A metaphor attributed to John Maynard Keynes maintains that using monetary policy to fight a severe recession is like “pushing on a piece of string.” When the problem is inflation, pushing up interest rates (pulling on a string) is a pretty effective policy tool — ask anyone who lived through the Volcker recession of the early 1980s. But when rates are pushed down to stimulate economic activity the ‘push’ becomes less and less effective the closer to zero rates get.
The power of this “pushing on a string” metaphor is especially apparent today. The Federal Reserve’s balance sheet shows that, since 2008, “deposits by depository institutions” (i.e. banks) have ballooned from about $30 billion to around $1.5 trillion. Why is all that money sitting at the Fed earning a meager 0.25% nominal interest when those same banks could make a lot more than that by lending it out?
The answer is simple: uncertainty about the future. Not uncertainty over Obamacare, or “regulation,” or any of the other bêtes noires of moment, but uncertainty over the lack of demand in an economy whose consumers and producers are paying back debt. After all, who opens a factory in the middle of a recession? But if we all think this way then investment expectations fall, which hits borrowing and lending activity, thereby bringing about the very recession that we all wanted to avoid in the first place.
The orthodox response in such a situation is to continue to push on the string, but as then Fed governor (and actual author of the “pushing on a string” quote) Marriner Eccles said back in 1935, “we are in the depths of a depression and … beyond creating an easy money situation through reduction of discount rates, there is very little, if anything, that the reserve organization can do to bring about recovery.”
Seen from this point of view, the policy responses of the Fed and the European Central Bank (ECB) over the past few years seem a bit more congruent than is usually appreciated, and suggest something new is afoot.
In the U.S., quantitative easing (QE) flooded the banks with money that, as noted above, they’ve kept in their accounts with the Fed rather than lending out. The Fed then thought, ‘OK, if that didn’t work let’s try it again,’ and so they did QE2, with the same result. After a bit of head scratching the Fed decided to try something else — the “twist” — where they bought short-term assets in exchange for long-term securities to try and lower long-term rates. That didn’t seem to do much either.
Meanwhile, over in Frankfurt, the ECB was at first busy fulfilling its mandate of fighting an inflation that died in 1923 by raising interest rates in the middle of a recession. Then ECB policy began to shift, first with a brief bout of bond buying in 2010, and then with the LTROs (Long Term Refinancing Operations) which started on Christmas Eve in 2011: a trillion Euros of liquidity in exchange for promises to lend. Once again, apart from some cash used to buy short-term government debt, most of it ended up back in the accounts of the banks at the ECB.
You can begin to see the symmetry here. Both monetary authorities sought to add liquidity to get rates down and lending up, with the difference being the rates that mattered in the U.S. were loan rates while in Europe it was government bond rates that were the target. In neither case did these policies work well.
That’s because a growth problem that is driven by investment uncertainty, augmented by deleveraging, and turbocharged by austerity politics (especially in the EU) cannot be solved with a monetary instrument already at its lower bound — a piece of string. Period. End of story. Fiscal problems can only be solved with fiscal instruments — government budgets or the taxation and regulatory systems of individual states. You can try and solve them with monetary instruments, as the Fed and the ECB have valiantly tried to do, but you will fail.
In the U.S. the problem is that there is a fiscal instrument, but it is so polarized and broken it is basically inoperative. It’s called Congress — they do the taxing and spending and regulation. Indeed, whether the growth solution is to be stimulus and infrastructure or tax cuts and debt reduction is at this juncture almost secondary to the fact that Congress cannot generate any meaningful policy response at all, and so the Fed has to get out its string and keep pushing.
The problem in the Eurozone is even more extreme. The European Union forgot to build a fiscal instrument and that’s why they have a Euro crisis. There is no European fiscal authority, only a monetary one that is still fretting over inflation in the middle of a continent-wide depression. They too have got out their piece of string, but it’s even shorter and less powerful than the Fed’s.
So what happens now? Monetary policy has run out of juice and the monetary authorities and the markets both know it. The banks want QE3 as a short-term boost, but will they get it? I think that despite the semi-positive noises made by Ben Bernanke at the Fed and Mario Draghi at the ECB over the past week or so there will be no big new pushes on their respective pieces of string.
First, Draghi is going to set up a yield curve trade that will supply liquidity at the short end of the curve and keep those rates down while letting the long end go higher and higher. This will allow the ECB to keep sovereigns and their banks liquid for now, but it does not try to solve their debt problems for them. Whether the sovereigns can use this time wisely is another question, but Draghi is going to use his string very sparingly, just enough to make sure that the national fiscal authorities know it’s their problem to fix and not his.
Similarly, if Bernanke knows that QE3 is just going to end up back at the Fed in the form of more depository-institution cash, look for him to keep the markets happy until the election and then to kick it right back to the Congress with the message that his string is being put away. It’s a fiscal problem — they need to go fix it. Whether they will do so is again an entirely different question.
Back when Eccles and Keynes thought about the limits of monetary policy they assumed that any decent government would readily take up the fiscal challenge allowing the monetary authority to put away the ineffectual string. They could not foresee a time when fiscal policy had fallen so far from grace that authorities in the U.S. could not conceive of using it while their European equivalents managed to build an entire economic system without reference to it. The result is that we are still pushing on a piece of string 80 years after we figured out how useless that policy can be.
Einstein is credited with the observation that doing the same thing over and over while expecting different results each time is the definition of madness. Look for Bernanke and Draghi to stop the madness soon.
This article was first posted on the HBR Blog Network.
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