There can be no question about it. Since the financial crisis started in 2007/08, we have experienced the most spectacular experiment in monetary policy mankind has ever seen. And as is typical for experiments, the outcome is uncertain. We have seen unprecedented liquidity support to the financial system, rescue operations for financial institutions, official interest rates near zero and large-scale asset purchases by central banks. The latest twist is negative interest rates and a discussion has started about ‘helicopter money’. How did we get here and where will we end up? I will try to answer a number of key questions about all this in this commentary. This Q&A format should allow readers to skip parts they do not find interesting.
There can be no question about it. Since the financial crisis started in 2007/08, we have experienced the most spectacular experiment in monetary policy mankind has ever seen.
Han de Jong Chief Economist
Why did policymakers start this experiment in the first place?
The economic contraction in 2008 and the start of 2009 was so severe that a repeat of the 1930s depression seemed a distinct possibility. Following the Great Depression, economists had concluded that monetary policy had been too tight at that time and that far too many banks were allowed to fail. Milton Friedman in particular concluded that the US Federal Reserve was to be at least partly blamed for a deep recession turning into a depression. Ben Bernanke was at the helm of the Fed when the crisis broke and he had become an expert on the Great Depression during his academic career before he joined the Fed. So we had the right man at the right time in the right place. Bernanke was determined not to repeat the mistakes of the policymakers in the 1930s. So he engaged in rescue operations for financial institutions, and eased monetary policy aggressively. Between September 2007 and December 2008, the Fed lowered interest rates ten times, bringing its Fed Funds rate from 5.25% to 0.25%. It was felt that rates could not be lowered further, but the Fed was convinced it needed to ease monetary policy further. So they started their (first) asset purchase programme late 2008 and turned it into actual quantitative easing early 2009. This led to a rise in base money with the purpose of preventing the money supply in the economy to shrink.
The ECB was much slower off the mark. While it had provided large liquidity support to financial markets in 2007, it mistakenly raised interest rates in July 2008, then started cutting rates in October. The ECB cut rates seven times between October 2008 and May 2009, bringing its refi rate from 4.5% to 1.0%. The ECB did not engage in quantitative easing at that time, although it did buy relatively modest amounts of securities in 2010 in response to the euro crisis.
What did commentators say about all this?
As was to be expected, some commentators were enthusiastic about this aggressive policy response, particularly of the Fed. But others warned that such loose monetary policies would lead to a sharp rise in inflation. The voting records of the US Federal Reserve show that some members of the FOMC voted against many of the policy easing steps.
Has this experiment been successful?
Yes, I think so, but economic historians will have to decide on that in the decades to come. I would just like to make the following observations. First, the US Fed was much more aggressive than the ECB and economic performance of the US has been much more positive than that of the eurozone. Second, a list of positives is easy to make. A depression has been prevented. Sustained deflation did not occur. Debt ratios of US households have declined against a background of economic growth and growth of private consumption. In Europe, debt has been moved from weak to stronger shoulders. Bank capital ratios have been raised materially. International payment imbalances have been reduced. Corporate profits are generally healthy, although they are now coming under some cyclical pressure. I would conclude that this experiment has been successful.
The Fed raised rates in December last year and all hell broke loose on financial markets after that. Does that not show that this aggressive policy has merely postponed the inevitable disaster?
No, this is a mistaken view. Some people argue that financial markets have been supported by easy money and that they have become like a drug addict. Even a modest reduction in the dose of the drugs leads to serious withdrawal symptoms. I disagree with that analogy for several reasons. While others may disagree, valuation of markets for risky assets do not seem particularly stretched to me. If markets were purely on steroids, valuation should be hugely stretched.
In addition, I think it is incorrect to suggest that the December Fed rate hike was the first step in the tightening process. There have been earlier steps. The announcement of tapering of QE on May 2013 was the first step, the actual start of tapering in December 2013 was the second step and the end of the QE programme in October 2014 was the third step. Academic studies on the so called ‘shadow Fed Funds rate’ suggest that these steps equal tightening of monetary policy of some 3% of Fed funds rate increases.
Third, I think that policy tightening comes too early as not all problems have been sufficiently dealt with. True, the US economy is growing, unemployment has fallen sharply and inflation in the US is creeping up. But Fed policy is not just monetary policy for the domestic US economy; it is policy for the US dollar area. In recent years, a large amount of dollar denominated debt has developed in emerging economies. Fed tightening will affect that debt and the amounts are so large that it will have an impact on global economic conditions. The turmoil in financial markets is simply the markets telling the Fed this.
While the US is tightening policy, the ECB is stepping up its stimulus. Why is that?
As mentioned above, the ECB was less aggressive after the start of the crisis and the recovery of the eurozone economy has been less impressive. In addition, inflation in the eurozone is uncomfortably low. Finally, the credit channel in the eurozone is functioning less well than in the US.
Are these reasons really sufficient justification for negative interest rates?
Nobody knows for sure. But Japan’s experience during the last three decades suggests that the best defence against deflation is to make sure you do not to end up in deflation in the first place.
Some people argue that low interest rates have lost their effect. Are they right?
Economists have diverging views. Those opposing the current stance on monetary policy argue that the ECB has brought interest rates to artificially low levels. This distorts financial markets, keeps unhealthy companies alive, encourages the wrong people to take on too much debt, gives policymakers in weak economies an escape from having to implement structural improvements in their economies and it makes life more difficult for banks. The sceptics often quote Albert Einstein who famously said that insanity is doing the same thing over and over again and expecting a different result.
Those in favour of current ECB policies question if interest rates are ‘artificially’ low. They support a view that is well known in economics and that holds that there is a level of interest rates that keeps the economy in equilibrium. That means that there is a level of interest rates at which all resources in the economy are employed. This is called the natural rate of interest. The problem is that we do not know where that level is and it is assumed that this natural rate can change over time. What central banks need to do is keep actual interest rates as close as they can to this natural rate. One may wonder how central banks can do this if they do not know where the natural rate is exactly. Well, if they keep rates too high, the economy will struggle, growth will be low, unemployment will be high and inflation will also be low. If central banks keep interest rates too low, the economy should be strong, inflation high and asset markets should be characterised by bubbles.
When we look at the economy, we cannot conclude anything else than that economic growth is weak, unemployment in the eurozone is high and inflation is very low. The evidence thus suggests that interest rates are not artificially low, but need to be this low because of economic circumstances.
But surely, economic growth is low because of all sorts of growth impediments and monetary policy alone cannot secure high, balanced and sustainable growth?
Correct. While central banks have pulled out all the stops to support economic activity, governments show no interest whatsoever in using fiscal policy to provide stimulus when that may be appropriate. And as far as making economies more dynamic by implementing structural reform of product and labour markets progress has been disappointingly slow. The fact that other policymakers are not doing their part cannot be an excuse for central bankers to stand idly by.
The debate in Europe has recently moved to ‘helicopter money’. What is that and why is that a good or a bad idea?
Milton Friedman coined this term in 1969. He argued that in an economy running substantially below capacity, policymakers could drop money from a helicopter and that this would encourage people to spend. Former Fed boss Ben Bernanke referred to this in 2002 when he was addressing the question if the Fed would have the tools to prevent deflation. He said “we have the technology”. ECB board member Peter Praet recently also raised this as a policy option should all other things fail.
It is not entirely clear how helicopter money would actually work in practice. It is unlikely to involve helicopters. More likely is that government spending or tax rebates will be funded through monetary financing.
Is helicopter money likely to happen in Europe?
No, at least not in the short term. There are all sorts of hurdles, ranging from opposition to it to legal complications. In addition, this measure is only going to be implemented in an extreme case. With economic growth in the eurozone running near trend at 1-1.5% and core inflation close to 1%, there is no justification for helicopter money at this point in time. A material deterioration of economic conditions and inflation prospects is required before helicopter would will be seriously considered. I think Peter Praet realises that. My interpretation is that the ECB is not really planning to go for helicopter money. What he is trying to achieve is convince people that the ECB can deploy a powerful instrument against the risk of a deflationary recession. He is trying to massage expectations.
Helicopter money would, at least theoretically, be much more powerful than quantitative easing as it has been carried out so far. By engaging in helicopter money, central banks would be pushing money into the economy much more directly, essentially by-passing the financial system.
Is the eurozone not going to end up like Zimbabwe?
No. Zimbabwe experienced hyperinflation in very different circumstances. Disastrous economic policies of the Mugabe government had done massive damage to the production capacity of the country. Policymakers then tried to remedy that with very loose monetary policy. That must lead to hyperinflation. The problem in Europe is not a lack of productive capacity, but underutilisation. So loose monetary policies are aimed at raising demand and activity to a level closer to the economy’s productive capacity. That is very different from what happened in Zimbabwe.
You make it sound as though helicopter money is a great idea, but what are the risks?
I think our paper-money system allows for such an option. The main risk attached is that people may lose confidence in the money system. That would be a catastrophe. It must therefore only be tried in extreme and extremely dire circumstances
Bundesbank President Jens Weidmann and his Dutch colleague Klaas Knot have recently expressed very critical views about ECB policy. What is that all about?
Mr Weidmann is warning that the ECB’s asset purchasing programme is leading to a bloated balance sheet of the ECB and that our central bank runs the risk of losing money. I think he is right. But the question is what the consequences will be. A central bank is not a ‘normal company’. There are several central banks in the world operating with negative equity. The central bank of Chili is an example and it could be argued that it is technically bankrupt. Yet, it is functioning. The risk with large losses of a central bank is not so much that they will actually go bust, but that, either people lose confidence in the money system, which has not happened in Chili, or that the central bank’s independence comes under threat, which has not happened in Chili either. Having said that, should the economy fall into a depression and the central bank is seen as having watched it without trying to prevent it, it may also lose its independence. Mr Weidmann is undoubtedly right, it would not be a good thing for a central bank to lose a lot of money, but I cannot see it happening anytime soon. I also believe that there could be circumstances in which risking to lose money is a price worth paying for trying to avoid economic disaster.
Let’s focus on the shorter term. What should we make of the ECB’s recently announced new measures?
I think the effects of these measures will be positive. I do not think that making official interest rates even more negative will have much of an impact. But the inclusion of corporate bonds in the ECB’s asset purchasing programme will lower the funding costs of corporates. And the new funding programme for the banks has the potential of having a very significant positive effect on eurozone banks. That has got to be positive. It should support the credit mechanism.