Monetarist's Mea Culpa

How the mighty have fallen.

Here are some interesting tidbits from an article in the Financial Times by Martin Wolf about monetarism as practiced by central banks during the last few decades:

Just over five years ago, Ben Bernanke, now chairman of the Federal Reserve, gave a speech on the “Great Moderation” – the declining volatility of inflation and output over the previous two decades. In this he emphasised the beneficial role of improved monetary policy. Central bankers felt proud of themselves. Pride went before a fall. Today, they are struggling with the deepest recession since the 1930s, a banking system on government life-support and the danger of deflation. How can it have gone so wrong?

This is no small matter. Over almost three decades, policymakers and academics became ever more confident that they had found, in inflation targeting, the holy grail of fiat (or man-made) money. It had been a long journey from the gold standard of the 19th century, via the restored gold-exchange standard of the 1920s, the monetary chaos of the 1930s, the Bretton Woods system of adjustable exchange rates of the 1950s and 1960s, the termination of dollar convertibility into gold in 1971, and the monetary targeting of the 1970s and 1980s.

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Complacency about the Great Moderation led first to a Great Unravelling and then a Great Recession. The private sector was complacent about risk. But so, too, were policymakers.

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Whichever critique one accepts, it seems clear, in retrospect, that monetary policy was too loose. As a result, we now face two challenges: clearing up the mess and designing a new approach to monetary policy.

On the former, we have three alternatives: liquidation; inflation; or growth. A policy of liquidation would proceed via mass bankruptcy and the collapse of a large part of the existing credit. That is an insane choice. A deliberate policy of inflation would re-awaken inflationary expectations and lead, inevitably, to another recession, in order to re-establish monetary stability. This leaves us only with growth. It is essential to sustain demand and return to growth without stoking up another credit bubble. This is going to be hard. That is why we should not have fallen into the quagmire in the first place.

On the latter, the choice, in the short term, is certainly going to be “inflation targeting plus”. “Out” is likely to be the “risk management” approach of the Fed, which turned out to give an unduly asymmetric response to negative economic shocks. “In” is likely to be “leaning against the wind” whenever asset prices rise rapidly and to exceptionally high levels, along with a counter-cyclical “macro-prudential” approach to capital requirements in systemically significant financial institutions.

This unforeseen crisis is surely a disaster for monetary policy. Most of us – I was one – thought we had at last found the holy grail. Now we know it was a mirage. This may be the last chance for fiat money. If it is not made to work better than it has done, who knows what our children might decide? Perhaps, in despair, they will even embrace what I still consider to be the absurdity of gold.

It is a rather sad tale, but I find encouragement in the fact that explanations are coming forward and prescriptions to prevent it are being offered.

The understanding of the Great Depression is generally settled but still argued over. I suspect that the Great Recession will be debated for the next fifty years before a real and complete understanding will be achieved.

The only really clear thing right now is that the lives of hundreds of millions of people have been severely impacted, that the miscreants behind the catastrophe will never be held accountable, and that no clear policies to fix the problems will be brought to bear in any timely way. In short, it is the 1930s all over again. Lots of fumbling in the dark by bureacrats with political tricksters creating pitfalls and traps along the way to advance their peculiar agendas.