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May 26, 2014 | by  | in Features Homepage |
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Increasing Interest/Inflating Hopes

Frequent readers of my column might have deduced a subtle cynicism that pervades my usual analysis, a presumption that – whether they know it or not – the things our leaders chase after are rarely in our interest. You’ll be relieved to know that when it comes to money, I don’t blame the politicians. With so much disagreement even among the governors of central banks and university chair professors, there is no hope for politicians. Amid all this uncertainty, anything can be justified. And quite often it is.

Nobody really knows what monetary policy is nor do we understand how it works. Resident political commentator Jade D’Hack explains why it is important and the ways it affects our lives.

We should never think that we cannot do better. 147,000 New Zealanders are currently unemployed – forced to rely on the scraps of government hand-outs, workless in a society where work is what we value most. We entertain far more struggle than we should. But dare mention consumer price indices or official cash rates in friendly conversation, and you’ll be met with glazed-over eyes. Monetary policy may be the most important thing a government does, but we don’t care about it because we don’t understand. This week, I have abandoned my usual column space to figure out why.

A very brief history of money

The history of money is the history of the business cycle – the coming and going of good times and bad. Until the ‘30s, economists didn’t think money mattered. Economies could find their own equilibrium, supply create its own demand. While shifting economic realities could temporarily leave workers without work, there was no possibility of a general glut. One area of the economy could only have unallocated resources if another didn’t have enough. Money was helpful – it’s a hassle bartering your cattle for a pint of your neighbour’s beer – but it had no role beyond lubrication.

Unfortunately, reality didn’t abide. In late 1929, financial crisis struck the global economy. The Great Depression had arrived. Businesses closed. Men couldn’t find jobs. Families starved. The gross scale of the unemployment proved economic slowdowns were not just uneasy transitions, but the economic orthodoxy couldn’t understand. Enter John Maynard Keynes. In The General Theory of Employment, Interest and Money he argued the Depression was caused by insufficient economic demand. People weren’t spending enough, and the solution had to involve governments reducing interest rates. For the first time, money mattered.

Not long after the General Theory was published, World War Two began, and Keynes died in 1946. His theories were abandoned to the thinking of others. An awkward combination of Keynesian macroeconomics and classical microeconomics emerged, agreeing that governments should lower interest rates to encourage spending but without understanding why. In 1958, William Phillips discovered the Phillips curve, thus becoming the first and last Kiwi economist to ever discover anything. The Phillips curve showed economies tended to either have high inflation or high unemployment. Happy to sacrifice the former, Keynesians controlling the world’s central banks reduced interest rates, providing jobs for anybody willing to work.

Milton Friedman was unimpressed. He and his Monetarist friends accepted that a lack of demand could induce depressions and that governments needed to fix help that. But they thought the study of money was crucial to understanding why. If the amount of money doubles but prices double too, nothing has really changed. Money shortages cause demand shortages only when prices and wages can’t shrink. But they always shrink eventually, so monetary stimulus cannot last forever. The Monetarists detested the Phillips curve because they thought it worked only through deceit. Unexpected inflation boosts employment by tricking people into thinking that their wages are higher than they actually are. But as soon as workers wise up, the Phillips curve would be lost.

History proved them right. In the ‘60s and ‘70s, governments found the price of low unemployment was ever-higher inflation. The Monetarists were welcomed into the world’s central banks, soon implementing strict policy rules which – though imperfect even by their own analysis – reduced inflation and stabilised incomes.

In some sense, the Monetarists strengthened the Keynesians; in another sense, they killed them altogether. We call the current paradigm ‘New Keynesianism’, but ‘New Monetarism’ would work just as well: macroeconomic models are built from microeconomic foundations, strict policy rules are favoured, and monetary policy has been relegated to recession-avoidance, not permanently increasing employment.

For three decades, the New Keynesians ruled in peace. But in 2008, the financial beast upon which we all rode was spooked, throwing us into sudden recession. Though the New Keynesians were shocked, they quickly rallied, drafting policy proposals to combat the panic. It was then that the greater shock hit. The proposals they drafted looked nothing alike.

The question with a thousand answers

New Keynesianism is not a tidy model or a policy agenda. It is a research project into how dynamic economies can permit occasions of deep suffering. Since 2009, the number of ways that question can be answered has become overwhelming.

It would be nice to agree on how monetary policy actually works. When it wants to spur the economy, the Reserve Bank reduces interest rates through the Official Cash Rate. But why does that work? Do interest-rate reductions directly induce investment by making borrowing cheaper? Do lower interest rates mean more money printed, higher inflation and therefore lower real wages, allowing businesses to hire more people more cheaply? Or is it to do with exchange rates, with lower interest rates making our currency unappealing to speculators, reducing our dollar and making exports more valuable? This is a fairly basic question, but it’s one with many answers.

And that answer matters. If monetary policy only works because it can lower interest rates, monetary policy won’t always work at all. It’s impossible for bank interest rates to be lower than zero per cent – if they were, we would use cash instead. In the current recession, many central banks have lowered their interest rates to zero. To do any more, they must rely on new tools like quantitative easing, where they print money to buy corporate bonds. But if monetary policy works only through interest rates, it’s unclear that quantitative easing will achieve anything.

There are an infinity of other questions. How best can we think of confidence? If people expect the economy to grow, they’ll hire more workers in anticipation, fulfilling their own prophecy. But can we manufacture optimism? And then there’s the ‘credit channel’. There’s ‘efficiency wages’, ‘wealth channels’ and ‘labour market matching frictions’. There are methodological issues like whether markets should be used as forecasts. I could go on, but I won’t. I know you’re confused. The problem is the New Keynesians are too.

And it gets worse. Snatching at the ankles of the New Keynesians are the others who claim to be monetary king.

There are the Austrians who detest the central bank. According to them, governments perverting the interest rate are spreading lies about the benefits of investment. Whereas natural changes in interest correspond to changes in savings, forced changes let people borrow money that doesn’t exist. This encourages over-investment and price bubbles, cysts filled with false money that must inevitably be lanced. When the bubble collapses, it brings the economy with it. In trying to prevent recessions, central banks create them.

There are the post-Keynesians – they also hate bubbles, but they blame the banks. For all their sophistication, New Keynesians barely give much thought to the financial sector. Post-Keynesians – Keynes’ apparent true successors – consider banks crucial. But the way banks work is complex. Failure to recognise this leads to bubbling and collapse.

The Austrians and post-Keynesians haven’t convinced mainstream economists, but by talking about bubbles they’ve influenced public discourse nonetheless. (If you’re ever talking to an Austrian or a post-Keynesian, ensure you point out this similarity. Austrians are libertarians, post-Keynesians generally leftists. They do not enjoy the comparison.)

Then there are the Real Business Cycle Theorists – stalwarts of the same monetary apathy that fuelled the pre-Keynesian era, albeit now with more mathematical sophistication. They argue that if our problems are monetary, our recession should be over. It’s been six years: prices have had more than enough chance to adjust. Our real problems are structural. Perhaps the crash convinced employers to fire their worst workers who no one wants to hire. Perhaps it hastened the robotic automation of our economy. If that’s the case, then no amount of money can bring the jobs home.

There are the Modern Monetary Theorists and the Marxians, the circuitists, neo-Ricardians and neo-mercantilists. There are a thousand vying theories. The only consensus among macroeconomists is that one of these ideas is obviously right. It’s unfortunate that they disagree which.

No hope for reason

Frequent readers of my column might have deduced a subtle cynicism that pervades my usual analysis, a presumption that – whether they know it or not – the things our leaders chase after are rarely in our interest. You’ll be relieved to know that when it comes to money, I don’t blame the politicians. With so much disagreement even among the governors of central banks and university chair professors, there is no hope for politicians. Amid all this uncertainty, anything can be justified. And quite often it is.

Perhaps by meddling with money, we risk distorting the very basis of our economy, causing the recessions we are trying to avoid. Perhaps we’re not meddling enough. It’s not just that we don’t know. It’s that we can’t. Macroeconomic models aim to predict the outcome of a million daily decisions. That’s impossible. We’ve got to get used to the idea that we don’t understand the most important forces in our society, that the social determinants of our happiness will be forever unknown.

We shouldn’t think that we cannot do better. But it’s time to accept that we cannot know how.

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