At the conclusion of a recent star-studded IMF conference, chief economist Olivier Blanchard argued that we may need negative real interest rates for a long time. Here is the passage in full:
“Now let me now turn to monetary policy, and touch on three issues: the implications of the liquidity trap, the provision of liquidity, and the management of capital flows.
On the liquidity trap: we have discovered, unfortunately at great cost, that the zero lower bound can indeed be binding, and be binding for a long time—five years at this point. We have also discovered that, even then, there is still some room for monetary policy. The bulk of the evidence is that unconventional policy can systematically affect the term premia, and thus bend the yield curve through portfolio effects. But it remains a fact that compared to conventional policy, the effects of unconventional monetary policy are very limited and uncertain.
There is therefore much to be said for avoiding the trap in the first place in the future, and this raises again the question of the inflation rate. There is wide agreement that in most advanced countries, it would be good if inflation was higher today. Presumably, if it had been higher pre-crisis, it would be higher today. To be more concrete, if inflation had been 2 percentage points higher before the crisis, the best guess is that it would be 2 percentage points higher today, the real rate would be 2 percentage points lower, and we would probably be close in the US to an exit from zero nominal rates today.
We should not dismiss the possibility, raised by Larry Summers that we may need negative real rates for a long time. Countries could in principle achieve negative real rates through low nominal rates and moderate inflation. Instead, we are still facing today the danger of an adverse feedback loop, in which depressed demand leads to lower inflation, lower inflation leads to higher real rates, and higher real rates lead in turn to even more depressed demand.”
Set aside the irony of the IMF chief economist arguing for higher average inflation rates as a normal state of affairs. Looking back, this doctrine would have required central banks to have pumped up housing and asset prices even faster than they did in the asset-price boom preceding the bust of 2007-8 – in order to obtain the needed lift in rates of consumer price inflation (which in many countries were declining), and thus caused a bigger crash and even bigger pile of dud loans and collapsed banks. Looking ahead, the Blanchard doctrine would make central banks’ “deflation phobia” even worse – it would make them panic at the very first sign that forecast inflation might dip below some threshold such as 4% – to avoid which they would in practice aim at significantly higher rates, such as 6%. Leave aside the lessons learnt with the paper money experience of the last century, that inflation at such rates is likely to be unstable and unpredictable, causing arbitrary, unfair redistributions of income and wealth and inhibiting capital investment. Leave aside the practical impossibility for central banks to fine-tune inflation rates in the way Blanchard assumes they can. Leave aside, finally , the glaring absence of any policy to get out of the hole Mr Blanchard describes that ‘we are still facing today the danger of an adverse feedback loop, in which depressed demand leads to lower inflation, lower inflation leads to higher real rates, and higher real rates lead in turn to even more depressed demand.”
What I want to focus on is something ignored or denied by Mr Blanchard that the monetary system itself is the main cause of unpredictable slumps. First, the international monetary system, as currently designed, inevitably produces periodic self-sustaining currency and asset booms and busts. All that the IMF has to offer to reduce these is more physical controls (this time on capital flows), which will inevitably fragment the world economy further and reduce efficient capital allocation. Second, experience has shown that the narrow focus on inflation targeting – controlling goods and services inflation – is counter-productive. It leads to an investment slump such as we are experiencing. This is because it neglects asset prices, including investment goods and other real assets. Fluctuations in the expected proceeds of new investment make it impossible to plan new projects with confidence. For example, if you plan to build a new house, but fear that the market value when it is built might be well below what you need to make a profit, you will not build the house. That is the reason for calls for negative real rates. (Notice that Blanchard has no suggestions for how to get out of this liquidity trap now – only that, next time, we need to engineer higher inflation before the trap).
Will we be forced to target stability in asset prices instead of CPI? Central banks are currently kidding themselves (and us) into believing that direct physical controls – dressed up as macro-prudential policies can prevent an asset bubble without using interest rates, but the period after World War II showed these don’t work, or rather they can be effective only by cramping the financial system so much that it cannot fulfil its economic functions. So once we relearn that lesson, we will be forced to reflect more deeply on the nature of the problem. Even before that time, complaints about the huge piles of cash sitting idle on corporate balance sheets will grow. Why are corporates not investing? Answer: because of uncertainty.
Professor Roger Farmer has advocated intervention to stabilise stock prices. Nobel Prize Laureate Robert Shiller has suggested that governments should issue GDP-linked bonds or “trills”. My suggestion is, like these, aimed at tying the the monetary and financial systems more securely to the real economy. As it was under gold.
I think that in the end we will have to dig deeper. What the crisis has brought into question is the nature of money. The primary function of money is, as Keynes said, as a unit of account. It is an abstract metric or measure of purchasing power. It is not an “object” that “circulates” or primarily a means of exchange. It is an achievement of civilisation. It depends on the keeping of promises. It is better, but not essential, if it has a “fall-back” value,in the market, like gold has. As it needs wide circulation and acceptance, the unit should be defined by the State, as the US Congress defines the dollar (but the actual creation or production of money to this standard can be left to the private sector operating under set rules as in a currency board). Credibility may be enhanced if it is “convertible” into real assets or claims.
But the nature of the “anchor” – gold, silver, commodity bundles, the SDR, or other assets – can change and has varied through history. I am suggesting, following Wolfram Engels’ essay of 1981 on the optimal monetary unit (on which I collaborated), as elaborated in The Money Trap. a different kind of “bundle” to serve as the anchor . Imagine a standard where the mechanism of international adjustment, the discipline on national policies, the money supply, and so on work as in an ideal gold standard – except that instead of gold, the anchor consists of tradable claims on real assets – the index of a diversified basket of such claims would be fixed. This would be counter-cyclical, automatically tightening money in booms and loosening money in downturns. This unit of account that would also allow investors to calculate the pay-off from new investments with less uncertainty – because the monetary roots of uncertainty, which lie at the heart of our present impasse, would be removed.
The clever economists of the IMF should lift their sights. Manipulation of our present monetary arrangements – QE for ever and pray for soemthign to turn up – is not working – or in IMF-speak “the effects of unconventional monetary policy are very limited and uncertain”. This is because it manipulates a form of money that is not well-designed to meet present social, economic or monetary conditions. Ongoing fragmentation is a sign that globalisation, from which the world has derived untold benefits, will not survive without a complete re-invention of the monetary constitution.
Debating the nature of money
At the conclusion of a recent star-studded IMF conference, chief economist Olivier Blanchard argued that we may need negative real interest rates for a long time. Here is the passage in full:
“Now let me now turn to monetary policy, and touch on three issues: the implications of the liquidity trap, the provision of liquidity, and the management of capital flows.
On the liquidity trap: we have discovered, unfortunately at great cost, that the zero lower bound can indeed be binding, and be binding for a long time—five years at this point. We have also discovered that, even then, there is still some room for monetary policy. The bulk of the evidence is that unconventional policy can systematically affect the term premia, and thus bend the yield curve through portfolio effects. But it remains a fact that compared to conventional policy, the effects of unconventional monetary policy are very limited and uncertain.
There is therefore much to be said for avoiding the trap in the first place in the future, and this raises again the question of the inflation rate. There is wide agreement that in most advanced countries, it would be good if inflation was higher today. Presumably, if it had been higher pre-crisis, it would be higher today. To be more concrete, if inflation had been 2 percentage points higher before the crisis, the best guess is that it would be 2 percentage points higher today, the real rate would be 2 percentage points lower, and we would probably be close in the US to an exit from zero nominal rates today.
We should not dismiss the possibility, raised by Larry Summers that we may need negative real rates for a long time. Countries could in principle achieve negative real rates through low nominal rates and moderate inflation. Instead, we are still facing today the danger of an adverse feedback loop, in which depressed demand leads to lower inflation, lower inflation leads to higher real rates, and higher real rates lead in turn to even more depressed demand.”
Set aside the irony of the IMF chief economist arguing for higher average inflation rates as a normal state of affairs. Looking back, this doctrine would have required central banks to have pumped up housing and asset prices even faster than they did in the asset-price boom preceding the bust of 2007-8 – in order to obtain the needed lift in rates of consumer price inflation (which in many countries were declining), and thus caused a bigger crash and even bigger pile of dud loans and collapsed banks. Looking ahead, the Blanchard doctrine would make central banks’ “deflation phobia” even worse – it would make them panic at the very first sign that forecast inflation might dip below some threshold such as 4% – to avoid which they would in practice aim at significantly higher rates, such as 6%. Leave aside the lessons learnt with the paper money experience of the last century, that inflation at such rates is likely to be unstable and unpredictable, causing arbitrary, unfair redistributions of income and wealth and inhibiting capital investment. Leave aside the practical impossibility for central banks to fine-tune inflation rates in the way Blanchard assumes they can. Leave aside, finally , the glaring absence of any policy to get out of the hole Mr Blanchard describes that ‘we are still facing today the danger of an adverse feedback loop, in which depressed demand leads to lower inflation, lower inflation leads to higher real rates, and higher real rates lead in turn to even more depressed demand.”
What I want to focus on is something ignored or denied by Mr Blanchard that the monetary system itself is the main cause of unpredictable slumps. First, the international monetary system, as currently designed, inevitably produces periodic self-sustaining currency and asset booms and busts. All that the IMF has to offer to reduce these is more physical controls (this time on capital flows), which will inevitably fragment the world economy further and reduce efficient capital allocation. Second, experience has shown that the narrow focus on inflation targeting – controlling goods and services inflation – is counter-productive. It leads to an investment slump such as we are experiencing. This is because it neglects asset prices, including investment goods and other real assets. Fluctuations in the expected proceeds of new investment make it impossible to plan new projects with confidence. For example, if you plan to build a new house, but fear that the market value when it is built might be well below what you need to make a profit, you will not build the house. That is the reason for calls for negative real rates. (Notice that Blanchard has no suggestions for how to get out of this liquidity trap now – only that, next time, we need to engineer higher inflation before the trap).
Will we be forced to target stability in asset prices instead of CPI? Central banks are currently kidding themselves (and us) into believing that direct physical controls – dressed up as macro-prudential policies can prevent an asset bubble without using interest rates, but the period after World War II showed these don’t work, or rather they can be effective only by cramping the financial system so much that it cannot fulfil its economic functions. So once we relearn that lesson, we will be forced to reflect more deeply on the nature of the problem. Even before that time, complaints about the huge piles of cash sitting idle on corporate balance sheets will grow. Why are corporates not investing? Answer: because of uncertainty.
Professor Roger Farmer has advocated intervention to stabilise stock prices. Nobel Prize Laureate Robert Shiller has suggested that governments should issue GDP-linked bonds or “trills”. My suggestion is, like these, aimed at tying the the monetary and financial systems more securely to the real economy. As it was under gold.
I think that in the end we will have to dig deeper. What the crisis has brought into question is the nature of money. The primary function of money is, as Keynes said, as a unit of account. It is an abstract metric or measure of purchasing power. It is not an “object” that “circulates” or primarily a means of exchange. It is an achievement of civilisation. It depends on the keeping of promises. It is better, but not essential, if it has a “fall-back” value,in the market, like gold has. As it needs wide circulation and acceptance, the unit should be defined by the State, as the US Congress defines the dollar (but the actual creation or production of money to this standard can be left to the private sector operating under set rules as in a currency board). Credibility may be enhanced if it is “convertible” into real assets or claims.
But the nature of the “anchor” – gold, silver, commodity bundles, the SDR, or other assets – can change and has varied through history. I am suggesting, following Wolfram Engels’ essay of 1981 on the optimal monetary unit (on which I collaborated), as elaborated in The Money Trap. a different kind of “bundle” to serve as the anchor . Imagine a standard where the mechanism of international adjustment, the discipline on national policies, the money supply, and so on work as in an ideal gold standard – except that instead of gold, the anchor consists of tradable claims on real assets – the index of a diversified basket of such claims would be fixed. This would be counter-cyclical, automatically tightening money in booms and loosening money in downturns. This unit of account that would also allow investors to calculate the pay-off from new investments with less uncertainty – because the monetary roots of uncertainty, which lie at the heart of our present impasse, would be removed.
The clever economists of the IMF should lift their sights. Manipulation of our present monetary arrangements – QE for ever and pray for soemthign to turn up – is not working – or in IMF-speak “the effects of unconventional monetary policy are very limited and uncertain”. This is because it manipulates a form of money that is not well-designed to meet present social, economic or monetary conditions. Ongoing fragmentation is a sign that globalisation, from which the world has derived untold benefits, will not survive without a complete re-invention of the monetary constitution.
Written on November 28, 2013 at 3:14 pm, by robert
Categories: "Gold", Banking, Homepage, News and Comment, Official Money, RP's Diary, The Ikon | Tags: Blanchard, Engels, financial crisis, global financial system, IMF, International Monetary System, Olivier Blanchard, robert pringle, Robert Shiller, the Ikon, The Money Trap, Wolfram Engels