This is a point that your humble blogger has been making.
It has been known since the 1870s that there is a lower bound to effective monetary policy. Walter Bagehot, the father of modern central banking, set this lower bound at 2%. He observed that below this rate, behavior would change.
Mark Twain explained exactly what this change in behavior would be when he observed that he was more concerned about the return of his money than the return on his money. In short, keeping interest rates below 2% interferes with investor attitudes towards risk taking.
I have documented that rates below 2% also interfere with current consumption. Savers offset the lack of return on their investments by deferring current consumption. I call this the Retirement Plan Death Spiral.
Confirmation of this self-reinforcing downward spiral is easily seen with companies with defined benefit pension plans. To offset the lack of earnings on the pension assets, these companies must contribute more money to the pension plans. The result of this is less money for the companies to reinvest or grow their own business. This in turn triggers lower return on pension assets ...
"Why did no one see the crisis coming?" Queen Elizabeth II asked economists during a visit to the London School of Economics at the end of 2008. Four years later, the repeated failure of economic forecasters to predict the depth and duration of the slump would have elicited a similar question from the Queen: why the overestimate of recovery?For the record, I saw the crisis coming and my estimates of recovery have mirrored what has actually taken place.
Consider the facts. ...
Some forecasters are more pessimistic than others (the OBR has a particularly sunny disposition), but no one, it seems, has been pessimistic enough.Unfortunately, I have been pessimistic enough. I said at the outset of the financial crisis until we bring transparency to the opaque corners of the financial system and deal with the losses on the excess debt, the global economy would be in a downward spiral. A downward spiral that vast quantities of fiscal and monetary stimulus is attempting to offset.
Economic forecasting is necessarily imprecise: too many things happen for forecasters to be able to foresee all of them. So judgment calls and best guesses are an inevitable part of "scientific" economic forecasts.
But imprecision is one thing; the systematic overestimate of the economic recovery in Europe is quite another.
Indeed, the figures have been repeatedly revised, even over quite short periods of time, casting strong doubt on the validity of the economic models being used.
These models, and the institutions using them, rely on a built-in theory of the economy, which enables them to "assume" certain relationships. It is among these assumptions that the source of the errors must lie.
Two key mistakes stand out.
The models used by all of the forecasting organisations dramatically underestimated the fiscal multiplier: the impact of changes in government spending on output.
Second, they overestimated the extent to which quantitative easing (QE) by the monetary authorities – that is, printing money – could counterbalance fiscal tightening. ...
Forecasting organisations are finally admitting they underestimated the fiscal multiplier.
The OBR, reviewing its recent mistakes, accepted that "the average [fiscal] multiplier over the two years would have needed to be 1.3 – more than double our estimate – to fully explain the weak level of GDP in 2011-12".
The IMF has conceded that "multipliers have actually been in the 0.9 and 1.7 range since the Great Recession". The effect of underestimating the fiscal multiplier has been systematic misjudgment of the damage that "fiscal consolidation" does to the economy.Which is a polite way of saying that austerity is the equivalent of throwing gasoline on a fire. It takes a bad situation and makes it worse.
Please recall that the argument for austerity is to reduce the government debt built up since the beginning of the financial crisis. And why was there an increase in government debt? To bail out the banks and protect their book capital levels and banker bonuses.
Effectively, the government socialized the losses in the financial system. This puts the burden of the excess debt on the real economy as oppose to the financial system that is designed to absorb it. Servicing this excess debt diverts capital from reinvestment and growth in the real economy. This is what triggers the downward spiral.
This leads us to the second mistake. Forecasters assumed that monetary expansion would provide an effective antidote to fiscal contraction. The Bank of England hoped that by printing £375bn of new money, ($600bn ), it would stimulate total spending to the tune of £50bn, or 3% of GDP.
But the evidence emerging from successive rounds of QE in the UK and the US suggests that while it did lower bond yields, the extra money was largely retained within the banking system, and never reached the real economy. This implies that the problem has mainly been a lack of demand for credit – reluctance on the part of businesses and households to borrow on almost any terms in a flat market.Actually, the decline in demand doesn't just represent a lack of demand for credit. It represents a decline in demand from savers.
These two mistakes compounded each other: if the negative impact of austerity on economic growth is greater than was originally assumed, and the positive impact of quantitative easing is weaker, then the policy mix favored by practically all European governments has been hugely wrong.
There is much greater scope for fiscal stimulus to boost growth, and much smaller scope for monetary stimulus.Actually, there is still significant scope for monetary stimulus.
The question is what monetary policies need to be followed to stimulate the economy?
Your humble blogger has been saying for years, listen to Walter Bagehot, reverse current zero interest rate and quantitative easing policies and raise interest rates back to 2%. Demand should increase as savers can generate a return on their savings and can boost their current consumption.
At the same time, stimulative fiscal policies should continue to be pursued. This complements monetary policy and reinforces growth in demand.
But what about the losses on the excess debt? Have the financial system absorb these losses.
This is all quite technical, but it matters a great deal for the welfare of populations.
All of these models assume outcomes on the basis of existing policies. Their consistent over-optimism about these policies' impact on economic growth validates pursuing them, and enables governments to claim that their remedies are "working," when they clearly are not.
This is a cruel deception.
Before they can do any good, the forecasters must go back to the drawing board, and ask themselves whether the theories of the economy underpinning their models are the right ones.