This is the first of two parts.
The Four Great Errors
The error of the confusion of cause and effect
The error of false causality
The error of imaginary causes
The error of free will – The Twilight of the Idols, Friedrich Nietzsche
IN 1951 Deutsche Bundesbank was the first central bank to be made independent of government control. In 1962 Milton Friedman suggested best practice might be to separate monetary policy from political control. As inflation accelerated through the 1970s and 1980s (see chart) the case for a new approach to monetary policy became more compelling. By the early 1990s there was a widespread trend toward governments handing control of monetary policy to their central banks. Independent central banking, with committees of experts regularly adjusting interest rates to control inflation, is now the accepted best practice for monetary policy.
The move to independent monetary policy was immediately considered a success. As inflation and interest rates began falling through the 1990s, confidence in the new regime grew. From the 1990s onwards, falling inflation and falling interest rates fuelled a golden age of economic expansion dubbed ‘The Great Moderation’ in 2004 by then Fed Governor Ben Bernanke. Alan Greenspan, the Fed Chairman from 1987 to 2006, presided over this success, becoming a revered celebrity; his biography was titled Maestro. In a 2004 speech, ‘Risk and Uncertainty in Monetary Policy’, Greenspan explained how he had engineered the American boom by implementing what he called his ‘risk management paradigm’. This involved an active interventionist approach to monetary policy aiming to pre-emptively head off any impending recessions.
The end of Greenspan’s tenure as Fed Chairman was followed almost immediately by the Global Financial Crisis (GFC) of 2007-2009. Initially this led to some introspection over both the validity of economic theory and the success of the Fed’s approach to monetary policy. In a 2008 testimony to Congress, Greenspan talked of having discovered a ‘flaw in the system’ while in 2009 Paul Krugman asked ‘How Did Economists Get It So Wrong?’ To many, it appeared the Fed’s policies had encouraged the excessive leverage which caused the crisis. However as the crisis evolved the Fed worked with the Treasury to enact even stronger monetary policy interventions, most notably the Troubled Asset Relief Program or TARP, to counteract the worst effects of the crisis. These interventions were seen as triumphs for successfully resolving the crisis. As a result, the community of central bankers emerged from the crisis not chastened by having caused it but emboldened by their successes in fixing it. The 2012 cover of The Atlantic, featuring then Fed Chairman Ben Bernanke, captured the prevailing mood well.
The GFC itself required a sharp lowering of interest rates to help the private sector deal with its bad debts and the state sector to service its higher borrowing requirements. To the surprise of many, the lowering of interest rates and printing of money, required to fund the various support programmes, did not generate higher inflation. Instead, inflation remained stubbornly low after the crisis and policymakers even began fretting about the possibility of the economy sliding into a 1930s style debt-deflation trap. To counteract this new threat, central banks continued pushing interest rates ever lower, their aim being to stimulate extra consumer demand which was expected to push inflation higher.
By the end of 2008 the Fed had cut its base interest rate to almost zero, where it remained until the end of 2015. Other central banks became even more experimental with their post-crisis interest rate policies, daring even to lower them into negative territory. There was much debate ahead of these moves as to whether negative rates were practically possible. Nevertheless, in 2012 the Danish Central bank introduced negative interest rates, followed by Switzerland at the end of 2014, Sweden in 2015 and Japan in 2016. These ultra-low interest rates filtered into the longer-term bond markets. By 2019 there was an estimated $16trillion worth of bonds trading with negative interest rates. For the first time in history lenders were paying interest to borrowers. In May 2020 Nestlé became the first corporate to issue a bond with negative interest rates.
By 2015 the US was able tentatively to edge away from its zero per cent interest rate policy (ZIRP) but other central banks remained seemingly trapped at what was called the zero per cent lower bound. In 2020, as governments and central bankers were working to fund the cost of lockdown, even the Fed was forced to re-join the zero-rate club.
This extended period of quiescent inflation and ultra-low or negative interest rates fostered new thinking on the part of economists. A remarkable idea emerged suggesting that governments could and should borrow without limit. This idea rapidly gained traction in both academic and policy-making circles under the name of Modern Monetary Theory or MMT. In essence, MMT argued that governments, who borrow in their own currency, can always print their own money to pay their debts. For this reason, they could safely borrow and spend without limit, never needing to worry about default. This idea was a marked shift from previously accepted wisdom that government spending should be kept broadly in line with its tax income, the balanced budget constraint. The only constraint placed on borrowing by MMT was through inflation; the borrowing must stop when inflation became unacceptably high. But with inflation having been so low for so long and seemingly impervious to either persistently low interest rates, or even the massive money printing of the GFC, this constraint was seen only as a remote hypothetical possibility.
Therefore, in early 2020, when fear over the Covid 19 virus suddenly hit, three important conditions were in place:
1. Deflation appeared a greater risk than inflation.
2. MMT said governments could borrow and spend without limit.
3. Capital markets were willing to lend to governments, at low or negative interest rates, seemingly without limit.
Against this backdrop, governments believed they could afford the experiment of shutting down their economies in the hope of curtailing the spread of the Covid-19 virus. In accordance with the logic of MMT, which imposed no limits on government spending, these policies were enacted without cost-benefit analysis.
From today’s conditions of surging inflation, rising interest rates and governments struggling to service their debts, the ideas and financial conditions prevalent just before lockdown seem literally incredible.
In Part 2 I will discuss whether the best monetary policy might be to have no policy.