In a welcome reprieve from Bill Gross and Neel Kashkari’s theatrical hand-wringing over Carmen Reinhart’s cynical warnings of “financial repression“, PIMCO’s Mohammed El-Erian warns that policy errors are a major risk facing the economy and financial markets. That risk is a cornerstone of our investment philosophy, but we agree that it’s especially acute at the moment. As he puts it (emphasis added):
The world economy is now in the grips of a damaging feedback loop involving deteriorating fundamentals, lagging policy responses and destabilised financial markets. If policymakers do not act boldly, and do so in a globally-coordinated fashion, the world risks tipping into a prolonged recession with worrisome institutional, political and social consequences.
It’s interesting to see that the continuing stresses of the global financial crisis may be undermining El-Erian’s faith in certain cornerstones of the macroeconomic catechism:
…the European Central Bank – a “Germanic” institution – became even more of a fiscal agency last Sunday by agreeing to buy Italian and Spanish government bonds…
In fact, under current institutional arrangements, monetary and fiscal operations are two sides of the same “vertical” coin, as the European Monetary Union is finally learning the hard way (and rather slowly).
In America, the Federal Reserve overcame on Tuesday three public dissensions to signal that its policy rate will probably remain floored at [zero] per cent for two more years. Yet the ability of such dramatic actions (particularly those by central banks, which were deemed unthinkable just a few weeks ago) to act as durable circuit breakers is questionable. Indeed, recent developments confirm a worrisome trend that has been evident for two years now – policy outcomes have consistently fallen short not only of what is needed but also of policymakers’ own expectations.
This should lead him to call into question prevailing beliefs about what effective economic policies look like. It doesn’t. Instead, he argues that structural conditions have made policy measures less potent:
If policymakers were to step back, they would quickly recognise that policy transmission mechanisms are severely undermined by structural weaknesses. Like clogged pipes, the output of actions is only weakly related to the input.
In America, this takes the form of persistently-malfunctioning housing and labour markets, uneven banking activity, poor infrastructure and medium-term fiscal rigidities. In Europe, the list also includes immediate debt solvency problems, fiscal governance issues and more severe competitiveness difficulties.
There are structural problems, as he notes, and I believe most policymakers are aware of this. But like them, he overlooks shifts in population age structure, which appear to have an especially powerful impact on economies and policy effectiveness. Under this and the conditions he outlines (save “fiscal rigidities,” which the U.S. does not face operationally, and which are being utterly refuted [I so badly want to write "refutiated"--it's such a great word!] by bond market behavior, as they’ve been during Japan’s ‘black widow trade’ decades), policies probably have to be more forceful than we’ve become used to in the eras of post-WW2 rebuilding and the passage of Baby Boomer generations through adulthood in many developed countries.
Unfortunately, El-Erian continues to struggle under the delusion that monetary policy is the most effective weapon in policymakers’ toolkits. Worse, he believes that central bank purchases of sovereign debt amount to “monetization.”
To get out of such an impasse, central bank crisis management remains critical; and it will probably involve further balance sheet operations and monetisation of debt. As critical as this is, it is unlikely to prove sufficient unless it is quickly accompanied by better policy framing at both the national and global level.
For a government whose debt is denominated solely in its own currency, this is a myth (and a stubbornly persistent one).
Unless the central bank pays for government debt without actually taking it onto its books, or pays significantly more than its market value, there is no monetization occurring. It’s merely a swap of one government liability for another, analogous to transferring money between your checking and savings accounts.
One can make the argument that a central bank’s interest rate target is set at a level that will prove inflationary, in which case its open market sales and purchases of government debt will have inflationary consequences. But that’s a far cry from what most macroeconomists think of as debt monetization.
Finally, El-Erian channels his inner Thomas Friedman in a strange paean to China’s policymaking practices:
In this specific area, the world should learn from one aspect of China’s economic policy approach. If it does, it would do three things differently. First, it would get buy-in from broad segments of society for medium-term policy objectives (in this case, high growth, greater employment creation and financial soundness). Second, it would link the objectives to specific structural reforms that are implemented simultaneously and – equally importantly – owned, closely-followed and coordinated at the highest political level. Thirdly, it would build institutional flexibility that facilitates timely midcourse corrections if needed.
These are mandarinate strategic objectives that are highly unlikely to succeed in or among western democracies short of war or depression. They are not bold and globally coordinated policy recommendations.
PIMCO’s big three continue to shoot blanks on sound economic policy. Congratulations again, Paul (and hang in there, Tony).
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