 "Deepak Lal: Money mischief")
The macro-economic landscape in advanced countries today is peopled by strange beasts: Ultra-low and, in many countries, even negative interest rates; exploding balance sheets of central banks; unprecedented debt-to-GDP ratios; low inflation and productivity growth; purported savings gluts and imminent secular stagnation. How have these arisen? An answer requires a return to the origins of modern macroeconomic analysis.
When I was a young don at Christ Church, Oxford, my senior colleague was Roy Harrod, the first biographer of John Maynard Keynes and keeper of his flame. On having to provide a reading list for my tutorials on “economic fluctuations and growth” I asked him what I should ask my pupils to read. I expected him to say Keynes and his own work. But after some reflection, he said Knut Wicksell. So before I prescribed this to my pupils I immersed myself in Interest and Prices and Lectures on Political Economy. Since then, I have been pleasantly surprised that most of the macro-economic perspectives on offer hark back to Wicksell.
Wicksell asked how could the price level be anchored in a pure-credit economy? Walter Bagehot had observed in Lombard Street that the whole of the Bank of England’s note issue depended on a slender and declining gold ratio. What if this ratio went to zero, asked Wicksell? His answer was that, if the bank rate was set at the natural rate of interest (nri), which balances productivity with thrift, the price level could be constant. This is, of course, the theory underlying inflation targeting, as embodied in the Taylor rule. As John Taylor has noted, it was the failure of the US Federal Reserve under the chairmanship of Alan Greenspan to follow this rule which led to the credit bubble after the dotcom bust (Taylor’s Hayek lecture Policy Stability and Economic Growth, Institute of Economic Affairs, 2016).
In a recent paper two German economists Andreas Hoffmann and Gunther Schnabal (“Adverse Effects of Unconventional Monetary Policy”, Cato Journal, 26(3) 2016) have argued that within Wicksell’s framework, the Greenspan Put also explains the nearly 25 years of declining long-term interest rates. In the so-called Jackson Hole consensus, US central bankers agreed that as the authorities do not have sufficient information to spot bubbles they should not attempt to prick them by raising interest rates, but should act swiftly to lower them in times of trouble. Thus, they have failed to raise interest rates above the nri during economic upswings fueling financial booms, but slashed interest rates decisively during financial crises putting a floor to losses on financial assets. This has led business cycles to a downward trend in nominal and real interest rates in advanced economies. Not as is currently claimed by many due to a savings glut (because of aging societies and growing retirement savings), combined with declining investment due to weak technological progress.
On the Wicksellian view, and its incorporation into the Austrian view of trade cycles by F A Hayek and Ludgwig von Mises, the asymmetric monetary policy associated with the Jackson Hole consensus also damages investment and growth. Within the Wicksellian and Austrian frameworks, the central bank interest rate (icb) fluctuates around the nri. (Figure A). During the boom, additional investment projects with low internal rates of return (ii) are financed. The marginal and average efficiency of investments decreases. During the downturn, low-return investment projects are cancelled, with an increase in the average and marginal efficiency of investment.
With an asymmetric monetary policy with a gradually declining nri, the internal rate of return needed to repay loans on investment projects also drops, keeping the ones which would have closed with a symmetric policy, alive. If during successive downturns the central bank rate is lowered beyond the pre-crisis level, then the marginal and average efficiency of investments continues to decline. (Figure B). This also leads to gradual declines in productivity gains, thence to growth and the secular stagnation currently being bemoaned.
Moreover, as the Greenspan put in the asymmetric monetary policy provides implicit insurance to financial assets, returns on real physical investments fall relative to those on financial assets, leading to an incentive for companies to substitute speculative financial investments for real investments. With an increase in the money supply through QE during the crisis, with asset prices rising faster than goods prices, there is a redistributive shift from labour (which faces wage compression from the decline in productivity) to holders of financial assets who are by and large high-income groups. So the lower and middle income groups bear the risks of boom and bust cycles in financial markets. With low or no growth in GDP, the absolute income gains of the higher income groups must lead to absolute income losses for the rest. Thus “since 1987, when Alan Greenspan took office... the share of the top one per cent of incomes in the US has risen from around 13 per cent to nearly 22 per cent of total income” (p 468). This has led to political polarisation and demands for a return to dirigisme in many advanced economies.
The way out of the purported secular stagnation (which is not the origin but the outcome of ultra-low interest rates) is to restore the signaling and allocative function of the interest rate. The presumed decline in Wicksell’s natural rate of interest is not due to exogenous changes in productivity and thrift, but due to the asymmetric monetary policy that the advanced economies have followed after the Great Recession. Milton Friedman wrote a book describing various historical episodes in which misguided monetary policy rather than changing animal spirits, exogenous changes in consumer preferences and/or technology were the cause of undesirable outcomes in the real economy. This post Great Recession episode of “secular stagnation” with the policy-engineered decline in Wicksell’s natural rate of interest would be another example of his title Monetary Mischief.
This piece has been revised to incorporate a factual correction
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