How to Fix Monetary Policy in Advanced Countries

Yves here. Readers may recall that William White, who was a senior BIS economist in the runup to the crisis, was (with fellow BIS economist Claudio Borio) early to warn central bankers that housing bubbles were underway in many advanced economies. Alan Greenspan blew him off in meetings presenting these findings, which gave other central bankers to do so as well.

Here he gives a useful description of how central bank use of monetary policy has gone off the rails and how it needs to be refocused on the financial system, and downgraded as a tool for managing the economy generally. He also recommends financial system reforms, most of which (like more modularity in the financial system) were also advocated right after the financial crisis but were ignored.

By William White, formerly Economic Adviser at the Bank for International Settlements and Chair of the Economic and Development Review Committee at the OECD. Originally published at the Institute for New Economic Thinking website

The objective pursued by most central banks in recent decades has been a low level of inflation. Since inflation was believed to respond to changes in unemployment, this implied a primary focus on labor market and output gaps in the “real” economy when setting monetary policy. In contrast, “financial” sector developments were thought to be of no great importance in setting the instruments of monetary policy.

My new INET Working Paper argues that the setting of monetary policy should be guided much more by financial sector developments and much less by near-term targets for inflation. The pursuit of stable prices remains important, but policy should focus on success over a much longer time period than the two-year horizon that has become fashionable in recent decades.

Perhaps the most effective way of showing the need for fundamental monetary reform is to point out the negative implications of the monetary policies followed by the major central banks in the advanced economies over the last few decades.

First, the general adoption of a positive (+2%) inflation target has prevented the downward adjustment of prices that would be the natural product of increases in productivity and positive supply shocks. As a result, prices have been drifting upwards (and significantly) for decades. Second, the recurrent use of monetary easing to spur demand and raise inflation becomes increasingly ineffective, inviting an ever-stronger policy response that could eventually work but might well prove hard to control. Third, stimulative monetary policy has had a variety of unintended and unwelcome consequences. Fourth, as the threat posed by these unintended problems has cumulated over time, “exit” and the “renormalization” of policy has become ever harder to achieve.

To sum up, the current monetary framework has trapped us on a path we do not wish to follow because it leads inevitably to ever bigger problems. This is why fundamental reform is needed.

These developments occurred because central bankers in the advanced economies generally shared a set of “false beliefs.” They overestimated the need for easy money. They overestimated its effectiveness in stimulating aggregate demand. They underestimated the unintended consequences. And, finally, they underestimated how difficult it would be to exit from such policies.

The need for monetary stimulus, the dominant stance of policy over the last two decades and more, has been the need to respond to levels of inflation that have persistently failed to achieve target levels. An associated concern was that low inflation might inadvertently slip into outright deflation and depression. In fact, the last few decades have been characterized by large, positive supply shocks in the global economy that led to the persistent downward pressure on prices. There is a large, now largely forgotten, literature that suggests these initial price declines should have been allowed to happen. Admittedly, if monetary stimulus induces an increase in both public and private debt that weighs on future spending, the need for stimulus becomes ever greater. However, this is a need that was ultimately created by monetary policy itself.

John Maynard Keynes, in the General Theory (1936) warned against the effectiveness of the expansionary monetary policies that he himself had recommended in the Treatise on Money (1930). Indeed, plausible arguments support the view that low interest rates might not stimulate either consumption or investment. Perhaps even more important, the effectiveness of monetary stimulus declines with repeated use as debt levels rise. That is, there is a fundamental intertemporal inconsistency, the feedback effect once referred to by Alan Greenspan as “headwinds.” Given the now highly elevated level of global debt ratios, these “headwinds” have now taken on “gale-force” strength.

The unintended accumulation of debt is perhaps the most important of the unintended consequences of monetary stimulus but by no means the only one. Recently, a great deal of attention has been paid to the rise of inflation and the role that expansionary monetary and fiscal policy during the pandemic might have contributed to this. This current concern is warranted, even if the primary cause was pandemic-related supply shortages. However, other unintended consequences have been cumulating without notice for years; credit-induced “booms and busts,” potential financial instability, fiscal unsustainability, a progressive loss of central bank “independence,” growing inequality of wealth and opportunity, and a slower growth rate of potential output. The great danger now is that these cumulative stresses have made the economy less resilient to the added stress of tighter monetary policy.

These underlying weaknesses, the unintended consequences of past monetary policy decisions, are at the heart of the exit problem today. In this regard, fears of financial instability in the private sector and fiscal unsustainability in the public sector should and will weigh on policy decisions. Moreover, looking forward, the trade-off between allowing higher inflation, and the dangers of resisting it, are likely to become much worse as positive supply shocks in the past are replaced by negative shocks in the future.

Given all the difficulties that have arisen from the use of the current monetary policy framework, there would seem to be a strong case for looking at alternatives. In identifying alternatives, an important initial observation is that an economy is not a simple, deterministic system as current economic models suppose. Rather, an economy is a complex, adaptive system, like many others in nature and society that have been well studied by other disciplines. One of the many insights provided by embracing the concept of complexity is that structure matters (e.g., building in modularity and redundancy improves stability) and structures can be changed by policy. Unnecessary complexity should be stripped out. From this complexity perspective, arguments for introducing a “narrow money” regime need much more serious attention. Moreover, with many central banks now studying the possibility of introducing a central bank digital currency, the timing would also seem right for further investigating this possibility.

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  1. The Rev Kev

    ‘The objective pursued by most central banks in recent decades has been a low level of inflation. Since inflation was believed to respond to changes in unemployment, this implied a primary focus on labor market and output gaps in the “real” economy when setting monetary policy. In contrast, “financial” sector developments were thought to be of no great importance in setting the instruments of monetary policy.’

    So if I am reading that right, when economic problems occur the first response is to reduce wages or increase unemployment to “stimulate” the economy but when it comes to the financial sector, it is basically a case of let the money and credit flow because it will be always good for the economy. You wanna fix the later, then it is time to make stuff illegal like it was in the past – like companies being allowed to do stock buyback and regular and investment banks being combined. It would be a start. And make banking boring again.

    1. aj

      I always thought that the prescription to inflation being lower wages and higher unemployment was nonsensical. It fails any test of morality on first principles alone. If your solution to a broken economy is to kick a bunch of people out of it, it’s my prerogative to not take anything you say seriously.

    2. some guy

      These exact things were done during the New Deal period. Then they were exactly reversed and erased during the Anti New Deal period.

      A New Deal Revival Party, under whatever name, could run on re-doing and re-establishing these exact same things again. Plus some punitively corrective action to make the Anti New Deal upper class somewhat less upper. Less upper enough that they don’t ever again have the power to undo it again.

  2. podcastkid

    Question from unlearned dept: What does “building in modularity and redundancy improves stability” mean?

    1. Kevbot9000

      For modularity think standardized containers for global shipping instead of what came before. Redundancy is having backups or enough slack so when things go wrong the whole system doesn’t seize up. The idea of tight versus loose coupling has come up here more than once and is the same vein, I always think of it as the difference between efficiency and efficacy. Stability results from shocks being absorbed by the redundancy and ease of replacement/access/whatever provided by modularity. In the financial setting my best guess is standardized products (no new takes on CDOs or CDS’ or other ways to slice and dice debt) would be the modular approach. Redundancy I can’t come up with anything other than less leverage or required cash reserves in this context. I might be missing the point in a financial context in which case I’m joining you in the unlearned department.

  3. James T.

    I think monetary policy should simply ensure there is enough capital for the economy to operate and generally stay out of making decisions on how to correct economic downturns. Unfortunately, the economists of today took one part of Keynes ideas to stimulate growth in the downturn but forgot the 2nd part which was to pay the debt back during the growth periods. This was supposed to be on the fiscal side but with the Fed just buying the debt it has become integrated. It seems as if this has led to a need to always stimulate every few years to keep the system afloat. If the dollar is truly not replaceable then this works fine for the US and the rest of the world just has to deal with volatility but if ever in the future the dollar is not king then the spiral downward will be severe. Or at least that is my opinion :)

  4. Altandmain

    This is a very roundabout way of saying that the central banks are trying to keep finance rich and ordinary people down.

    Essentially the ruling class has done the opposite of what they should be doing. Money is being transferred from the real economy to rent seeking finance. That’s central bank policy. Easy money has also led to dangerous speculation that results in economic decline when the bubble is destroyed.

    The inflation 2 percent target is the same. It serves the rich. Ultimately if we have a system that served the people, it would be a public banking system that is designed to help the real economy and works with tax policy to discourage rent seeking.

    That’s going to involve a showdown with the rich to do.

    1. Nevermore

      By now it should be obvious that what we call democracy is but a smoke screen for the rich, effectively we have a plutocracy.
      So the ruling class did what it was expected to do.
      The problem with the showdown with the rich is that they might win again. Being smaller in numbers they have less difficulty to stay united and be organized, contrary to the plebs.

      1. some guy

        How much more could they win by winning a “showdown” than what they have won already? In other words, if the Lower Class Majority has already lost everything, what more can it lose if it could somehow engineer a showdown with the rich?

  5. David in Friday Harbor

    Cui bono?

    Back in 2020 Laurie Macfarlane reported in Open Democracy that the number of U.S. billionaires had grown from 66 in 1990 with an inflation adjusted net worth of $240B to 640 in 2020 with a net worth of $3 Trillion, an 1130% increase in net worth against a median household worth growth of 5% during the same time period.

    The Wealth-X Billionaire Census 2023 reports that there are now 955 U.S. billionaires, outranking #2 China’s 357 and #3 Germany’s 173 by a country mile.

    Everything is going according to plan.

  6. lyman alpha blob

    I would make one small change in your intro Yves, and I’m sure you’re well aware of what I’m getting at. Where it says “…it needs to be refocused on the financial system, and downgraded as a tool…”, I would replace “a” with “the” since currently it’s about the only tool on offer.

    Good to know at least one person in the industry is calling this out. As the author notes, “…plausible arguments support the view that low interest rates might not stimulate either consumption or investment”, and I would put housing costs as something lowering rates doesn’t do much to correct. Low rates simply mean loans are cheaper, and then the assumption is built in that people can afford higher principle payments, and prices rise. With today’s rising interest rates, housing prices are going down, however home buyers now have greatly increased interest payments so overall are buyers really better off? I would argue not, since there have been multiple studies over many years showing the average citizen is paying much more for housing as an overall percentage of income.

  7. Susan the other

    I think White is saying get rid of the debt and construe some good industrial policy, but he also seems to say that complexity is both a stabilizer and a destabilizer and much depends on eliminating the destabilization. Which is horrifying because we want to let the “Market” make all the difficult decisions and the market probably won’t do that until all the oxygen has been burned up. At which point it will advise us to stockpile cans of oxygen. That’s how stupid the market is. When capitalism reaches critical mass it’s too late. So when White recommends the use of “narrow money” to stabilize monetary policy and create a culture of resilience he almost by definition has to be thinking in terms of money that represents resilience, which imo means money that represents a properly protected and maintained environment-civilization…. Which, of course, requires sufficient funding. Money well spent.

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