Central banks’ actions have staved off second Great Depression

More relevant criticism is not whether they have done too much, but whether they have done too little

Federal Reserve Board chairman Ben Bernanke: in testimony to Congress last month, he noted: “The Congressional Budget Office estimates that the deficit reduction policies in current law will slow the pace of real GDP growth by about 1-1 percentage points during 2013, relative to what it would have been otherwise.” Photograph: Alex Wong/Getty Images

Federal Reserve Board chairman Ben Bernanke: in testimony to Congress last month, he noted: “The Congressional Budget Office estimates that the deficit reduction policies in current law will slow the pace of real GDP growth by about 1-1 percentage points during 2013, relative to what it would have been otherwise.” Photograph: Alex Wong/Getty Images

Wed, Jun 5, 2013, 01:00

It is easy to find people on Wall Street who believe that the aggressive monetary policies of central banks, particularly the US Federal Reserve’s quantitative easing (QE), are destabilising the economy. In some quarters, as my colleagues Dan McCrum and Robin Harding have reported, this suspicion has been elevated to a self-evident truth. But it is wrong.

Central banks, including the Fed, are doing the right thing. If they had not acted as they have over the past six years, we would surely have suffered a second Great Depression.

Avoiding such a meltdown and then helping economies to recover is the job of central banks. My criticism, albeit more of the European Central Bank than of the Fed, is not that they have done too much, but that they have done too little.

This does not mean that the policies central banks have adopted are either riskless or costless. They are not. It does mean that they were the least bad option.

What is more, the fact that yields on bonds of highly rated sovereigns have risen recently is surely a sign of success.

What seems to be happening is the rebirth of some confidence in the economy, particularly in the US. This is encouraging investors to expect an earlier exit from QE and other forms of expansionary monetary policy than was foreseen a few weeks ago.

As Gavyn Davies notes, this may be the start of a return to normality. Yes, yields on US conventional 10-year bonds are up about 40 basis points over the past month. But they are still just over 2 per cent. This is hardly a bond market Armageddon.

If recovery takes hold, as we hope, yields will rise further. Nobody can have supposed that nominal and real long-term interest rates would remain at basement levels forever.


Public purpose
Why are the criticisms of the Fed’s policies so wide of the mark? The answers are both philosophical and more narrowly economic.

The philosophical answer is that the central bank is a public institution charged with a public purpose. Its role is to stabilise the economy against financial upheaval. Some insist that the central bank bears sole responsibility for the turmoil. But the view of the late Hyman Minsky that the credit-driven financial system generates instability internally seems more plausible.

On the economic side, the financial crisis disrupted the creation of money, for which private institutions – the banks – are normally responsible.

Huge attention has been paid to the expansion of the balance sheets of central banks. But far more important are the broader monetary aggregates, which measure money in the hands of the public. The growth of broad money depends on the willingness of banks to lend more. After the crisis, that vanished.

One can see this in the measure known as “divisia broad money”. The Center for Financial Stability in New York estimates that, on this measure, the money supply was just 0.7 per cent higher in April 2013 than it had been in October 2008 – despite the expansion of the Fed’s balance sheet. This is a monetary famine, not a feast.

The second economic answer is that the financial crisis coincided with falling real house prices in the US and triggered deleveraging among financial institutions and households. It took strong monetary and fiscal action to offset these contractionary forces. Since fiscal support was, alas, withdrawn prematurely, the burden fell on the Fed. With short-term interest rates at the zero bound, it had to influence longer-term rates if monetary policy was to gain traction.

Moreover, since US gross domestic product in the first quarter of this year was just 3.3 per cent higher than in the second quarter of 2008, it is easier to believe that the Fed has done too little than too much.

Critics warned of imminent hyperinflation, but inflation expectations are under control, while core inflation in the year to April 15th last was a mere 1.7 per cent. The risk of a collapse into Japanese-style deflation was greater.

Exceptional times call for exceptional measures. Those who criticise the Fed so bitterly either lack imagination or are indifferent to what would have happened to the economy and fellow citizens if the Fed (and other central banks) had sat on their hands. This does not mean that normalisation will be easy. The secular fall in bond yields may indeed be at an end. This is sure to create difficulties, particularly for leveraged investors.


Three challenges
The central bank now confronts at least three challenges. The first is how to execute its exit. This involves questions not just of timing, but of providing clarity about its plans in an inherently uncertain environment. In current circumstances, the key will be to avoid acting prematurely, so risking an aborted recovery.

The second challenge is dealing with uncertainty beyond policy makers’ control. One unknown is US fiscal policy. In testimony to Congress last month, chairman of the Federal Reserve Ben Bernanke noted that:“The Congressional Budget Office estimates that the deficit reduction policies in current law will slow the pace of real GDP growth by about 1-1½ percentage points during 2013, relative to what it would have been otherwise.”

This is troublesome. Equally out of his control are events in the euro zone, though it does look much less unstable than a year ago.

The third challenge is over the longer- term sources of demand. I look at this issue in terms of the sectoral financial balances – the balances between income and spending – in the household, business, external and government sectors.

The question, then, is where expansion will come from.

In the first quarter of this year, the principal offset to fiscal contraction was the declining household surplus.

What is needed, as well, is a big swing towards surplus in the US current account or a jump in corporate investment, relative to retained profits. Neither seems imminent, though the second seems more likely than the first. The worry is that the only way to balance the economy will be via big new bubbles.

If so, this is not the fault of the Fed. It is the fault of structural features of the domestic and global economies that shaped the pre-crisis excesses, hampered the recovery and threaten the sustainability of future growth.

Broadly speaking, the Fed has done the right thing in trying to bring the US and world economies through the crisis. It deserves praise. But the persistence of the global imbalances and the huge surpluses of the corporate sector will combine to make achieving a strong and sustained recovery difficult.

The central bank cannot fix such problems. It can only do what it can. In the US, at least, it has done so. – (Copyright The Financial Times Limited 2013)

martin.wolf@ft.com

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