Today’s monetary policy debates sound increasingly like the process of trying to get a picture on the wall centered and straight: “A little more to the left.” “No, that’s not helping, more to the left.” “Yes, that is helping.” “No, that is making it worse, back to the right.”
Depending on your perspective, the picture is either crooked or straight. And when a host of people is noisily debating whether the frame should be tilted left or right, the sound can become downright unhelpful. The same goes for monetary policy.
Yesterday, the Federal Open Market Committee (FOMC) released the minutes from its June meeting, giving financial industry analysts a peek inside what our illustrious leaders at the Federal Reserve are thinking. Unfortunately, there is little agreement as to what the meeting notes mean—there's a near 50/50 split on whether the FOMC’s concerns about a deteriorating economy are proof positive that we’ll see QE3 or some other monetary stimulus program later this year.
QE—or quantitative easing—is a fancy way of saying create money out of thin air to put in a digital bank account and then spend on mortgage-backed securities or government debt in order to lower long-term interest rates. It's kind of like that Libor interest rate scandal you might have read about, except the Fed fixing interest rates is, well, sold as more of a market driven process for setting rates at a non-market established rate.
Beyond disagreement in the perennial guessing game of “What Will Bernanke Do Next?”, there is plenty of debate over whether monetary policy can even influence interest rates any further. Since QE2 and Operation Twist have not moved long-term interest rates much, a third round (fifth round if you could the two “twists”) of monetary stimulus is unlikely to have any additional impact.
Still, even if QE3 could substantively impact the market, there remains the question of whether the weak economy merits more monetary stimulus. For example, unemployment remains high, but it matters whether the problems in the labor market are structural or still remnant of the financial crisis. If unemployment is due to economic immobility, education gaps, and changes in growth sectors of the economy (i.e., more IT workers needed for cloud computing and fewer manufacturing workers needed to operate machinery) then more QE is not the prescription for the economy. If the problem is just that the economy needs a better jumpstart for borrowing to lead to consumption and investments, then leading to hiring, then QE could be warranted (from a neo-Keynesian perspective).
But all of this misses the point in the monetary policy debate.
While the mainstream coverage of the Fed has focused guessing what tie Bernanke will wear when he nexts argues with Rep. Ron Paul (R-Texas) during congressional hearings, or whether there is more room for monetary stimulus to continue aiding the economy, we’ve failed to ask a simple question: Is the current monetary policy paradigm actually helping economic growth?
This sounds like a simple question, and for many commenters in the debate it is a given that monetary stimulus has been a good thing. However, there is a difference between whether monetary stimulus has impacted the markets (clearly it has) and whether this impact has been for the better.
Last month the Bank for International Settlements—based in Basel, Switzerland, and operating as something of a global financial mediator and commenter—released is annual global economic report, with two chapters focusing on warnings for how central banks around the world are actually doing more to destabilize our financial future than helping economic growth.
In what ways are Federal Reserve monetary stimulus policies causing more harm than good?
First, monetary policy is creating a future asset bubble crisis. Consider that cheap money does inspire borrowing, even if not at the levels monetary policymakers would have preferred. Since the start of quantitative easing in 2010, equity prices have steadily grown with investors able to borrow for virtually nothing and take advantage of arbitrage opportunities in a volatile stock market. Commodities like gold, cotton, wheat, heating oil, and coffee are all higher as well, as traders have used cheap money to flood the future markets.
The fears of bubbles are well founded. Consider that unemployment remains high, economic growth stagnant to non-existent, and household debt still sky high. So how is it that the stock market can be 10 percent to 15 percent higher than in 2005 and 2006 at the height of the housing bubble and be seen as in anyway sustainable? And when the Fed does eventually decide to tighten policy from today’s levels this could suck the life out of commodities trades funded not with capital raised in normal markets, but with cheap capital funded by a manipulative Fed.
So when these asset bubbles eventually unwind, it could be very painful. Supporting asset prices masks problems on bank balance sheets, and we could see another example of the subprime crisis as toxic assets are revealed when prices decline.
Essentially we will have responded to the deflation of one bubble (housing) with another. Unfortunately, that would make for a trend. The Fed responded to the dot-com bubble’s bursting with policy that created another bubble, and congressional and regulatory policies channeled this into the housing market. In effect, this is an intentional cycle of boom, bubble, bust. A present crisis is solved by creating a future crisis.
The Bank for International Settlements is not saying anything new by pointing out this fear, but it is telling the Fed that it is time to start paying more attention to this concern.
Second, monetary policy is contributing to global economic weakness. Many quality foreign firms have taken advantage of low interest rates, borrowed dollars, and then sold them in their home countries for local currency to fund expansion (essentially betting they will be able to pay back the dollar denominated loans easily and cheaply). The problem is that this increases the supply of dollars in foreign economies and drives up demand for local currencies. Foreign central banks, particularly in emerging market countries (EMCs) have not liked seeing the value of their currencies appreciate because that means fewer companies will be buying their exports (since the cost of goods in countries with stronger currencies is higher). In response, central banks in emerging market countries have been buying up dollars and inflating the value of their currencies to remain competitive in the export markets.
Essentially, the Fed’s inflationary policy has been transmitted to EMCs. The result has been the stifling of growing middle classes in those countries. Consider Turkey, one of the fastest growing EMCs, which has been favoring its export market by inflating its lira to the detriment of the Turkish middle class. GDP per capita in Turkey nearly doubled from 1999 to 2007 as the country experienced a dramatic economic revolution, but since then has leveled out. Inflation was just 6.3 percent in 2009 but has flirted with the 11 percent range this year.
This is not a class issue, but rather a matter of growing the global consumption base. The weakened purchasing power base of EMCs has contributed to a weakened global economy.
Third, the current monetary policy paradigm has threatened the future of American economic policy integrity as the line between monetary and fiscal policies has become completely blurred. As Atlantic Capital Management President Jeffrey Snider writes, there is nothing really “monetary” about today’s unconventional policies. Buying up bonds and securities to influence long-term interest rates is just borrowing money to create growth, like any other fiscal stimulus program.
The challenge with determining if these are ultimately harms (or evening happening) is that monetary policy is just that—policy making. It involves weighing trade-offs, doing cost/benefit analysis, and making a choice through a particular framework.
If the framework values short-term benefits then the asset bubble harm does not seem like that much of a problem. Much better to help out a few people today and worry about controlling the deflation of commodities and equities prices later. The slow down in emerging market countries is also of limited concern under this view, since low currency values can lead to increased exports as a quick way to boost economic growth. And monetary policy being blurred with fiscal policy is certainly not a concern in a short-term benefit framework since anything would go in order to achieve the objective of attempting to smooth out economic pain.
Contrast this with those taking a long-term benefit view as their framework for assessing the potential harms of today’s monetary policy paradigm. The risk of yet another bubble is terrifying and certainly worth serious consideration. Exports are certainly important for the growth of EMCs, but so is the ability of a local middle class to gain purchasing power and raise GDP-per-capital levels (not just overall economic growth); and that can’t happen with central banks forced to inflate away the value of local currencies. Furthermore, the long-term framework holds in higher esteem the integrity of the Federal Reserve as a monetary body while keeping fiscal policy choices with Congress, creating an inherent knee-jerk reaction against continued stimulus.
So if the FOMC is taking a short-term view (as any body integrated into the political system is wont to do) it is clear why monetary policy has maintained its stimulative levels. Tightening policy could cause credit to contract and possibly slow down an already weak economy. The fact that it could help prevent a steady build-up of misallocated capital is understood, but the benefits of stopping a potential bubble are less than the potential harms of breaking from today’s norms—at least according to today’s leading monetary theorists.
Seemingly lost on the Fed is the irony that this was Greenspan’s logic for ignoring the housing bubble. Back in 2004, economists from the Bank for International Settlements warned about problematic monetary policy creating cheap money that was flowing into U.S. asset markets (particularly housing) and creating a pattern of unsustainable growth. Eight years later we can look back and see how policymakers ignored these warnings and instead lashed out in frustration at that crooked picture on the wall. In 2020 will we look back again and lament Bernanke's current refusal to heed the warnings?
Anthony Randazzo is director of economic research at Reason Foundation and is co-author of "The Hayek Rule: A New Monetary Policy Framework for the 21st Century."