Monetary Policy and the Global Economic Recovery
Adam S. Posen (PIIE)
Keynote Speech delivered virtually at the 2nd Bund Summit
October 24, 2020
Thank you very much for having me join, virtually this year, the Bund Summit. The Bund Summit has already become a major international financial event on the calendar and I look forward to joining in person again next year, if allowed. I particularly want to thank Chen Yuan, Tu Guangshao, Zhou Xiaochuan and my good friend and longtime colleague Wang Haiming from the organizing committee, and also Governor Yi Gang for lending his participation to upgrade the summit. I particularly want to thank Wang Haiming and the colleagues of the China Finance 40 Forum (CF40) for continuing to have international dialogue in a substantive, objective as possible, non-political way, in a time when that is increasingly difficult. It is a service to the community. We at the Peterson Institute value our ongoing partnership with CF40, and as part of that, my colleagues and I are participating in the Bund Summit.
I've been asked today to discuss monetary policy and I think it's important we start with the recognition of just how well monetary policy has done, but move on quickly from that to how much monetary policy has run up against particular realities that have been evident for some time, but now are unavoidable. And then finally, to think about the global implications of the monetary policies pursued in recent years, including quantitative easing, and how this will play out for the major economies and the currencies in the international system.
So first, if you had told me a good six months or a year ago, that the central bankers would be more trusted than public health officials around the world, I would have said you were crazy, frankly. And yet, that is where we find ourselves. The central banks were able to cooperate internationally at the start of the financial effects from the COVID pandemic. In particular, the Federal Reserve played a constructive leading role in utilizing the network of swap lines, but all the major central banks, including importantly, the People's Bank of China, participated, and they made work arounds and new functions to allow everyone to have access rapidly to dollar liquidity without issue. And the reason this was significant was not just that it worked, but that it was not politicized in domestic context.
Coming out of the last global financial crisis, the US, in particular, political system had attacked the swap lines that the Fed had engaged in as one of the supposedly worst things that the Fed did during its response. Ben Bernanke, much less importantly, myself, and others, all wrote that we were worried that this would be interfered with. But when push came to shove it was used, the international coordination was good, and the political climate around the monetary policy activism has been, if anything, much better this time than in the past crisis. But as I mentioned, this is taking place against the background of limitations for monetary policy. The G20 has paid lip service for nearly a decade to the idea that fiscal policy has to take over for monetary policy in recovery and now, of course, we saw a massive fiscal response from the G7 economies, from most of the G20 economies, from the Ministry of Finance in China as well. And this fiscal response has been highly effective, and now unfortunately seems to be getting prematurely halted or at least interrupted in the US. But central bankers, including Jerome Powell, chair of the Federal Reserve, Christine Lagarde, President of the European Central Bank, and others, have been out there publicly calling for better coordination between monetary and fiscal policy, and more fiscal policy. This is a rather unusual set of circumstances, especially as compared to the response and the gaming between fiscal austerity and monetary ease that took place last time we had a global crisis just a decade ago.
So where do we go from here? And what does this mean? My contentions are as follows:
First, that this was, in a sense, inevitable, and never should have been so fraught. By this I mean the limits to monetary policy, and the active use of fiscal policy. My colleague Olivier Blanchard at the Peterson Institute, of course, has led the way on the intellectual foundations for this. But a number of us have been speaking about this for some time, as I gave in a speech a decade ago in 2011 when I was a policymaker at the Bank of England. I said that there is no reason independent central banks can't cooperate on fiscal policy, so long as they do so willingly, visibly, and do not speak about the nature of fiscal policy, or the specifics of fiscal policy, that is for our elected officials. But it's adolescent to say, "I'm independent, therefore, I can never play along." An adult chooses when to cooperate.
And so I don't think that this is as big an issue as people have made it out to be, nor do I feel necessarily that we need very elaborate contingent contracts or delegation of fiscal authority… In fact, I am a little bit discomforted now as I was in May 2010 when I was in the UK, that the central bank chair or governor is speaking so bluntly about fiscal policy ahead of an election. It so happens in this case. I completely agree with the analysis behind Chair Powell's discussions, but it is a bit awkward and I think it's also not making that much difference. And it would have been just as well for the Fed to just simply indicate that it was ready to act and quietly speak.
Nonetheless, that is a small issue. The important issue is that all the models about central bank independence, about time and consistent clarity of monetary policy, which I have been inveighing against, since my doctoral dissertation in 1994, have again been proven to be largely irrelevant in this period, that we have had what's seen as a fiscal extension of the munition by some of central bank independence and this has had no effect on long term inflation expectations and on central bank credibility.
And, as in so many other things that I will talk about, the Bank of Japan has led the way in this, both in terms of what it's had to experience, and in terms of its dealing with this. Governor Haruhiko Kuroda and the Policy Board in the Bank of Japan has been soft coordinating with fiscal policy in Japan since the start of 2013 and this has not led to hyperinflation, if anything, the opposite—not quite the opposite, but very little traction or jump in inflation expectations and, if anything, no problems in fiscal markets for Japan or the currency. So that's the first point.
The second point is that monetary policy is much better at defense than offense in the context we're in. For those of you who are in China and basketball fans, you will understand what I mean, people who watch American football. It's the ability to stop the opponent from scoring on you, versus your ability to put up points. In economic terms, it's the ability of monetary policy to prevent or offset financial panics and sharp deflationary stocks, but the inability to push forward a recovery when there are real factors, and behavioral factors keeping investment and wages down. This asymmetry, of course, goes back to Keynes talking about pushing on a string—that you can lower interest rates, but if there's no "animal spirits", no investment demand, expansion and inflation will not result. And we saw this very clearly again in Japan throughout the last eight years, in fact, throughout the last 20 years, and we saw this in the aftermath of the global financial crisis for the US and European and other central banks. And so this should not have surprised us. And this is another argument for "why fiscal policy".
Another implication of this argument is that what I referred to, starting in 2009, as mechanistic monetarism—focusing on the amount on central banks' balance sheets—is completely misleading. Because if you really want to reduce it to Milton Friedman, PQ equals MV, then basically what you're saying is that all the action is in V. V drives everything, and V is determined by non-monetary factors. I think there are more sophisticated and more nuanced ways of talking about it, but essentially, the basic point holds. If we are in a phase of secular stagnation, as Lawrence Summers, I think, has rightly characterized our era, this is a phase in which the pushing on a string, in which the downward pressure on velocity, is overwhelming in fluctuations and that is what determines the outcomes of nominal GDP, as well as to some degree growth, real growth and it's not for monetary policy to affect that. So if we were to have, again, a widening of spreads of financial panic, a major currency swing in one of the major economies a deflationary shock, rather than just a slow, ongoing down grinding demand, any of those, monetary policy still has plenty of ammunition and can act. But it is not going to be something that will help us get the recovery from this crisis, which, even more than the previous one, has a supply side component, has a behavioral component.
I think it is reasonable to expect, although I will be happy to be proven wrong, that for the US, for many of the high-income economies, the shock from the pandemic, and, frankly, the mismanagement of the public health aspects of the pandemic, will be lasting. People will be more risk-averse, people will be less mobile, there will be higher savings rates persisting, not at the extremes we saw in the immediate aftermath of the disease spreading, but raised from what they were before, even in the US, and risk aversion in corporate markets continues to be quite high. Note, profitability can go up even when risk aversion is high, even when there's little investment, through channels of competition being wiped out, through channels of political capture, through channels of network effects, and oligopoly and these are things that we should be deeply concerned about, and I'm glad to see that the political groupings in the US are finally starting to confront these issues. Because these are fundamentally important. But from a monetary point of view, it all just tells you that you don't need to track the movements and asset markets unless and until they start constraining credit conditions in a profound way or moving in very large amounts, because they are, indeed, disconnected, particularly publicly traded equity markets, disconnected from inflation and growth developments in the economy for the most part.
So another point about the monetary experience of the last 20 years in Japan and of the last 10 years around the world, in particular the last nine months, is that inflation is not a risk around the corner, and this is why it is so commendable that the Federal Open Market Committee (FOMC) in the US, as a part of their strategic framework review, moved away from taking a preemptive approach to inflation based on unemployment numbers. Now Chair Jerome Powell, Vice Chair for Monetary Policy Richard Clarida, Governor Lael Brainard, New York Fed President John Williams, have all articulated the reasons for this, and I'm sure the people participating in the Bund Summit are well familiar. I will just give my brief notion of why this is critical.
As David "Danny" Blanchflower and I argued in 2014, when we were pushing against the beat to raise rates in the Federal Reserve at that time, the focus on labor markets as a trigger for pre-emptive monetary policy move, had, among other things, two very obvious failings. First, that participation, in the broad sense, meaning measured labor force participation, but also measures of underemployment, part time work, and so on, were much better measures of labor market slack than whatever measures of unemployment you used. And that, therefore, people who were considered out of the workforce unlikely to return to work or indeed still putting downward pressure on wages throughout. And we came up with some evidence on that, Jan Hatzius at Goldman Sachs, his team came to it in a different way. The Fed researcher Michael Kiley, around the same time, had his evidence. And yet, when we look back at the Fed's decisions then, which Janet Yellen and others have acknowledged, Charles Evans have acknowledged, were probably a mistake, you had Yellen's discussion of a 14-point dashboard on labor markets, but the one that was blinking "don't raise rates"—labor force participation—was the one that was ignored.
And we can see this also again in Japan where one of the massive accomplishments of Abenomics, perhaps the most important accomplishment of Abenomics, was a major shift in female labor force participation. And that had a disinflationary consequence. And that totally changed what one's expectations should be about how hot the economy could run in Japan. But again, it wasn't just Japan. In Germany, in the US, in other countries, you found repeatedly that unemployment could go much lower than the central banks and other forecasters had thought it could go without prompting inflation. And again, this is a characterization of our period, that wage bargaining power for labor is very weak. And unfortunately, the pandemic, one of its many side effects beyond the great human loss, is that many women are being forced out of labor force or into part time work as they shift to adjust to look after family members, particularly school aged children. And just more generally, we're seeing a very persistent surge in unemployment in certain sectors. And so this will continue to put downward pressure on wages, which leads to the last point that you can always talk about hyperinflation and monetary policy, and monetary determinants, but in the end, it's very difficult in an advanced economy, or any form of market economy, to have inflation sustained without tight labor markets and strong labor bargaining power.
So what about the international aspect, which Wang Haiming and the organizers asked me to speak about. I think, in a sense, I've already spoken about it — the coordination in the common framework. And so therefore, by implication, the differences of monetary policy, and even monetary regime between central banks, are far less important than these global factors. But let me make a couple other points about the international situation.
The first is that the Dollar's over-representation in all measures of international commerce and finance, whether it's share in official reserves as held by SAFE and others, whether it's share in cross border bank lending and official sector lending, whether it's in invoicing of trade and so on, these are matters that we will see slowly unwind, but not go away. But the reason they will slowly unwind and not go away has nothing, or almost nothing, to do with the central bank or the monetary policy. It has to do with the currencies and reserve status being locked in the least ugly contest. And so what would happen in 2008 to 2010, and what has happened in previous crises, generally—you have to go back to 1979 for an exception—is that as bad as the US messed up, as bad as things went in the US, things would generally go worse in the other major currency zones, in Europe, in China, in Japan, in emerging markets. And therefore capital flows on net would come to the US, the US would win the relative contest. It might get uglier, but it was still less ugly than the others. The political divisions in the US, the dysfunctionality of our fiscal process, the worries for the first time in my lifetime, about genuine problems with rule of law and corruption in the federal government, thanks to the Trump Administration, the conflicts and abdication from peaceful international economic relations, all of these things are important and real and even if, God willing, Trump is to lose in three weeks, that they will not immediately be restored and all countries in the world will, understandably, be less trusting for the US in the economic sphere.
As I've argued many times, including before CF40, there are a number of ways in which this is far from optimal. It is very harmful to see globalization corrode, and the post-American world economy is not one that's good for developing countries, or most people. But the bottom line is that we should expect a down step over time in the next couple of years of the US financial role and, in particular, this will be accelerated if the US government engages in unilateral financial sanctions and overuse of its powers of control over the world's financial system, which are exaggerated, but real in terms of access to payments. Now, what is the beneficiary, as it were, or what is the alternative currency? In my view, it is not likely to be the Yuan or the Renminbi, despite the innovations by Governor Yi and the others at the People's Bank in, for example, digital central bank currency. Ultimately, you need to believe in the property rights' ability to get your money in and out of a denominated currency, and while China in many ways is beating the US on less ugliness, particularly in its public health management of late and its generosity to international institutions, there is not an obvious ability of non-Chinese citizens to get their money in and out in an easy way, in a trustworthy way.
So it is the Euro, frankly, and a number of small currencies that will continue to be vastly overvalued. And, sadly, alternative currencies and real estate assets will be … I say sadly for that last class because that is a class without any real returns. But that's where the money will go.
Finally, to close, one of the greatest surprises to me, and I think many people of this crisis, is the extent to which a number of emerging markets, and even developing countries, have had room to run loose monetary policies, and even fiscal stimulus in response to the pandemic. This takes nothing away from Managing Director Georgieva and President Malpass' recent statements about how much we need to put money into the developing world to prevent a lost generation, not just a lost decade, the human toll of the pandemic is terrible, but speaking from a financial and monetary perspective, after the enormous rapid capital outflows seen at the start of the pandemic, the return of capital to these markets, and importantly, for places like Brazil and India and others, to be able to run relatively loose monetary policy, relatively active as fiscal policy in the face of the situation is, I think, unprecedented. And this is actually, in many ways, one of the few hopeful results of this crisis, that perhaps, at least on some basis, the emerging markets in the developing world are getting now to do some of the things that the developed world or the rich countries have been able to do on macro policy to the benefit of their people, which brings us a full circle to where we started.
Central bank activism, central bank use of quantitative easing and other asset purchases, central bank commitment to focusing on crisis fighting and financial disruptions, as opposed to worrying about low probability inflation risks, and central bank cooperation across borders to make sure that liquidity is provided in dollars or what is needed. All of these have worked. They cannot overcome political divisions in our societies, they cannot even give us the recovery we need. It is, if anything, an irony of the first order that just as the US and some other advanced economies are messing up their own public health and their own future prospects, as well as their trading relationships, that the emerging markets on average are able to now emulate their better policies. But nonetheless, that is where we are.
Again, thank you for including me in this year's Bund Summit. I look forward to hearing about the discussion.