the economy.
POSTSCRIPT: At the time I wrote this, I was not aware of Richard Koo’s work on balance sheet recessions. This issue, heavy debt liabilities, seems of central importance, and has been completely ignored by Stiglitz, and many other authors (though not Mian & Sufi: House of Debt). See the 10m Video: Koo: Balance Sheet Recessions or read the RWER paper by Koo: The World in Balance Sheet Recession