It is popular in some quarters to point the blame for the present turbulence of the financial markets squarely on Keynesian intervention, most especially on central banks and governments living beyond their means.
As we will show, there are at least four reasons why this is nonsense.
Private, not public excess
A sea of debt, even we have warned of it, does not make for a pretty picture:
However, one should realize that the culprit behind financial crisis is usually private, rather than public debt. Here is the FT:
In an update of work on debt and deleveraging, McKinsey notes that between 2000 and 2007, household debt rose as a proportion of income by one-third or more in the US, the UK, Spain, Ireland and Portugal. All of these countries subsequently experienced financial crises. Indeed, huge increases in private sector credit preceded many other crises: Chile in 1982 was an important example of this connection. Ruchir Sharma of Morgan Stanley argues that the 30 most explosive credit booms all led to a slowdown, often a crisis. Thus, in seeking new vulnerabilities, we need to look for economies that have had sharp rises in private debt.
That doesn't mean we're not worried about the increase in levels of public debt, but financial crisis in developed countries are usually caused by excess private debts. Public debt only really becomes a problem when countries borrow in another currency.
The latter occurs in two types of situations:
- Developing countries with weakly developed domestic bond markets.
- Developed countries which are members of a currency union.
This is why developing countries have been getting in trouble (Argentina, etc.), although private debts can also play a big role (like in the Asian crisis of the mid-1990s).
It's why so many eurozone countries are in trouble, most especially Italy, which we still consider as one of the biggest threats in the world economy (see here for the reasons).
These countries borrow in euros, a currency over which they have no control and as a consequence, they are largely sitting ducks. As we showed in detail, unlike countries with their own currency, when money leaves a eurozone member monetary conditions tighten.
Central banks dunnit
Central banks are usually the sole culprit for Austrian inspired economists like Edward Pinto, Peter Schiff, David Stockman, or ZeroHedge. The argument is that they are way too loose with monetary policy, which leads to a credit explosion and subsequent asset bubbles.
Many of the authors just mentioned often rail especially against the Fed, in no uncertain terms. There are a number of points one can bring against this kind of analysis:
- Austrians have a great faith in markets, it is odd that markets can be so completely manipulated by just one administered price.
- The Fed has much less control over interest rates than is assumed. It has control over the short end, but not over lending standards or the longer end of the yield curve.
- Interest rates are low even in absence of the Fed due to a world savings glut.
Let's start with the latter, as that's fundamental. Basically there is a world savings glut stemming from demographics (baby boomers starting to save for their pensions by the turn of the century), the falling cost of capital goods and the accumulation of forex reserves by Asian countries, Germany and oil exporters.
This produces a situation of low bond yields, as much of these savings were recycled into U.S. Bonds. So interest rates are low even in the absence of central banks:
A credit explosion takes more than just low interest rates; it invariably involves many banks loosening lending standards. This is exactly what happened during the housing boom in the first decade of the century.
Many banks and financial institutions were able to get risky mortgages off their balance sheets by repackaging them into inscrutable tradable securities.
This practice turned the mortgage business into a volume business, where almost anyone with a pulse was able to get a mortgage. And many banks abnegated from their prime economic function, the assessment of credit risk.
Rising house prices provided growing collateral for a further expansion of credit. The rest is history.
So the most that can be said is that central banks enabled the credit explosion, but much of it would have happened anyway considering the secular fall in interest rates and the loosening of lending standards.
And then again, one wonders what alternative central banks had, especially given the low inflation.
Should central banks have tightened monetary policy in the face of low inflation, just because of fears of an asset bubble? This presupposes three things:
- That central banks can correctly identify asset bubbles way before they burst.
- That they would be willing to unleash monetary tightening to curtail speculation, taking lower growth as a necessary collateral.
- That central banks do not have alternatives to deal with asset bubbles.
The first is highly contentious, in our view. But even if central banks are able to correctly identify asset bubbles before they burst (making them smarter than markets, rather at odds with the Austrian view, ironically enough), should they tighten policy?
Basically, should central banks tighten policy to reign in Wall Street?
One could answer affirmatively if three conditions are met:
- That central banks can successfully identify bubbles before they burst.
- That the cost of not tightening policy in order to deflate a bubble is higher than the cost of doing so.
- That central banks do not have alternative courses of action.
As we argued, the first is rather controversial. The answer to the second question is probably yes. The cost of asset bubbles bursting expands as those asset bubbles get bigger, so nipping it as soon as possible is less costly, even if the resulting tightening of policy reduces growth.
It's much more difficult to identify bubbles in their early stages of formation. But luckily, there is a much better alternative in the form of so called macroprudential policies.
If there is little inflation it's hard to argue that monetary policy is too loose. Even if asset bubbles are forming, it's better to prevent asset bubbles by other means.
This involves things like limits on leverage, increasing margin requirements, increasing down payments on housing, limiting mortgages in relation to incomes.
This directly attacks the loosening of lending standards, rather than having to increase interest rates and slowing down economic growth even when inflation is well behaved.
After all, until the 1980s, the U.S. didn't really experience a major financial crisis; only when financial deregulation ensued did the financial system become less stable.
Here is Bridgewater's CEO Ray Dalio, with a familiar sentiment:
He's also worried about the effectiveness of monetary policy right now. He wonders whether it can do anything to spur growth.
Indeed. Even a simple Keynesian take is that monetary policy becomes near powerless when interest rates are at the zero lower bound (ZLB). The LM curve simply becomes horizontal and people keep holding cash.
Keynes himself famously compared this to pushing on a string. Richard Koo of Nomura added another element to this. In his view household balances were so damaged because of the housing crash that people preferred to repay debt rather than borrow more, no matter how low interest rates got.
Whilst monetary policy becomes nearly impotent under these conditions, fiscal policy becomes much more powerful, for a couple of reasons:
- Governments can borrow very cheaply under these conditions and there is little to no upward push on interest rates (despite many dire warnings over the past years) as long as substantial output gaps exist.
- Persistent large output gaps ultimately reduce potential growth through hysteresis effects. Unused capital deteriorates and reduces incentives to replace, affecting both the quantity and productivity growth of existing capital stock. The long-term unemployed lose skills and motivation, and get discriminated against. Using fiscal expansion to reduce the output gap reduces these corrosive effects, not only on production today, but on future production capacity growth.
This is not just theory, but born out in real life. Even the IMF had to conclude that under these circumstances fiscal multipliers are much larger than previously thought. Here is then head IMF economist Olivier Blanchard:
The main finding, based on data for 28 economies, is that the multipliers used in generating growth forecasts have been systematically too low since the start of the Great Recession, by 0.4 to 1.2, depending on the forecast source and the specifics of the estimation approach. Informal evidence suggests that the multipliers implicitly used to generate these forecasts are about 0.5. So actual multipliers may be higher, in the range of 0.9 to 1.7.
So the simple truth is that in Keynesian models monetary policy is nearly powerless, while fiscal policy becomes more powerful under the conditions of zero lower bound and/or in a period of deleveraging.
Richard Koo of Nomura has even been rather hostile to the use of monetary policy. Yet Austrians like Schiff and Stockman continue to blame everything on the expansion of central bank balance sheets, and continue to call that Keynesian folly.
They also argue that the end of the balance sheet expansion will bring some sort of economic collapse, as the recovery has been 'artificial.'
Well, the 14 million private sector jobs that have been created since the recovery don't feel artificial, and we're sure most people who manage to get these jobs are pretty happy...but anyway.
The bigger point is that most academic research (and here) has shown that QE has had only a mildly positive effect on the real economy. It's therefore odd to expect some collapse now that this has ended.
The one area where the Austrians make sense is to warn against the towering debt levels all around the world, even if putting all the blame on central banks is rubbish. But one can go overboard, as Stockman does:
At the towering levels of debt which exist in the world today, however, borrowing does not create new wealth; it only mortgages future income.
He is speaking of peak-debt and argues that the household and business spending it financed cannot be sustained and this will lead to losses and write-offs, and a wave of deflation.
Yes, probably at least some of it. But borrowing can't create new wealth? We should then basically abolish banks and other financial intermediaries, and the bond markets. This is clearly nonsense.
Borrowing can actually create new wealth, as long as the returns on the projects the money is invested in surpass the cost of borrowing. The income so generated will be spent, generating secondary effects; it can clearly generate wealth.
Apart from these demand dynamics, borrowing, for instance to improve education or infrastructure or research can boost productivity and thereby potential supply.
But of course projects can also fail. This is the market, where perfect foresight does not exist. One assumes that risks will be assessed in a responsible manner, by people with a stake in the game, but this isn't always the case, as we already explained above with the housing example.
Stockman rails especially against China, arguing it's a Ponzi scheme about to crash when debt has increased 60 times since 1995. However:
- Almost all of that debt is internal; for every debtor there is a creditor.
- Over the same 20 year period, China has manifestly created wealth; the country has changed beyond recognition.
That doesn't mean we don't worry about these debt levels; we do. Not only about the levels, but the quality of the debt as well, as it happens. For sure there will have to be restructuring of overcapacity in many industries, and there will be substantial write-offs.
While that process could very well slow Chinese growth further, most of the results of that debt binge will remain in the form of whole cities, dozens of airports, underground networks, infrastructure, the longest high-speed rail network in the world by far, an untold number of millionaires and billionaires, world-class companies, etc.
Lest we forget, it has also lifted hundreds of millions of people out of dire poverty - one of the biggest, and surely the fastest transformation in history. China wasn't, and isn't, immune to the laws of economics, and it will surely have problems and slowdowns and even recessions, but it isn't about to collapse. Ponzi scheme really is a misnomer.
It's also curious to see that after the 2008 crash and the monetary expansion, many Austrians were warning against hyperinflation (or currency debasement), a bond market crash and a dollar crash.
Nothing of that has happened; in fact, quite the contrary. Inflation is below the Fed target still, bonds are very high and the dollar has gained against almost all currencies in the world.
So now they are worried about deflation rather than inflation. At least that's the correct worry, even if the diagnosis and the model leaves much to be desired.
Austrians, who have great faith in the market system, nevertheless confer mythical powers to central banks. By only varying short-term interest rates or the size of their balance sheets, they can unleash a wave of credit creation leading to, in Austrian view, a wave of unproductive investments.
All the actors in between, working in those efficient financial markets assessing credit risks and investment returns, deserve no blame; they're merely extensions of almighty central banks.
When central banks push the button, they follow and unleash the next wave of credit and bubbles. We thought markets always knew best.
The funny thing is, the Austrians exhort central banks to rein in the credit before any bubble even has a chance. But this picture presupposes an all-knowing central bank, and obedient financial markets.
Of course, many Austrians want to abolish central banks altogether (as well as any other active public intervention in the business cycle). Instead, we would rely on that mythical Wickselian interest rate that equates savings and investment and the problem would be solved.
But economic cycles existed prior to central banks, and those Wickselian interest rates are not independent of income (this is the innovation of the Keynesian LM curve); and low interest rates can come from structural factors rather than from central banks.
It is, for instance, entirely possible for credit to generate additional income. Since part of that is saved, it also generates additional savings.
As we discussed above, there are reasons to assume that these effects are particularly strong under the present circumstances (deleveraging and/or zero lower bound), and this is borne out by research.
Exactly for those reasons, Keynesians would much prefer the use of fiscal, rather than monetary policy. So it also misses the mark to blame central bank excesses on Keynesianism.
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