One of the things we remember most from our days as an economics student is something we heard during our first macroeconomics lecture.
We were shown a chart of world GDP over the past 150 years. It was meant to serve as a reminder of the fantastic advances in growth in a global economy powered by industrialisation, but there was one big blip in this line of progress: the end of the 1920s and the beginning of the 1930s.
After pointing it out, the lecturer said confidently: “But don’t worry, we know how to solve that problem, it won’t happen again.”
The feeling in 2000 when we heard that lecture was that Robert Lucas and the macroeconomic brotherhood had made a shortage of aggregate demand a thing of the past. We knew how to fight another Great Depression.
It was an era where central banks around the world were gaining independence to set interest rates as they saw fit, buffered by doctrine that said for as long as inflation was kept at a low level and exchange rates were flexible, global growth would remain stable. Fiscal policy largely disappeared from the scene, the feeling being that it would need to provide automatic stabilisers to temper booms and busts but not much besides that. As for the banks? Well, they would be held in check by the theory that markets are efficient and that in a monetary stabilised world a financial panic simply would not happen.
The hubris of that world was revealed clearly by the 2008 crisis. And yet, when future economic historians try to pinpoint at what point the hubris became insufferable, they might well choose the Jackson Hole conference during the dying days of the summer of 2019 as a marker of the final nail in the coffin of the old way of thinking.
When we first read Jay Powell’s speech on Friday night, we thought it said little because it did not offer any new information on what the Fed might do next. In fact, that the policy path of the world’s most important central bank is so uncertain spoke volumes about policymakers’ anxiety.
Their angst stems from two overlapping sources.
The first is that in many parts of the world inflation targets haven’t been hit in years and most central bankers understand there is a limited amount of ammunition left to address this. You can (if you are lucky) do a few normal rate cuts. Failing that you can go below the zero bound into negative territory, you can buy more bonds, but at some point your actions become either extremely controversial or are subject to diminishing returns. Or both — so uncharted is the territory that we don’t really know how things play out next.
The second is that they are spooked by the sheer unpredictability of Donald Trump’s behaviour. Central banking is a global club whose members are followers of an academic discipline that often requires its practitioners to suspend disbelief and act as though people and markets are rational. They cannot understand why Trump would impose trade tariffs and challenge central bank independence — both policies which they view not as a zero-sum game, but as destructive to everyone involved. To them he is not only maddening, but simply mad.
Mark Carney’s speech at the forum spoke to both of these problems, and made clear that they both are symptomatic of a far deeper issue: an over-reliance on the dollar that inflation targets and flexible exchange rates can no longer keep in check.
20 years ago, the theme of this symposium was “New Challenges for Monetary Policy”, and my predecessor, Mervyn King, was one of the speakers. His reflections were on the merits of inflation targeting and flexible exchange rates. The applications of his insights have contributed greatly to improved economic outcomes around the world in the intervening years.
But during that same period, the deficiencies of the [International Monetary and Financial System] have become increasingly potent. Even a passing acquaintance with monetary history suggests that this centre won’t hold. We need to recognise the short, medium and long term challenges this system creates for the institutional frameworks and conduct of monetary policy across the world.
The dollar’s dominance of the global economy was a disaster waiting to happen long before Trump, or even the global financial crisis. Its use in trade and finance has for decades massively outweighed the contribution the US makes to global GDP — as illustrated by this chart lifted from Carney’s speech.
When the US is out of sync with the rest of the global economy, the Fed sets interest rates which are inappropriate for borrowers outside the country — but which nevertheless are affected by them. This, in turn, weakens the US economy, further weighing on global growth and so on.
As Carney continued:
There are relatively few fundamental imbalances in terms of capacity constraints or indebtedness that would of themselves portend a recession. However, the combination of structural imbalances at the heart of the [International Monetary and Financial System] itself and protectionism are threatening global momentum. The amplification of spillovers by the IMFS matters less when the global expansions are relatively synchronised or when the US economy is relatively weak. But when US conditions warrant tighter policy there than elsewhere, the strains in the system become evident.
That the system would become as irremediably broken as it has today is definitely not something that our economics professor ever thought was going to happen. Jackson Hole has shown the old certainties have now all but disappeared.
But the new paradigm is far from clear.
China’s grip on the international role of the renminbi has loosened but not to the extent that the currency is widely used in global markets or world trade. The euro does not have afixed-income asset marketas deep and liquid enough as US Treasuries, and a common bond is unlikely to happen anytime soon. Some have mooted a global central banking body to police these overspills and coordinate monetary policy. But we can’t see Trump handing the power to set US interest rates over to a bunch of technocrats in Basel — though if he did, then ironically he might get his wish of lower US borrowing costs. Others, such as Robert Pringle who has written about central banks from more than 40 years, call for a world currency linked to the value of global stocks. Carney wants a digital currency tied to a basket of global currencies — either something like Libra coin, or something issued by global central banks. From his speech (our emphasis):
History shows that the rise of a reserve currency is founded on its usefulness as a medium of exchange, by reducing the cost and increasing the convenience of international payments.
The additional functions of money – as a unit of account and store of wealth – come later, and reinforce the payments motive. Technology has the potential to disrupt the network externalities that prevent the incumbent global reserve currency from being displaced. Retail transactions are taking place increasingly online rather than on the high street, and through electronic payments over cash.
And the relatively high costs of domestic and cross border electronic payments are encouraging innovation, with new entrants applying new technologies to offer lower cost, more convenient retail payment services. The most high profile of these has been Libra – a new payments infrastructure based on an international stablecoin fully backed by reserve assets in a basket of currencies including the US dollar, the euro, and sterling. It could be exchanged between users on messaging platforms and with participating retailers.
There are a host of fundamental issues that Libra must address, ranging from privacy to AML/CFT and operational resilience. In addition, depending on its design, it could have substantial implications for both monetary and financial stability.
The Bank of England and other regulators have been clear that unlike in social media, for which standards and regulations are only now being developed after the technologies have been adopted by billions of users, the terms of engagement for any new systemic private payments system must be in force well in advance of any launch. As a consequence, it is an open question whether such a new Synthetic Hegemonic Currency (SHC) would be best provided by the public sector, perhaps through a network of central bank digital currencies.
We will write again on whether or not a central bank digital currency is a good idea. But relying on the private sector to plug the gap seems a non-starter. Libra’s launch has been a disaster (we hear a lot of the participants at Jackson Hole were rather miffed as to why Carney suggested Facebook’s stable coin as a viable alternative to the dollar), the white paper begging more questions than it answers.
Perhaps we are also looking for answers in the wrong place too.
Since the Greenspan era, the onus was primarily on monetary policy to boost growth to the extent that since the financial crisis the central banks have in economies such as the eurozone become the only game in town. Even in places such as the US, where there was a post-crisis fiscal stimulus and government-sponsored bank recapitalisations, the Fed has been the dominant player.
In a sense, Alphaville’s lecturer was right. This generation’s central bankers did learn the lessons of the Great Depression, with Ben Bernanke — a scholar of the period — adamant that the Fed under his stewardship would keep liquidity cheap and plentiful. This has, however, also led to monetary easing papering over deep cracks in national economies and the global monetary and financial order.
Our inkling is that fiscal stimulus should once again become the main focus for economic policymaking. Not only in boosting growth but in addressing the problems that central banks, with their blunt tools and narrow inflation-focused worldview, cannot. Think inequality, or climate change.
But, to paraphrase the POTUS, “…WHERE IS THE LEADERSHIP?”
Further reading
Mark Carney’s speech
Central bankers rethink everything at Jackson Hole – FT
Libra myth-busting – FTAlphaville
Germany and the ECB should do a deal on economic stimulus – FT
