Unconventional Thinking about Unconventional Monetary Policies

By Barry Eichengreen

KONSTANZ – The policy interest rates of advanced-country central banks are stuck at uncomfortably low levels. And not just for the moment: a growing body of evidence suggests that this awkward condition is likely to persist. Inflation in the United States, Europe, and Japan continues to undershoot official targets. Measures of the “natural” rate of interest consistent with normal economic conditions have been trending downward for years.

Estimates of the natural rate for the US currently put it in the range of 2.25-2.5% – in other words, just where the Federal Reserve’s policy rate is lodged. This means that the Fed has little scope for tightening without missing its inflation target and endangering economic growth. And what is true of the Fed is truer still of the European Central Bank and the Bank of Japan.

This ceiling on the feasible level of interest rates means that when the next recession hits, central banks will have little scope for reducing them. To be sure, certain creative members of the central banking community have experimented with negative interest rates. But scholarly post-mortems suggest that negative rates adversely affect commercial banks’ profitability and weaken the banking system. It follows that risk-averse central bankers will be loath to repeat these experiments.

Thus, when the next recession hits, central banks will again be forced to resort to quantitative easing. QE4, if we can call it that, will elicit howls of protest from the critics of previous rounds of QE, who warned that central banks were exceeding their mandates. By purchasing mortgage-backed securities and corporate bonds, the detractors complained, central banks were distorting financial markets. By engaging in maturity-extension operations, they were destroying the information content of the yield curve. By expanding their balance sheets, they were exposing themselves to the risk of capital losses.

Disapproving politicians questioned whether central bankers could be entrusted to carry out this expanding range of transactions without “adult supervision” by the public’s designated representatives, namely themselves. It followed, as sure as night follows day, that central banks’ independence came under increasingly hostile political attack.

The lesson drawn by those who set great store by central-bank independence is that QE should have been avoided last time and is best avoided in the future, because it opens the door to political interference with the conduct of monetary policy.

But QE’s opponents should consider the alternative. Absent this support from advanced-country central banks following the global financial crisis, a debilitating deflation might have set in, and the post-crisis recession would have been more severe. What would the critics have said then? It seems unlikely that central-bank independence would have survived the even more damning accusation, justified in the event, that monetary policymakers were asleep at the switch.

Another criticism of QE, especially prevalent in Europe, is that it creates moral hazard for governments. Central banks’ purchases of government securities artificially depress the cost of borrowing. Normally, governments issuing additional debt see their borrowing costs rise, which discourages them from overdoing it. In particular, market discipline in the form of higher interest rates will cause a government like Italy’s, tempted to increase deficit spending, to think twice. Not so, however, when the central bank acts as bond buyer of last resort and is prepared to purchase government securities without limit. In such circumstances, market discipline will be incapacitated.

Populist leaders predisposed to ignore budget constraints and promising lavish transfers to their constituents will then have more room to run. The economy will experience an immediate sugar high as a result of the additional public spending, solidifying support for the political incumbents. But, as the American economist Herbert Stein famously observed, something that can’t go on forever ultimately won’t. In the long run, either debt default or debt monetization and inflation will inevitably result from populist profligacy.

It is better, the implication follows, for central banks to resist the siren song of QE. Governments will then feel pressure to live within their means. If populist leaders nevertheless implement their characteristically irresponsible fiscal policies, financial markets will take them to task. If investors sell off massively on the populists’ watch, their political support will collapse.

Again, however, one must consider the alternative. If central banks shun QE in the next downturn, the resulting output collapse will be more severe. Populist politicians, arguing that mainstream leaders and their appointees are not reliable stewards of the economy, will have more evidence to invoke and more anger to channel when they campaign for office. With populists heading more governments, budget deficits will be larger, not smaller. Instability will be greater, not less.

The critics of QE are right to warn of unintended consequences. But shunning QE may have unintended consequences as well. The critics should be careful what they wish for.

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Eichengreen is Professor of Economics at the University of California, Berkeley. His latest book is The Populist Temptation: Economic Grievance and Political Reaction in the Modern Era.