The premise of this blog is simple: prospects for global growth and development are clouded by a miasma of uncertainty that stifles investment and demand. The analytics of the problem are captured by the option value of waiting — the notion that uncertainty creates an incentive for individuals to "wait and see" rather than invest and spend. A similar fog of uncertainty prevailed during the years of stagnation in the Great Depression; FDR's admonition, "the only thing we need to fear, is fear itself," was intended to rouse people from the stupor of uncertainty and get the economy moving again.
Outgoing Fed chairman Bernanke studied those years of wasted potential and broken dreams and resolved not to repeat the mistakes of his predecessors in 1929. In the dark days following the demise of Lehman Brothers in September 2008, therefore, he followed Bagehot's dictum and provided liquidity as global credit markets were collapsing in on themselves. By doing so, chairman Bernanke helped prevent another Great Depression.
But, having reduced the threat of economic collapse, the Fed's efforts to foster vigorous, sustained growth sufficiently robust to move the economy to full employment have been tested. In part, this reflects the effects of perverse fiscal policy that has replicated the pro-cyclical fiscal policy demanded by adherence to the gold standard in the 1930s. While the situation is not nearly as dire as it is in Europe, where euroland elites have unwittingly reconstructed the dysfunctional gold standard of the inter-war years, were it not for that fiscal drag, the U.S. recovery would look much stronger — much more like past post-war recoveries.
Part of the story behind the tepid recovery might also be about the effects of pervasive uncertainty. And, by uncertainty, I don't mean increased volatility. What I am thinking of is Frank Knight's definition of an inability to assess risk. What's the difference? Good question. Here's an attempt at an answer:
Think of risk as the probability of an event from a known distribution. Knight's classic, "Risk, Uncertainty and Profit," compared it to the number of bottles that would be broken in any given hour on a production line. The actual number might vary by hour, but over long observation the parameters of the distribution could be assessed and verified, so that a manager could say with some assurance: "on average, there is a risk that x bottles will be broken, with a standard deviation of y."
Now, as I think about it, Knightian uncertainty would prevent the manager from making that kind of statement. The number of bottles broken might be 5, 10, or 50, with an unknown standard deviation. The manager is unable to assess the potential breakage. What would account for such a situation? Perhaps the introduction of a new machine that has yet to be tested; regardless, in the example, the manager is unlikely to make other fundamental changes to the production line until this uncertainty can be dispelled and the risk assessed.
In a sense, this may be the challenge facing central bankers today. Before the global financial crisis, the prevailing monetary policy framework of inflation-targeting central banks was relatively transparent and reasonably well understood. They sought to maintain low, stable inflation using their ability to affect the very short-term interest rate under their influence. With clear communications policies, markets understood that negative demand shocks would elicit a reduction in short-term interest rates, while a positive demand shock would result in higher interest rates. Without output fluctuating around a rising trend of potential output, the framework was helpful in allowing individuals to assess the risks they faced.
In the wake of the global financial crisis, the usefulness of the framework is unclear and the ability of individuals to assess risk more problematic. With four major economies (the U.S., the euro zone, Japan, and the U.K.) operating in liquidity traps, interest rates were dropped to the effective zero lower bound. But even at that low rate, with the risk of deflation present, some argued there was a need for rates to go even lower — consider a situation in which, with zero nominal rates, an increase in deflation means that real rates are positive and rising. In such abnormal circumstances, the pre-crisis inflation-targeting doesn't really help anyone. The problem is one of uncertainty about how to implement monetary policy, on the one hand, and what the effects of policy might be, on the other hand.
For this reason, a number of central banks have adopted unconventional policy frameworks to deal with liquidity trap. These include quantitative easing and forward guidance. In the U.S., the former is designed to keep long-term interest rates low in an environment where the Fed can't reduce short rates any lower. In contrast to traditional monetary policy operations, which work through the term structure of interest rates (long bond yields are a geometric mean of current and future short rates), quantitative easing operates directly through the demand for long bonds. Similarly, forward guidance is intended to provide a framework with which individuals can understand the future evolution of the economy. Here, too, the contrast with pre-crisis inflation targeting, which was helpful in understanding the relationships between negative and positive shocks and the path of short-term interest rates, is instructive. In the context of the liquidity trap, forward guidance aims to give assurance that the highly-accommodative stance of monetary will not be prematurely reversed should inflation approach its target level. It does this by conditioning a shift in policy to a third variable — unemployment.
For the avoidance of doubt, I think forward guidance and quantitative easing are important innovations; while some may warn of risks of extraordinary measures, that criticism alone misses the point that not doing something in the face of potential protracted stagnation also entails risk. On balance, some risks are worth taking. But here's the rub: there is uncertainty associated with forward guidance that commits to keeping interest rates low until unemployment is below x%. Even if the central bank has perfect credibility, financial markets will not passively wait for unemployment to hit that threshold. The reason is that moving first may allow some to avoid losses when rates do move. Of course, if all move in lock-step (as arguably they did in mid-2013) rates will move higher, with potential negative effects on growth and stalling the recovery. That outcome would put off crossing the threshold.
What is to be done? In effect, the central bank must commit to a policy of keeping interest rates low beyond the absolute minimum to achieve "escape velocity" and restore full employment. But how is any respectable central bank going to do that?
One way is through political commitment — Japanese Abe has provided political cover for Bank of Japan governor Kuroda to double the size of his balance sheet; indeed, one suspects that Kuroda-san's failure to follow through with Abenomics would lead to his dismissal. As a result, for the Japanese the uncertainty that has hounded BoJ decision making for the past two decades is dispelled. It may be radical, it may end in tears, but none can say that they are uncertain about what the government and the BoJ want.
Simon Wren-Lewis, in his excellent blog, Mainly Macro, suggests another approach that the ECB might adopt — targeting monetary aggregates. He argues that the ECB could publish targets for monetary aggregates (as a stalking horse for nominal GDP targeting, which some might find "unsound"), making, in effect, the kind of pre-commitment that would resolve the time inconsistency problem of making policy in a liquidity trap.
Perhaps, a third possibility would be to make a commitment to a fixed exchange rate. A country could credibly commit to maintain an under-valued fix, creating the conditions that would, over time, generate real appreciation through higher inflation. Such an approach might work for a small country fixing to a supportive large country; however, I don’t think it would work in current circumstances, in which the risk of stagnation and deflation stalk the old major economies that still account for much of the global economy. Nevertheless, in some respects, thinking of exchange rate regimes as a means of pre-committing policy to avoid deflation provides some perspective on the Bretton Woods system established 70 years ago this July. (The threat of deflation and a relapse of global stagnation was, after all, the fear that haunted the corridors of the Mount Washington Hotel, Bretton Woods, New Hampshire, in July 1944.) It also suggests that a global financial crisis that has led to upheavals in international monetary practice may require a concerted, international approach to dealing with its legacies.
More on this in a follow-up post.