In the period of low interest rates and low inflation after the 2008 financial crisis, fiscal and monetary policies underwent a radical reassessment. But now that macroeconomic and financial conditions may be changing once again, the reassessment will have to be reconsidered.
CAMBRIDGE – The long era of ultra-low interest rates that began after the 2008 financial crisis has led to a significant reassessment of monetary and fiscal policy. Should the sharp, global increase in inflation call into question policy recommendations that were shaped largely by events of the past 15 years, rather than by longer experience? One might think so, even if neither mainstream economic forecasters like the International Monetary Fund nor financial markets seem to be anticipating much of a shakeup to the status quo. I am not so sure.
Everything comes down to one’s confidence that “lower for longer” real (inflation-adjusted) interest rates actually means “lower forever.” If real interest rates are negative (the short-term real interest rate in the United States as of this spring was an incredible -5%), private creditors are effectively willing to pay governments for the privilege of lending. Under these conditions, governments can be far more aggressive with fiscal policy, because they don’t have to worry about jeopardizing their ability to react to future crises, much less creating a genuine debt problem.
Moreover, the argument that average long-term growth rates are reliably higher than average interest rates paid on government debt implies that any level of debt relative to income is sustainable. If one genuinely believes this, governments can therefore use deficits with abandon to fight recessions and crises, because they no longer need to worry about reducing the debt in good times to prepare for the next downturn.
Regardless, while ultra-low interest rates appear to empower fiscal policy, they have the opposite effect on monetary policy. There is little question that central-bank independence has suffered over the past 15 years. If the current inflation is reined in and real interest rates remain low, the “neutral” monetary policy interest rate will remain near zero most of the time, depriving central banks of their main policy instrument.
Yes, there is still the option of quantitative easing (QE). But as I argued in my 2016 book The Curse of Cash, central banks’ purchases of government bonds are effectively smoke and mirrors. Consolidating the balance sheets of the government and the central bank merely shortens the maturity structure of government debt held by the public (including bank reserves). While this can certainly drive down long-term interest rates in practice, the effects appear to be quite small.
There is still plenty for central banks to do during crises (and we have had a lot of those lately). In particular, they can serve as market makers of last resort, intervening to prevent private markets from collapsing, as the US Federal Reserve did during the global financial crisis and again during the COVID-19 pandemic. The European Central Bank has done the same; and because its debt is effectively joint and several among its members, its QE serves as a vehicle for northern eurozone countries to guarantee debt in the periphery.
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But during the intervals between crises, progressives often seek to repurpose central banks to achieve political aims that are difficult to push through a divided government. Hence, in recent years, there has been intense pressure on central banks to fight climate change and inequality. These are both worthy goals, but the instruments with which central banks might pursue them are quite weak.
For example, the demand that central banks should force commercial banks to show that their loan books are resilient against decades-long climate trends is political theater, and an extremely poor substitute for, say, a sufficiently high carbon tax. Even if interest rates remain ultra-low, fiscal authorities should take the lead in these areas; they have both more political accountability and more effective policy options.
These are hardly the only problems with the “new view” that has emerged over the past 15 years. Another is the idea that fiscal policy can be used in a neutral, technocratic way to counteract recessions. This has proven to be ludicrous. The $1.9 trillion US stimulus package in March 2021 did exactly what the late Chicago School economist Milton Friedman would have predicted: it generated a significant increase in inflation, which the Fed, under considerable political pressure, was too slow to counteract. (Had the US stimulus been only half as large, with the rest going to fund a World Carbon Bank to help low-income countries launch a green-energy transition, almost everyone would have been better off.)
Similarly, proposals for automatic stabilizers to take politics out of the equation are interesting but unrealistic. Most European countries have significantly higher taxes and means-based transfer payments than the US does, but their legislatures routinely override the effects of these policies with supplementary measures whenever they are unhappy with the outcomes. The great triumph of modern monetary policy was to turn decisions about inflation and short-term stabilization policies into a technocratic issue. The push to expand central banks’ remit will draw them back into the political realm, which will make them less effective at fighting inflation, as we have already seen.
One way to restore central banks’ political independence and monetary-policy effectiveness is to raise the inflation target to 3% or 4%, which would relax the zero-bound constraint. But an even better option is for governments to take the steps needed to allow central banks to implement an effective negative interest-rate policy.
The fallout from Russia’s war in Ukraine is yet another reason for a rethink. Governments can no longer exhibit a blasé attitude about debt and deficits during peacetime, given the disappearance of the peace dividend, the risk that deglobalization will undercut growth, and the recognition that fiscal space must be preserved for urgent national-defense expenditures.
After so many recent shocks, the smug certainty that real interest rates will remain negative forever has become untenable. Major realignments in the global economy can lead to unpredictable consequences. The post-2008 maximalist view of macroeconomic policymaking must place greater weight on resilience.
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CAMBRIDGE – The long era of ultra-low interest rates that began after the 2008 financial crisis has led to a significant reassessment of monetary and fiscal policy. Should the sharp, global increase in inflation call into question policy recommendations that were shaped largely by events of the past 15 years, rather than by longer experience? One might think so, even if neither mainstream economic forecasters like the International Monetary Fund nor financial markets seem to be anticipating much of a shakeup to the status quo. I am not so sure.
Everything comes down to one’s confidence that “lower for longer” real (inflation-adjusted) interest rates actually means “lower forever.” If real interest rates are negative (the short-term real interest rate in the United States as of this spring was an incredible -5%), private creditors are effectively willing to pay governments for the privilege of lending. Under these conditions, governments can be far more aggressive with fiscal policy, because they don’t have to worry about jeopardizing their ability to react to future crises, much less creating a genuine debt problem.
Moreover, the argument that average long-term growth rates are reliably higher than average interest rates paid on government debt implies that any level of debt relative to income is sustainable. If one genuinely believes this, governments can therefore use deficits with abandon to fight recessions and crises, because they no longer need to worry about reducing the debt in good times to prepare for the next downturn.
Regardless, while ultra-low interest rates appear to empower fiscal policy, they have the opposite effect on monetary policy. There is little question that central-bank independence has suffered over the past 15 years. If the current inflation is reined in and real interest rates remain low, the “neutral” monetary policy interest rate will remain near zero most of the time, depriving central banks of their main policy instrument.
Yes, there is still the option of quantitative easing (QE). But as I argued in my 2016 book The Curse of Cash, central banks’ purchases of government bonds are effectively smoke and mirrors. Consolidating the balance sheets of the government and the central bank merely shortens the maturity structure of government debt held by the public (including bank reserves). While this can certainly drive down long-term interest rates in practice, the effects appear to be quite small.
There is still plenty for central banks to do during crises (and we have had a lot of those lately). In particular, they can serve as market makers of last resort, intervening to prevent private markets from collapsing, as the US Federal Reserve did during the global financial crisis and again during the COVID-19 pandemic. The European Central Bank has done the same; and because its debt is effectively joint and several among its members, its QE serves as a vehicle for northern eurozone countries to guarantee debt in the periphery.
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At a time of escalating global turmoil, there is an urgent need for incisive, informed analysis of the issues and questions driving the news – just what PS has always provided.
Subscribe to Digital or Digital Plus now to secure your discount.
Subscribe Now
But during the intervals between crises, progressives often seek to repurpose central banks to achieve political aims that are difficult to push through a divided government. Hence, in recent years, there has been intense pressure on central banks to fight climate change and inequality. These are both worthy goals, but the instruments with which central banks might pursue them are quite weak.
For example, the demand that central banks should force commercial banks to show that their loan books are resilient against decades-long climate trends is political theater, and an extremely poor substitute for, say, a sufficiently high carbon tax. Even if interest rates remain ultra-low, fiscal authorities should take the lead in these areas; they have both more political accountability and more effective policy options.
These are hardly the only problems with the “new view” that has emerged over the past 15 years. Another is the idea that fiscal policy can be used in a neutral, technocratic way to counteract recessions. This has proven to be ludicrous. The $1.9 trillion US stimulus package in March 2021 did exactly what the late Chicago School economist Milton Friedman would have predicted: it generated a significant increase in inflation, which the Fed, under considerable political pressure, was too slow to counteract. (Had the US stimulus been only half as large, with the rest going to fund a World Carbon Bank to help low-income countries launch a green-energy transition, almost everyone would have been better off.)
Similarly, proposals for automatic stabilizers to take politics out of the equation are interesting but unrealistic. Most European countries have significantly higher taxes and means-based transfer payments than the US does, but their legislatures routinely override the effects of these policies with supplementary measures whenever they are unhappy with the outcomes. The great triumph of modern monetary policy was to turn decisions about inflation and short-term stabilization policies into a technocratic issue. The push to expand central banks’ remit will draw them back into the political realm, which will make them less effective at fighting inflation, as we have already seen.
One way to restore central banks’ political independence and monetary-policy effectiveness is to raise the inflation target to 3% or 4%, which would relax the zero-bound constraint. But an even better option is for governments to take the steps needed to allow central banks to implement an effective negative interest-rate policy.
The fallout from Russia’s war in Ukraine is yet another reason for a rethink. Governments can no longer exhibit a blasé attitude about debt and deficits during peacetime, given the disappearance of the peace dividend, the risk that deglobalization will undercut growth, and the recognition that fiscal space must be preserved for urgent national-defense expenditures.
After so many recent shocks, the smug certainty that real interest rates will remain negative forever has become untenable. Major realignments in the global economy can lead to unpredictable consequences. The post-2008 maximalist view of macroeconomic policymaking must place greater weight on resilience.