While the failure of fiscal policy is widely recognized, monetary policy still enjoys credibility. Yet monetary policy is like shooting in a dark room. Monetary policy suffers from a profound pretense of knowledge. When central banks are not able to fulfill their claim and promote economic growth, employment and price stability, the question comes up what their real mission is. The Federal Reserve System was founded in with the intention to safeguard the big players of the financial system. Now we are fully back at this paradigm. The main purpose of quantitative easing is not to promote prosperity in the first place but to help the banking sector to stay afloat.
Ineffective Monetary Policy
On September 13th 2012, the Federal Open Market Committee of the US Federal Reserve System (Fed) announced its third round of quantitative easing. After a series of failed attempts to bring the US economy back on its track, a new package of monetary easing was launched as “the Committee agreed … to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities… These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.”
The question arises what’s behind this statement of the Fed. Why did earlier packages fail and what are the potential implications of the new round of monetary stimuli, the Fed’s quantitative easing number thee or “QE3”.
“Quantitative easing” means that the central bank buys bonds and other assets from the financial sector in exchange for fresh money, which the central bank creates out of thin air. This money from the central bank is the so-called “monetary base” and forms the foundation of the inverted pyramid of money creation in the financial system.
As is shown by the data of the US Federal Reserve, the monetary base underwent an explosion since 2008. From little more than US$ 800 billion, base money increased to almost US$ 2,800 billion. This is amazing in itself, yet even more so when taking into account that in the decades before this upturn the monetary base showed only tiny regular increases. Even during the inflationary times of the 1970s and the boom years of the 1990s the expansion of the monetary base was moderate compared to what happened in the past few years. Yet this enormous expansion of base money did not yet show up in a similar expansion of the money supply. US money supply in the form of M2 is still pretty much on the same trend line as it began in the mid-1990s. While the banking sector is awash with fresh money there has been relatively little increase in lending to the private sector of the economy. Thus the extreme increase of the monetary base has not gushed over into the real economy in the same dimension. Banks have become more risk-averse and reluctant to lend and part of the private sector refrains from borrowing due to overindebtedness. Companies are cautious to invest and many families reduce outstanding debt. Consequently the official price level has not risen as much as the increase of the monetary base would indicate and the monetary impulses that were discharged by the American central bank during the past five years have had little effect to reduce the unemployment rate (see chart 1).
US inflation and unemployment rates – official and Shadow Government Statistics rates
Not only did the policy stimuli have little effect on the money supply, the monetary stock itself has had less impact on economic activity because the frequency of transactions, the so-called “velocity” of money, has fallen hit new lows in the past years (chart 2).
Velocity of Money for M2
The data provide ample evidence that monetary policy has been ineffective to stimulate economic growth and promote employment. Of course, one could argue that without such an expansive monetary policy things would be worse and that unemployment would be much higher. One could claim that the economy as a whole would have fallen over the cliff into a deflationary depression without the massive stimuli. Yet such contentions are empty because there is no way to prove them. The point that can be shown is that despite the vast size of the monetary stimulus and even more so because together with the monetary expansion by the US central bank, the US government also provided enormous fiscal stimulus packages with an extraordinary surge of US federal government debt, the economic activity did not take off as the monetary and fiscal authorities in charge promised that it would happen.
Why things don’t work
Before the outbreak of the current crisis central bankers lowered the monetary interest rates and felt justified by an apparently stable price level. This happened during the period that was euphemistically baptized as the “The Great Moderation” by the instigators of the latest episode of an unsustainable boom. Now, the very same central bankers downplay the risk of inflation and claim that the money and debt creation through monetary and fiscal policy has not gone far enough and that it takes even more new money to bring the economy back to life.
Once again monetary policy is confronted with the fact that in economic matters there are no stable quantitative relationships in place. Macroeconomic correlations between aggregates that have held for decades can break down not only abruptly but also in an extreme way. As it is shown by the “velocity” of the M2 money stock (chart 2), the frequency of monetary transactions was increasing for decades before it took a dramatic turn towards contraction at the turn to the new century. The rise and fall of velocity reflect the degree of inflationary expectations. Behind the macroeconomic variables lies human action, and human beings are able to learn and to anticipate and to change their expectations and goals. Neglecting this fact limits severely the possibility of a “science of monetary policy” and explains its poor predictive record.
The impulse of an increase of the monetary base can be amplified or nullified depending on the size of the monetary multiplier and the velocity of circulation. A variation of the monetary base may go into the prices of consumer goods or it may affect mainly the prices of investment goods. Excess liquidity may go mainly into the asset markets. The performance of each link in the monetary transmission process from base money to output and prices is not mechanistically determined but the result of the actions of individual economic actors. Given that there are no reliable quantitative relations among the variables, central banks are unable to calibrate their policies. There is no certainty as to whether the monetary impulse will affect in a specific way a specific variable. Only in the most general form can it be said that an inflation of the monetary side will affect the goods side. Monetary policy is like shooting in a dark room.
What is central banking good for?
What, so we must ask, is central banking good for when it is not even able to guarantee a stable price level (see chart 3)?
Purchasing power of the US dollar 1913-2012
Why keep a quasi-dictatorial creature within the government body that operates largely outside of public control? Why hold on to an institution that more often than not has failed to provide full employment and price level stability? By these criteria the Fed has indeed been a failure. What then, we must ask is the true mission of central banking as one cannot calibrate accurately the effects of monetary policy on the real economy and price level? The answer is provided by the historical origin of central banking. As Rothbard and other authors such as more recently Lawrence White have shown, central banking grew out from the cooperation between the state and the big players of the banking sector. The deal that was struck said that the big banks will finance government and that the government won’t let the big banks go bankrupt. For that purpose a lender of the last resort was installed in the form of a central bank which would obtain the privilege by the government to produce unlimited amounts of fiduciary money.
Historically the scope of discretion was restricted by the gold standard at first, yet over time the various constraints have been removed step by step beginning with World War I. With the so-called Smithsonian agreement of 1971 the last anchor for the US dollar fell. At the day when President Nixon fully abandoned what was still left of the gold standard, the starting gun was fired for the escalation of the financial sector to grow into its current gargantuan proportions. In tandem with the expansion of the financial sector, government grew its public debt into its current colossal dimensions.
While central banks are effective as lender of the last resort and thereby to safeguard the big players of the financial system from going bankrupt, they are not only incapable of promoting economic growth, employment and price level stability, they are in fact the major perpetrators of the business cycle. Always under pressure to set the interest rate as low as possible, central banks provoke artificial booms which inevitably must result in a bust. The big players in the financial market can profit on the way up without fear about the downturn as they can rely on the central bank to bail them out.
In an academic paper Bernanke (2001) and his co-author argued explicitly that central bankers should not try to prick asset bubbles but stand ready to bail out banks and financial institutions when the bubble bursts. In his speech as a Governor of the US central bank on “Monetary Policy and the Stock Market”, Bernanke declared in 2003: “The ultimate objective of monetary policymakers is to promote the health of the U.S. economy by pursuing our mandated goals of price stability and maximum sustainable output and employment. However … monetary policy actions have their most direct and immediate effects on the broader financial markets, including the stock market, government and corporate bond markets, mortgage markets, markets for consumer credit, foreign exchange markets, and many others.” The message was well understood. The big players in the financial market could rest assured that their central bank would bail them out when a new episode of the lending spree began - the housing bubble. Operating as bailout machinery for the financial system, the US central bank has thoroughly infected the monetary system with moral hazard.
Central banks create money out of thin air and as such they are able to provide liquidity without a limit as lender of the last resort. In this sense the monetary policy of the US central bank has fulfilled its mission since its inception and has continued doing so over the past couple of years not much different from what central banks have done in Japan and what they carry out in Europe right now. Central banks do not have the tools to create economic growth and employment. The monetary transmission mechanism is far too complex to be calibrated in any reliable way. What central banks have under control is the monetary base. With this instrument they hold the assurance in their hands to provide liquidity at will. The main job of central banks consists in protecting the financial system in the bust. Central banks perform this task by funding without limit the major players of the financial sector.
Over the past decades financial markets have been swamped by an avalanche of liquidity and the financial sector has grown into its current gargantuan proportions. This growth of the financial sector has been built on the expansion of debt. Now this debt expansion has reached its limit, the boom has turned into a bust. Quantitative easing has allowed that banks and other major financial institution could unload many of their bad assets on the central bank. By this process commercial banks are cleaning their balance sheets while the central bank picks up the dirty clothes. In the end it will be the tax payer who has to pay the bill. The Fed has perverted the financial system into a scheme that subsidizes private profits in the boom and socializes losses in the bust.
Assuming that the financial system does not collapse and that the current monetary policy will succeed in reviving the economy, commercial banks will resume lending to the private sector. With commercial banks having stacks of liquidity at their disposal, lending of mammoth proportions can take place. Uncertainty of the outlook and political pressures will make central bankers reluctant to match rising price inflation with corresponding increases of interest rates. Sooner or later negative real interest rate and the expectation of higher price inflation will trigger a rush to borrow. Hyperinflationary conditions will emerge when the financial system gets into a state of feedback that is the opposite of the current state of affairs. While presently the multiplier and the velocity of money are low, these variables would go off when inflationary expectations take hold. Then the mass of base money which central banks have supplied no longer functions as a cushion to safeguard the banks but turns into financial dynamite that will detonate into price inflation.