Why is mon­e­tary pol­icy un­der­rated?

Financial Mirror (Cyprus) - - FRONT PAGE -

In Jan­uary – just a few days be­fore the Euro­pean Cen­tral Bank an­nounced its in­ten­tion to ini­ti­ate quan­ti­ta­tive eas­ing (QE) – I at­tended a sem­i­nar in Geneva with in­ter­na­tional jour­nal­ists, pol­i­cy­mak­ers, and in­vestors. The dis­cus­sions there, much like those in Ja­pan be­fore Prime Min­is­ter Shinzo Abe launched his ground­break­ing eco­nomic-re­form strat­egy in 2012, re­flected an in­ad­e­quate un­der­stand­ing of un­con­ven­tional mon­e­tary pol­icy’s trans­for­ma­tive po­ten­tial.

In­deed, at the sem­i­nar, Euro­pean econ­o­mists and jour­nal­ists – es­pe­cially the Ger­mans, and even some of the Bri­tons in the room – adopted a dis­mis­sive tone. “Mon­e­tary pol­icy’s power is limited, par­tic­u­larly when the in­ter­est rate is so low,” some said. “We can­not count on ac­com­moda­tive mon­e­tary pol­icy to spur a port­fo­lio reshuf­fling,” oth­ers added.

Th­ese state­ments were all too familiar – and some­what sur­pris­ing, given the progress that Ja­pan’s on­go­ing QE-based strat­egy has en­abled the coun­try to make. Clearly, many in Europe lack an un­der­stand­ing of the his­tory and sig­nif­i­cance of so-called “Abe­nomics”; but such an un­der­stand­ing should in­form their mon­e­tary-pol­icy de­bates.

In 2001, the Bank of Ja­pan (BOJ) was strug­gling to find ways to help the econ­omy es­cape re­ces­sion. Hav­ing al­ready re­duced the tar­get short-term in­ter­est rate to very close to zero, it turned to open mar­ket op­er­a­tions – specif­i­cally, pur­chas­ing long-term gov­ern­ment bonds and in­creas­ing bank re­serves held at the BOJ – in or­der to in­crease the money sup­ply and re­duce long-term in­ter­est rates.

But the BOJ’s at­tempt at QE proved to be too lit­tle too late, and no re­cov­ery ma­te­ri­alised. Ben Ber­nanke, then the chair­man of Prince­ton Uni­ver­sity’s eco­nomics depart­ment, took note of this fail­ing, declar­ing that the BOJ should pur­sue a more ag­gres­sive mon­e­tary pol­icy.

When the US in­vest­ment bank Lehman Broth­ers col­lapsed in 2008, trig­ger­ing a global fi­nan­cial cri­sis, Ber­nanke – who had since be­come US Fed­eral Re­serve Chair – took his own ad­vice, in­sti­tut­ing a bold QE pro­gramme to re­vive the United States’ mori­bund econ­omy. The United King­dom, too, pur­sued ro­bust QE – and, like the US, it is now experiencing rel­a­tively strong eco­nomic growth (which is why the Bri­tish par­tic­i­pants in Geneva should have known bet­ter).

Ja­pan, by con­trast, hes­i­tated to ex­pand its money sup­ply sub­stan­tially, leav­ing the yen’s ex­change rate against the US dollar to ap­pre­ci­ate to 76 (from less than 100 be­fore the Lehman cri­sis), and caus­ing GDP growth to decline fur­ther. In 2009, Ja­pan’s econ­omy was per­form­ing at 8% be­low po­ten­tial, even though its fi­nan­cial sys­tem was sound. In short, the Ja­panese econ­omy suf­fered far more than the US and UK economies, which were di­rectly af­fected by the Lehman shock.

A small group of econ­o­mists, in­clud­ing me, recog­nised this dis­crep­ancy, and ar­gued stren­u­ously that mon­e­tary eas­ing was crit­i­cal to fight de­fla­tion and ex­treme cur­rency ap­pre­ci­a­tion. But our ar­gu­ments were con­sis­tently dis­missed. Sound familiar?

Abe changed ev­ery­thing. With mon­e­tary pol­icy as the ba­sis of his po­lit­i­cal agenda, he be­came Prime Min­is­ter (for the sec­ond time) in De­cem­ber 2012.

Soon af­ter, QE was off and run­ning. Al­most im­me­di­ately, the yen de­pre­ci­ated, ex­ports in­creased, and the stock mar­ket soared. Af­ter nearly two decades of re­ces­sion, the Ja­panese econ­omy was grow­ing again – and it had Abe­nomics to thank for it.

Of course, ev­ery­thing did not go en­tirely smoothly; a 3% con­sump­tion-tax hike, which had been put in place by the pre­vi­ous gov­ern­ment, in­ter­rupted Ja­pan’s progress. And Ja­pan still has a long way to go to achieve ro­bust long-term eco­nomic growth, with the next phase of Abe­nomics – sup­ply-side re­forms – re­quir­ing the gov­ern­ment to over­come re­sis­tance from bu­reau­crats and spe­cial in­ter­ests.

Nonethe­less, QE’s ef­fec­tive­ness was clear – so clear, in fact, that last Oc­to­ber the BOJ an­nounced an ad­di­tional round of it. Judg­ing by the over­whelm­ing victory of Abe’s Lib­eral Demo­cratic Party in a snap gen­eral elec­tion two months later, Ja­panese vot­ers are sat­is­fied with this ap­proach.

Now it is Europe’s turn to ben­e­fit from the power of mon­e­tary pol­icy. But, for the ECB’s plan to work, its QE must be ro­bust – and that will re­quire broad sup­port. Af­ter all, eu­ro­zone mon­e­tary pol­icy is the prod­uct of joint de­ci­sion­mak­ing within the ECB gov­ern­ing coun­cil, where Ger­many’s in­flu­ence is strong.

Given QE’s suc­cess in the US, the UK, and Ja­pan, at­tract­ing such sup­port should, one might as­sume, be rel­a­tively easy. Yet my ex­pe­ri­ence in Geneva was not an iso­lated in­ci­dent; many pol­i­cy­mak­ers re­main con­vinced that mon­e­tary pol­icy is not all that pow­er­ful. At last year’s World Knowl­edge Fo­rum, sev­eral lead­ing cen­tral bankers – in­clud­ing for­mer BOJ Gover­nor Masaaki Shi­rakawa, for­mer ECB Pres­i­dent Jean-Claude Trichet, and for­mer Bank of Korea Gover­nor Kim Choong-soo – also dis­missed the po­ten­tial of un­con­ven­tional mon­e­tary pol­icy.

The be­lief that mon­e­tary pol­icy does not mat­ter is not just “the most danger­ous idea in Fed­eral Re­serve eco­nomic his­tory,” as the econ­o­mists Christina and David Romer have noted; it is ex­ceed­ingly haz­ardous to any econ­omy. Europe faces enough se­ri­ous risks al­ready; it should not need­lessly add to them.

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