A Re-assessment of What Monetary Policy Is

Bryan Gould writes:

A complete understanding of great events will often have to wait until well after the shouting and the tumult die away and a longer perspective permits a more objective assessment of what really happened.

Even then, though, greater elucidation proceeds at a glacial pace.

Today, we may well find ourselves again at the beginning of just such a process.

Just as it took a decade and a Second World War to achieve a broad consensus as to what had really caused the Great Depression in the 1930s, we can now begin to survey the events that led to the Global Financial Crisis, and the response that has been made by orthodox policy to the recession that followed, and to assess them in the light of the accumulating evidence of actual outcomes since those events.

The evidence is surely mounting that the remedies to recession proposed by orthodox policy have failed.

The German insistence on austerity, smaller government and eliminating deficits has led directly to the travails of the euro zone and the real threat of renewed recession, with the result that countries like Greece and Spain are in desperate straits and the continued viability of the euro itself is at risk.

The British, despite all George Osborne’s chest-beating, have endured five years of austerity and the longest and deepest recession in modern times.

Living standards have still not returned to pre-2008 levels and such prospects as there are for the future rest on an unsustainable consumer boom and asset inflation in the housing market.

The more moderate approach, the relaxed monetary policy and greater government involvement put in place by President Obama have produced, by contrast, at least a partial recovery in the American economy.

The comparison compels conclusions that call into question the whole thrust of policy around the globe over the last three decades.

It is not just that neo-classical economics have failed to produce a solution to the problems created by the Global Financial Crisis.

It is rather that the policies that were put in place before the GFC – and that we are now beginning to see were responsible for bringing it about in the first place – are now being pursued all over again, with every likelihood that they will produce the same outcomes.

The simple certainties that were the basis of the monetarist revolution that began in the 1980s – that national economies were just like private businesses, that there was little role for government, that the market could safely be left to produce optimal outcomes, that restraining inflation through controlling the money supply could and should be the only goal of macro-economic policy – are now being looked at in a different light.

The questioning is still piecemeal, still nibbling at the edges rather than constituting a full-scale assault, but there is no doubt that future historians will mark this decade as the point when the counter-revolution began.

At the heart of that new thinking will be a re-assessment of what monetary policy is and should be about.

Already, we see governments (for example, Shinzo Abe’s government in Japan), central banks (even the Bank of England, with New Zealand’s Reserve Bank deserving an honourable mention), and leading academic economists beginning to understand that a monetary policy instrument that is only ever used rather ineffectually to damp down asset inflation is absolutely missing the point.

That can be seen very clearly when we look again at the seminal paper published in the Bank of England Quarterly Review in March last year.

That paper conceded (the first such concession made by any major central bank) that 97% of the money in the UK economy was created out of nothing by the banks; a similar proportion would be found in many western economies, including New Zealand.

The whole basis of monetarist policy was thereby revealed to be a charade.

Governments may cut spending and impose austerity, and may raise interest rates in a vain attempt to control the money supply (while doing unnecessary damage in passing to investment in the real economy), but the banks go on printing money as though there is no tomorrow.

The greater part of that new money is created – not for productive investment – but for house purchase, and all of it for private profit rather than the public good.

This huge increase in the volume of money, most of it directed into the housing market and unbacked by any corresponding increase in real production, has inevitably created a huge asset inflation, a dangerous bias in the economy in favour of speculation and against productive investment, a major driver of inequality between those who own property and those who do not, and an economic policy that is totally ineffective in the hands of governments that do not have the slightest understanding of what they are doing.

As for the banks, their profits soar, the bonuses they pay themselves multiply in size, and their ability to create wealth out of nothing means that the asset bubbles that eventually burst to bring about the Global Financial Crisis are again being inflated as we watch.

How did all this come about? The answer is simple.

In the 1980s, financial services were deregulated, governments withdrew from macro-economic policy, banks moved in to displace building societies as the main suppliers of mortgage finance, restrictions on capital movements were removed.

The result? The banks discovered that lending on house purchase was hugely profitable and almost risk-free, and that there was in practice no limit to how much money they could create; the only constraint was the presence or otherwise of willing borrowers.

While governments strained every sinew to “control the money supply” and their own spending, the banks’ ability to create new money through the stroke of a book entry continued unabated.

A recent study by the National Bureau of Economic Research in the US of bank lending in twenty countries and over long periods shows an undeniable link between the increase in the money supply (though even these expert authors seem not to quite understand how that increase happens) on the one hand and asset inflation in the housing market and an increased risk of financial crises on the other.

The outcomes of this huge shift in economic power, away from governments and in favour of banks, are felt everywhere in our daily lives – in housing costs, in jobs, inflation, government spending, growth rates, balance of payments.

Yet the change is hardly remarked, let alone understood.

That is about to change – and not before time.