Inflation & Unemployment: Fiscal actions (i.e., “daily governance”) & Banking Regulation Work. Monetary “Policy” Does Not

[Image: Alexandria Ocasio-Cortez presiding over the House, 2019]

The source of money for government expenditure is unequivocally Parliament via its Supply votes and Acts.

An Accounting Model of the UK Exchequer (2020), p. 116

First of all: fiscal “policy” and banking regulation occur every day, all the time.
“Fiscal Policy” is simply whatever spending and taxing decisions that have been put in place by the government, generally congress/parliament with “the power of the purse” (and banking regs by a varied set of government agencies.)

There is no such “thing” as “not using fiscal policy” or an absence of fiscal policy “dominance.” Fiscal policy is always there, all around us, every day, and is quite simply the most fundamental output of our elected governments – how to spend, how to tax, and, relatedly, how we control the publicly-licensed banking system. (And no, I do not mean to imply taxes are needed for spending in the way the public is usually taught; non-paywalled here).

Any argument that there is a “fiscal policy versus monetary policy” debate that somehow suggests we primarily rely on the latter is misspecified. You cannot not be primarily “doing fiscal;” it is simply not possible. (Whether done well or not is a different issue; the very belief that somehow fiscal takes a backseat is the key reason it has been done poorly for decades).

Yet there did become a belief that central bank actions, especially manipulation of the base interest rate, was useful for price stability and/or unemployment. For example:

“In the course of the Great Moderation of the 1990s, central banks…instead concentrated on the short-term interest rate as their sole monetary policy tool.”

p. 3 Threat of fiscal dominance? (bis.org) Moessner, Richhild and Philip Turner 2011 (2012). Threat of fiscal dominance? BIS Papers No 65

and

“in the last 30 years there seems to have been a widespread regard of monetary policy as the prevailing, supreme policy of choice for most of the advanced economies.”

The dominance of monetary policy over other forms of policy is now an accepted aspect of Modern macroeconomic management. – The Marshall Society

But all the while Congress was of course making spending and taxing decisions (and government agencies making bank regulation decisions) that were then, always did, and still do guide the economy.

So the question is not whether governments are “doing fiscal vs. monetary policy.” They are always “doing fiscal,” and on a massive scale. The question is: Were/are the additional actions of central banks, primarily of manipulating interest rates as noted above (and post 2007, quantitative easing) helpful in any way regarding inflation and unemployment?

The short answer is no. So-called monetary policy, especially the primary approaches it has taken in the last 3 to 5 decades (interest rate propping-up and easing-of-propping) and QE (post 2007, also useless) simply does not have the effects it is believed to have.

The immediate response to that by the mainstream will be: “but look at how steady and low inflation has been since the rise of a belief in monetary policy, and the overall relatively low unemployment rate. Of course monetary policy works!” (That is, for those who even understand that a “national debt” does not “drive up rates;” that the government can completely control the base rate, not just the overnight rate but for any yield curve; see also Mosler and Armstrong 2019). Any base rate over nominal zero is always a government manipulation in one way or another).

And they will likely also cite the double spike of 70’s inflation (that additionally occurred with increased unemployment) as being “fixed” by monetary policy under Volcker.

However, there are numerous “illusions” at work here. There is little empirical evidence monetary “policy” has the effects it is thought to have. And both theoretical and empirical evidence that it does not. And there are many other reasons for the long period of price stability and relatively low unemployment in recent decades.

Evidence

It is such an article of faith that interest rate manipulation is a useful tool that there is not much genuine (i.e., empirical) testing of the issue (there are endless mainstream articles on highly stylized aspects of monetary policy; they are so full of non- real-world assumptions as to be useless in actually judging empirical reality). (Just as I was writing this sentence a new book with a theme in part similar to this post came to my attention on the UK that states the same: “Clearly the prescriptions of the economic elite are incomplete in some way, couched as they are in abstract language and arcane mathematical formulae that are more in keeping with alchemy than science.”)

One of the few empirical examinations of effects of interest rate manipulation finds:

The rate of interest – the price of money – is said to be a key policy tool…To investigate, we test the received belief that lower interest rates result in higher growth and higher rates result in lower growth. Examining the relationship between 3-month and 10-year benchmark rates and nominal GDP growth over half a century in four of the five largest economies we find that interest rates follow GDP growth and are consistently positively correlated with growth…We conclude that conventional monetary policy as operated by central banks for the past half-century is fundamentally flawed

Reconsidering Monetary Policy: An Empirical Examination of the Relationship Between Interest Rates and Nominal GDP Growth (2018)

Also – countries that have had very low interest rates have not had inflation (note especially Japan).

One can even make the argument that the base interest rate just is (or becomes) the “inflation” rate, because it is the “price of money” and futures markets.

Note also Neo-Fisherian arguments:

But what if central banks have inflation control wrong? A well-established empirical regularity, and a key component of essentially all mainstream macroeconomic theories, is the Fisher effect—a positive relationship between the nominal interest rate and inflation. 

Was Irving Fisher Right on Raising Inflation? | St. Louis Fed

and

“if the central bank wants inflation to go up, it should increase its nominal interest rate target, rather than decrease it, as conventional central banking wisdom would dictate. If the central bank wants inflation to go down, then it should decrease the nominal interest rate target.
…In other words, in the long run…if the nominal interest rate went up by 1 percent, so should the inflation rate”

Was Irving Fisher Right on Raising Inflation? | St. Louis Fed

See also “Why U.S. Monetary Policy Makes No Sense”

The original reason interest was paid on government bonds is that proto-states in the medieval past were sometimes genuinely “borrowing.” But under modern tax/tax-credit systems, there is no need to pay a rate for one’s own currency (the tax-credit). Much later, the idea that paying a rate (propping up the base interest rate with bond sales or interest on reserves) served some useful purpose somehow arose, maintaining the vestigial practice of interest rate payments on saved government currency (bonds, which serve no modern purpose).

The “logic” given for interest rate manipulation is primarily that raised rates will reduce economic activity (and thus inflationary pressures) via the lending/credit channel, and lowered rates will increase activity (a good thing if inflation is not a problem at the time).

However, as the empirical study cited above shows, rate changes follow rather than cause price-level changes.

Even via the lending/credit channel, interest rate changes do not affect the economy as strongly as mainstream theory believes. Businesses don’t necessarily strongly consider interest rates in their investment decisions; see “Why isn’t Investment More Sensitive to Interest Rates: Evidence from Surveys“)

and

Modern macroeconomic textbooks typically suggest that there is an inverse relationship between interest rates and business investment (e.g. Mankiw 2007; Blanchard 2017). In the textbook description, this inverse relationship is essential to understanding how changes in monetary policy affect the economy. Despite its theoretical importance, as the quote above suggests, empirical evidence for this inverse relationship is difficult to establish. In surveys, businesses themselves argue that their investment decisions are not affected by changes in the cost of borrowing.

Do Interest Rates Affect Business
Investment?

Furthermore, there are channels for rate changes to have the very opposite effect that they are intended to have:

• Raising rates means more government $ (or £’s etc.) will be paid into the real economy, and lowering rates means less. This is a relentless process that eventually has large, perverse effects.
• Businesses price-in added interest costs; a raise in rates can put upward pressure on prices, rather than downward pressure.

At worst, this can mean the impact of rate changes is the exact opposite of the what the mainstream believes and a government desires at any given time. At a minimum, it means rate changes have complex mixed effects; they work at cross-purposes to themselves, making the economy much harder to analyze/stabilize than if rates were just left at their natural rate of zero.

Spending, tax, and banking regulation decisions would be more transparent in an economy without the unnecessary uncertainty and complexity that changing base interest rates creates. Governance aimed at maintaining price stability and employment would be more effective.

Illusions of effectiveness

First, on Volcker: There was a real-resource reason for the spikes in inflation (the twin oil shocks of the 70’s: ’73 Yom Kippur/OPEC; ’79 Iran Revolution).

When there is inflation from genuine shortages of supply, the logical response is to let the inflation pass-through on that product, in order to allow markets to function as they should: causing reduced usage, substitution, and technological development.
We would be ahead in environmentally friendly vehicles and energy sources had the cost of oil been allowed to pass through in that sector in the 70’s. The draconian response by Volcker not only interrupted that process with lasting negative consequences. It did so at immense, and long lasting, cost to many other sectors of the economy. Volcker’s actions were a “double” pox on the real economy, both then and for years after (the immediate pain and the undermining of long-term technological change regarding energy/oil use):

the Volcker shock — lasted until 1982, inducing what remains the worst unemployment since the Great Depression…To catalog all the results of the Volcker shock — shuttered factories, broken unions, dizzying financialization — is to describe the whirlwind we are still reaping in 2019.

This article continues:

The illusion is that interest rate tweaking (which after the early 80’s is all it amounted to) was somehow causing stability, when in fact many other real-economy facts conspired to both maintain relatively low unemployment and low inflation.

• Real increases in economic productivity (high yield crop varieties [“world grain production increased by about 160%.^[57]],
• the eventual results of the containerization revolution and resulting steep decline in the cost of transport for exports/imports (listen to Bloomberg/Odd Lots this week on the effects of “The Box”
• wages held down by neoliberal policies and suppression of unions (esp in US and UK) (not a good thing, but a real effect). Similarly, “globalization” overall worked to reduce wages in a race to the bottom.
• organizational power of computers: e.g, just in time delivery, CAD, and in myriad other ways. (An overview of the never ending decrease of technology costs.)

Simply put – the coincidence of the rise of a faith that interest rate manipulation is somehow effective came at precisely the same time period when real factors were driving prices of almost everything inexorably down. Simple-minded economists fixated on the 1970s and non- real-world factors came to believe interest rates were doing what in fact technology and social/political factors were doing. An abdication of serious social science.

Notes

On the optimality of a permanent zero central-bank rate: Why were central banks created?

Federal Reserve Interest Rates Should Be Near Zero Forever

Mainstream economics itself recognizes that their models/theories concerning interest rate manipulation do not correspond to the real-world. They call these “puzzles.” Indeed!

2018: “The New Keynesian (NK) framework is the core of most models used for policy analysis since now decades, yet makes a series of predictions that are largely thought to be counterfactual, or “puzzles”.

The article continues (LT = liquidity trap):

Loanable funds and other myths still told to our policy makers.

With “friends” like these, who needs enemies? In 2019, by the Congressional Research Service: (“Informing the legislative debate since 1914” and “Prepared for Members and Committees of Congress.” Everything in the following paragraph is incorrect, and hugely so. Of course our government cannot govern well…they are being fed straight-up lies as fact by influential sources:

“At any given time, there is a limited supply of loanable funds available for the government and private parties to borrow from—a global pool of savings. If the government begins to borrow a larger portion of this pool of savings, it increases the demand for these funds. As demand for loanable funds increases, without any corresponding increase in the supply of these funds, the price to borrow these funds, also known as interest rates, increases.”

“Fiscal Policy: Economic Effects,” Fiscal Policy: Economic Effects (fas.org)

System Dynamics of Interest Rate Effects on Aggregate Demand

This post got long-ish and I still have not discussed banking regulation and inflation. The short story is that properly regulating the finance/banking sector would reduce (real-economy) unproductive lending, impacting price levels.
Some seem to think MMT doesn’t focus on banks and finance etc; yet the banking proposals by Mosler are crucial to implement, and would greatly reduce bank credit-“money” inflationary pressures.
Warren Mosler’s Proposals for the Treasury, the Federal Reserve, the FDIC, and the Banking System

“Right now, we have far more finance than we need. Exactly how much of it we could eliminate as unnecessary is up for debate. I wouldn’t be surprised if our economy would actually run better if finance was downsized by 90%”
L. Randall Wray 2014

“The correct approach, as highlighted by the MMT view, is to reduce bank lending by banning its use for anything that isn’t constructive. Bill Mitchell regularly suggests that 97% of financial transactions should be illegal.”
Neil Wilson 2014 (Neil has since deactivated his “3spoken” website; this is a “wayback” link).