Among the dangerous delusions to have taken hold since the financial crisis went viral in 2008 is the belief that dollops of monetary lubricant can take the place of real economic reforms.
Your banks are bust? Labour markets gummed up? Whatever. If a national economy is simply a big factory producing GDP widgets, it doesn't matter why it's not cranking out what it used to, or why folks aren't buying. Speed of lightning, roar of thunder, central banks can always step in to do the lending or the buying.
The world's loudest economist has been banging this drum for 10 years. During the 2001 downturn Paul Krugman wrote that “The driving force behind the current slowdown is a plunge in business investment.”
Yet “to reflate the economy,” he assured us, “the Fed doesn't have to restore business investment; any kind of increase in demand will do.” In particular, “Housing, which is highly sensitive to interest rates, could help lead a recovery.” A year later, he divined that “[the Fed] needs soaring household spending to offset moribund business investment. And to do that [it] needs to create a housing bubble to replace the Nasdaq bubble.” Wish granted.
It is the great seduction of this crude brand of Keynesianism that its economics consists merely in the government manipulating national economic aggregates, and that the flagging animal spirits of the inscrutable entrepreneur can be compensated for, quickly and painlesly, by government money-printing and spending.
Yet it is crucial to note that no central bank outside the Fed and ECB, which mint 90% of the world's monetary reserves, can even attempt such heroics. “Wow,” Krugman wrote after reading former Salvadoran finance minister Manuel Hinds and me say as much in the Financial Times on 24 May, “Have these guys ever talked to anyone in Sweden, which doesn't need euros to create more kronor?”
Well, let's look at the data – for Australia too, which Krugman throws into the mix.
As the figures show clearly, when the Swedish and Australian central banks expanded credit dramatically during the recent financial crisis they also liquidated foreign assets. That is, both central banks accompanied their massive easing with a scramble for reserve currencies. And this is not merely a crisis effect, as three full decades of Australian data show. Any country that ploughs on creating credit without ample reserve currencies – dollars and euros – eventually becomes a ward of the IMF.
The ECB and the Fed are hardly omnipotent, however. Far from it.
Back in 2000, the ECB's first president, Wim Duisenberg, explained that he knew the Bank's operational framework for implementing monetary policy was working well because it was successfully steering short-term market interest rates exactly where the Bank wanted them to go.
Prior to the crisis, the ECB's policy rate was indeed tightly connected to three-month eurozone government borrowing rates. In a growing swath of the eurozone, however, this relationship has collapsed – in the case of Spain, from near-100% to near-0%. Default risk increasingly dominates these rates, which themselves strongly influence rates in the private sector.
By Duisenberg's criterion, monetary policy in the eurozone is becoming less and less effective as the ECB wades deeper and deeper into the political quicksand of fiscal policy and discretionary credit allocation. In continually insisting that a eurozone sovereign debt restructuring is out of the question, the ECB is merely trying to avoid the threat to its independence that would follow if the Bank were itself to need a recapitalisation by the member states.
For its part, the 2011-model Fed sports a 55-1 leverage ratio, and is so exposed to interest rate risk that a roughly 40-basis-point rise in long-term yields would wipe out its capital. It too could be in line for a Treasury bailout. Given that the Fed is currently the world's leading consumer of Treasury debt, this would be the ultimate monetary irony.
Benn Steil is director of international economics at the Council on Foreign Relations and a winner of the 2010 Hayek Book Prize. His co-winner, Manuel Hinds, and CFR analyst Paul Swartz contributed to this column
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