Unconventional Monetary Policies: A Cure Worse than the Disease?
UMPs, intended to combat the global financial crisis, have seriously distorted the economy, fuelling asset price bubbles and worsening inequality.
In the world of medicine, there is such a thing as a curse worse than the disease. Think of someone suffering from insomnia, who then is prescribed sleeping pills that cause serious side effects and who suffers withdrawal symptoms while painfully tapering the medication over a period of months or years. Such a person might wish that they had dealt with insomnia by meditation, mindfulness, and herbal tea, rather than harsh medications. Unconventional monetary policies (UMPs) are a bit like that.
This post is intended, in part, to collate some of my thinking on this topic over the years. First, though, for those not conversant with the jargon of monetary policy, let’s understand what UMPs are. The first plank are interest rates at or near what is called the “zero lower bound” — in other words, interest rates at or just above zero (although slightly negative interests are possible, and some central banks have experimented with them). In simpler terms, money is cheap to borrow. The second plank, probably best known by the public, is the large scale purchase of assets, including non-traditional assets (that is, other than just government bonds, gold, and the like), by the central bank. This has become known as “quantitative easing”. The third plank is called “forward guidance” — this is just the central bank making commitments on the future course of the policy interest rate (or other policy instruments); for instance, a commitment not to raise the policy rate into the indefinite future. The sum total of these policies amounted to pumping billions of dollars of liquidity into the financial system. The goal was to ward off the downturn following the global financial crisis of 2007-9, and the policies may well have done that — although we can never observe the counterfactual scenario. But, as early as 2013 or 2014, many economists began to believe that the policies had outlived their usefulness and were becoming downright harmful.
The first occasion on which I encountered a serious discussion of the downsides of UMPs was when I was invited to become a member of the Santa Colomba Conference, an invitation-only annual event convened, and chaired, by economist Robert Mundell. Bob, as we all called him, won the Nobel prize in 1999 and, as it happens, he was Canadian born, and, along with Jagdish Bhagwati, was one of my principal mentors and advisors in graduate school at Columbia and thereafter became a lifelong friend. I use the past tense when referring to Bob, as he passed away last year. I wrote an appreciation of his life and work for Canada’s Financial Post here. All told, I attended every meeting of the conference from 2014 up until 2019, except for 2018, when I was at a family gathering. The event first convened in 1971, just weeks after US President Richard Nixon’s Secretary of the Treasury, John Connally, closed the “gold window”, all but killing the Bretton Woods system, and, regrettably, 2019 was the final meeting. (For further reading on this, see here and here.) It was impossible to convene in 2020 during the first summer of the pandemic, and, alas, Bob did not live to host another one.
The Santa Colomba Conference is very different from the conventional academic conference that most university economics professors attend. For one thing, the invitees have always been a diverse group, comprising not just academics, but bankers and former central bankers, politicians, and folks from the private sector, the world of journalism, and other walks of life. Some of the attendees had been, or went on to become, policymakers themselves, or senior advisors to policymakers. They brought a very different perspective to the table than conventional academics such as myself, who are great at theorizing about money but often not so great at either making it or managing it in the real world. Another difference is that, while papers were circulated in advance, discussions around the table were not based on dreadfully monotone presentations that do little more than flip through an already prepared slide deck, but conversations moderated by Bob and co-conveners based on a set of topics for debate and discussion prepared by co-curators. I had the privilege, and the pleasure, of being one of the co-curators at the last meeting in 2019.
The setting makes a huge difference, too. Most academic conferences take place in drab conference centres or meeting rooms at generic business hotels. The Santa Colomba Conference convened in a grand meeting space in Bob’s home, a Renaissance palazzo near Monteriggioni in the rolling hills of the province of Siena in Tuscany. This is the Chianti country, and lunches in between the morning and afternoon sessions featured salads, cheeses, and, of course, a wonderful selection of Tuscan wines. Each evening over a weekend of meetings would be capped with dinner at a restaurant in the historical city centre of Siena, a gorgeous mediaeval town infinitely more beautiful and charming than Florence. This is the sort of ambiance and setting that fosters interesting conversations and thinking that doesn’t always hew to orthodox narratives or received wisdom. I wrote about my first time at the conference, in 2014, here, and wrote a piece every time thereafter — the last, from 2019, is here.
What became clear to me during the meetings, perhaps every year with greater clarity than the previous one, was the damaging effects of UMPs, in distorting not only the financial sector, but the “real” economy — in other words, not just Wall Street, but Main Street, too. And, perhaps, the biggest problem was the elephant in the room — the problem of exit. I wrote about this in 2016, here, and several times thereafter, most recently in 2021, here. More recently, I revisited UMPs and their significant downsides, in writing about the inflation problem in Canada for the Financial Post, here. I also joined a spirited discussion on, among other topics, how inflation was hurting average Canadians, in a podcast organized by New Left Radio, here. Readers are encouraged to click on these links for more detailed argumentation than I provide in this post.
Briefly, the distortions caused by UMPs spring from the fact that, with low or zero interest rates and lots of money sloshing about the financial system, there are very few investments in the real economy than can generate an acceptable return on investment for fund managers and large investors, both private and corporate. As a result, a lot of this loose cash found its way into the financial markets worldwide, and, in particular, into asset markets — everything from real estate, both household and commercial, to vintage automobiles, Old Master paintings, and everything in between. Especially with assets in relatively fixed supply, such as property, the obvious effect of all that money pouring in is asset price inflation — indeed, with asset prices so frothy that they verge on bubble territory. Stock markets around the world kept touching new highs — even during the depths of the COVID19 pandemic — and this is in due, in no small measure, to all that loose cash chasing too few legitimate investment opportunities. One consequence is exacerbated currency and financial market volatility in the emerging economies, due to the harmful “spillovers” of UMPs from advanced to emerging economies. At the same time, poor and middle class households in many advanced economies, such as the US and Canada, are drowning in debt — mortgage, credit card, lines of credit, you name it — as money has been relatively cheap. The net result is a sharp increase in wealth and income inequalities, as the wealthy, whose income derives largely from investments and not labour, profit from inflated asset prices, while the poor and middle class don’t benefit from such opportunities.
With inflation now on the rise in the advanced world — both the US and Canada have seen their highest inflation rates in many years — the inevitable tightening of monetary policy, and walking back from UMPs — an exit that was delayed by the pandemic — is, inevitably, going to be very painful for ordinary folk. For one, consumer price inflation hurts the poor and the middle class much more than it does the wealthy. Rent (or mortgage), utilities, groceries, and fuel use up the bulk of an average household’s monthly budget but form a much smaller part of the budget of the wealthy. What is more, as I argued in the Financial Post article and podcast linked above, it is principally the wealthy who benefit from inflated asset prices. Average folk have what little savings they’ve managed to collect in bank accounts that pay little or no interest, and, if they do pay interest, the interest rate isn’t indexed to inflation. Meanwhile, asset price inflation has outstripped consumer price inflation, again benefitting the wealthy but not everyone else.
The unravelling of UMPs and the eventual normalization of monetary policy — I haven't even touched on the havoc that fiscal profligacy is wreaking with prudent public finance — is going to hurt, especially the poor and the middle class. The wealthy are going to remain wealthy, and higher interest rates will help them diversify their investments away from risky financial bets into more profitable opportunities in the real economy, as borrowing costs rise. I find it deeply ironic, though, that inflation (both consumer price and asset price), a consequence of excessively loose and unsound monetary policy, is seen as a cause of conservatives rather than liberals (noting that I use these terms in their American, not British, sense). Ironically, it was then presidential candidate Donald Trump who, in 2016, called out the “false economy” that the US Federal Reserve had created through UMPs (he did change his tune, however, when he became President). When it is the working poor who will suffer the most, there’s a bizarrely deafening silence from large swathes of commentary from the left, at least in the Anglo-American sphere. There’s likely also a suspicion that those academics and other commentators who drone on about sound money and prudent public finance are making the case insincerely, while they really bat for business tycoons, monied oligarchs, and the like. I can’t think of any other plausible reason why fiscal prudence, sound money, and the twin inflation problems aren’t more of a raison d'être for friends on the left. If you have any other possibilities in mind, do share your thoughts in the comments section below.