What’s left of macroeconomic policy?

The policy reaction to the crisis of 2008 was a massive Keynesian and monetary stimulus, which continues to this day. Recession was avoided but at what cost? What does the future hold? A column by Victoria Curzon Price.

Victoria Curzon Price
«The whole economy is too complex for anyone to make precise predictions. We manage with guesswork which often turns out to be wrong.»

Boom and bust! Humanity has experienced economic cycles ever since history began. Pharaoh of Egypt, advised by Joseph, successfully offset seven lean years by saving during the seven fat ones. The good burghers of Amsterdam created an amazing tulip bubble in the 17th century, remembered to this day because it shows how crazy people can be. The «gay twenties» were followed by the Great Depression (from 1929 to 1933 about a third of US national income was lost over 4 years).

Our collective memory only records the most distressing, amazing or funniest examples, but it is a fact that economic affairs never run in a straight line. Economists have sought to discover a pattern in economic fluctuations – obviously! If you could predict the next up-turn or down-turn you could make a fortune. Equally obviously, no one has ever succeeded in doing this. We know only that business cycles occur, we can see roughly what is happening, but the whole economy is too complex for anyone, even helped by the most powerful computer endowed with the most up-to-date information, to make precise predictions. We manage with guesswork which often turns out to be wrong.

This has not stopped economists from studying history in order to learn what to avoid, and political leaders from trying to prevent the worst crashes. In 1936 John Maynard Keynes published The General Theory of Employment, Interest and Money, thus changing for ever the way economists and political leaders looked at business cycles. Keynes developed a macroeconomic perspective and suggested that the whole economy could be represented in a few simple aggregates, such as consumption, saving, investment, government expenditure etc. The business cycle was elegantly explained as being the result of too much or too little expenditure confronting too much or too little production.

The elusive multiplicator

The key to understanding the dynamics of the cycle was the multiplier. A small amount of extra expenditure at the bottom of the cycle would give rise to multiple increases in incomes as extra cash was spent and re-spent, pulling the economy out of the rut. Conversely, at the top of the cycle, a small amount of extra saving on the part of consumers, or less investment on the part of producers, and the whole process would go into reverse, triggering a recession. Keynes’s approach suggested that government should be entrusted with «macroeconomic demand management», ironing out the natural ups and downs of the economy with small adjustments to public expenditure at just the right time.  Most importantly, government could finance extra expenditure in a recession by borrowing from the market, and repay the loan from the extra income generated by the multiplier during the following recovery.

Like many excellent ideas, this one suffered from political pollution and a certain amount of over-optimism. The multiplier turned out to be much smaller than initially assumed, perhaps even non-existent. The macroeconomic aggregates turned out to be much harder to measure, let alone predict. Governments eagerly embraced this new responsibility, spent lavishly during recessions, but forgot to budget a surplus to repay the loan when the economy improved. Trade unions soon figured out that public sector deficits in T1 produced inflation in T2, and anticipated wage demands accordingly, creating what came to be known as «stagflation». Artificially low interest rates led to «mal-investment». Globalization increased the size of the traded sector to the point that most economies became «open», adding to the complexity of predicting when to act and reducing the size of the elusive multiplier.

Monetarists, Austrians, classical economists, Marxists, neo-Keynesians all waded in with their criticisms and alternative solutions. Monetarists, in particular, suggested that expanding the money supply at a constant rate and aiming at a low positive rate of inflation was about as much as could be expected. Alan Greenspan, President of the US Federal Reserve from 1987 to 2006, presided over a marriage of Keynesian and monetarist approaches which kept recession at bay for 20 years, but allowed public and private debt to build up and up, thanks to «easy money». It all ended in tears with the Global Financial Crisis in 2008, unanticipated by most observers and shaking the world economy to its very foundations.

Huge debt and negative interest rates

The policy reaction, as is well known, was a massive Keynesian and monetary stimulus in most countries, which continues to this day. Recession was avoided but at what cost? What does the future hold?

All major Central Banks and Treasury Departments, the IMF and OECD, the World Bank and the United Nations, and in many economics departments at our Universities, Keynesian models continue to churn out ever more sophisticated macroeconomic data and forecasts. But they have lost all credibility.  They failed to predict the last crisis, so why should they predict the next one?

Private and public debt is at an all-time high, a sleeping monster awaiting an interest rate rise. It used to be believed that nominal interest rates could not fall below zero. Real interest rates (nominal rates minus the rate of inflation) of course do accidentally drift into negative territory because of macroeconomic policy panics, time-lags, lack of adequate anticipation and so forth. But negative nominal interest rates seemed impossible. You had to think of people being prepared to pay their banker to keep their money safe. Surely there would always be better things to do with it? For instance keeping it in cash in a bank vault, or buying short maturity Treasury Bonds. But for whatever reasons, we have seen negative nominal interest rates in all major countries. And they do not appear to have produced lots of extra investment,  expenditure, or growth.  They seem to have lost their power to stimulate the economy.

Adventurous central banks

The counterpart to these amazingly low interest rates is, of course, «unconventional» monetary policy, namely «quantitative easing» or more simply the monetization of public and private debt instruments. The sort of thing you would expect of a Latin American dictatorship.

In the past decade sophisticated, responsible and advanced economy governments have leaned on their Central Banks to lend them cash to finance public expenditure to avoid recession. The most adventurous, by far, is the Bank of Japan, which holds 35% of the national debt, itself standing at 228% of Japan’s remarkably unresponsive and sluggish GDP (OECD Economic Outlook, November 2018).

It is followed by the European Central Bank which presides over the fortunes of the 17 Euro zone countries, and which has bought up 25% of the public debt of this club, financing the deficits of Italian, Spanish, French and other euro zone governments to the tune of some €2,8 trillion and rising.

Perhaps inflation down the road

Most worrying is that the vastly inflated assets of the world’s senior central banks are now composed up to 2/3 of their own government’s bonds. So much for central bank independence. The US Federal Reserve announced in December 2015 that it would soon start unwinding its $4.5 trillion of government paper to anticipate inflationary pressures. Infinitesimal sales of $50 billion per month started in 2018, accompanied by small, well-spaced interest rate hikes. However, in February 2019 Jerome Powell, the current Fed President, suspended this programme in the light of unspecified macroeconomic uncertainties (although inflation is currently running at about 2.5% and expected to rise).

Ten years after the 2008 financial meltdown, triggered by massive debt overhangs, we still have massive debt overhangs, but we have few policy buffers if the sleeping monster awakes. We can only imagine more quantitative easing, more government debt stacked up against wobbly currencies and inflation awaiting us somewhere down the road. Perhaps this is what our political leaders want, anyhow – it is a tried and tested method of getting rid of debt. But for the general public a total re-set of the economy will be a painful affair.