Why monetary policies are impotent

2 Sep, 2019 at 18:57 | Posted in Economics | 3 Comments

Even if interest-rate cuts at all points proximately increase demand, there are substantial grounds for concern if this effect is weak. It may be that any short-run demand benefit is offset by the adverse effects of lower rates on subsequent performance …

commercial illustratorFrom a macro perspective, low interest rates promote leverage and asset bubbles by reducing borrowing costs and discount factors, and encouraging investors to reach for yield. Almost every account of the 2008 financial crisis assigns at least some role to the consequences of the very low interest rates that prevailed in the early 2000s. More broadly, students of bubbles, from the economic historian Charles Kindleberger onward, always emphasize the role of easy money and overly ample liquidity.

From a micro perspective, low rates undermine financial intermediaries’ health by reducing their profitability, impede the efficient allocation of capital by enabling even the weakest firms to meet debt-service obligations, and may also inhibit competition by favoring incumbent firms …

In moving toward the secular stagnation view, we have come to agree with the point long stressed by writers in the post-Keynesian (or, perhaps more accurately, original Keynesian) tradition: the role of particular frictions and rigidities in underpinning economic fluctuations should be de-emphasized relative to a more fundamental lack of aggregate demand …

What is needed are admissions of impotence, in order to spur efforts by governments to promote demand through fiscal policies and other means.

Lawrence Summers & Anna Stansbury

New ‘Keynesians’ — like Paul Krugman and Simon Wren-Lewis — have long been arguing that, at the zero lower bound of nominal interest rates, central bankers don’t have the tools to effectively fight recessionary tendencies in the economy. This yours truly and other Post Keynesian economists have criticized, arguing that those monetary measures don’t work even when we’re not even close to the zero lower bound.

In the New ‘Keynesian’ world we don’t need fiscal policy other than when interest rates hit their lower bound (ZLB). In normal times monetary policy suffices. The central banks simply adjust the interest rate to achieve full employment without inflation. If governments in that situation take on larger budget deficits, these tend to crowd out private spending and the interest rates get higher.

Now, the logic behind the New ‘Keynesians’ loanable-funds-IS-LM-theory is that if the government is going to pursue an expansionary fiscal policy it will have to borrow money and thereby increase the demand for loanable funds which will — “other things equal” — lead to higher interest rates and less private investment. According to this approach, the interest rate is endogenized by assuming that Central Banks can (try to) adjust it in response to an eventual output gap. This, of course, is essentially nothing but an assumption of Walras’ law being valid and applicable, and that a fortiori the attainment of equilibrium is secured by the Central Banks’ interest rate adjustments. From a Post Keynesian point of view, this is a belief resting on nothing but sheer hope.

We have to free ourselves from the loanable funds theory — and scholastic gibbering about ZLB — and start using good old Keynesian fiscal policies. Keynes — as did Lerner, Kaldor, Kalecki, and Robinson — showed that it was possible to promote economic growth with an “appropriate size of the budget deficit.” The stimulus a well-functioning fiscal policy aimed at full employment may have on investment and productivity does not necessarily have to be offset by higher interest rates.

larryNow Larry Summers has come to realize that the New ‘Keynesian’ dogma is wrong and that we need other stabilisation (read fiscal) tools to get the economy going. That’s great. Now we’re eagerly awaiting some other guys to finely wake up …


  1. “low rates undermine financial intermediaries’ health by reducing their profitability”
    Buy a bond Exchange Traded Fund. As yields go down, your return on the ETF goes up. Banks have figured this out even if Summers hasn’t.

  2. This is an admission of failure during the neo-classical/neo-liberal age (of which Summers played a central role as one of the three ‘masters of the universe’) on multiple fronts.

    Most important is the admission that during the Great Moderation there was excess liquidity. This proves that monetary policy and particularly interest rates targeting was never a reliable way of conducting macro policy. Taylor rules and output gaps are part of this targeting strategy. As part of this, neo-classical/neo-Keynesian rational expectations sticky price optimisation models must go if we are to sensibly understand economies and the problems facing capitalism.

    So far neo-classicists have admitted they got globalisation and deregulation wrong during the Great Moderation. Now, at last, their approach to macro-policy was wrong as well.

    The neo-liberal approach that macro policy, particularly monetary policy, handled by independent central banks and left to its technocratic experts needs to be fundamentally revised.

    This should be part of aims to increase pluralism in the discipline and social involvement in policy.

    This is not pie in the sky: many continental European countries have long operated with facets of social democratic policy.

    For the discipline of economics we here have recognition that sticky price assumptions, output gaps, and zero-lower bound exceptionalism are artificial creations or red herrings that ignore almost everything that is important.

    Model ultimately failed, as Kindelberger or Maddison could have told you. I am glad to see a reference to the former here. We need a more multidisciplinary less a-historic approach to the discipline that does not sideline to casual remarks facts and context which cannot be usefully understood through abstraction or are unquantifiable. The things that cannot be formally modelled are usually the most important things we need to know.

    • I should say I meant New-Keynesian here, not neo-Keynesian.

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