Jacob Frenkel shared his views on how unconventional central banking policies are shaping global economies in a conversation with AGI Distinguished Fellow Andrew Sheng and President of the Institute for New Economic Thinking Robert Johnson.
Real-time news doesn’t always reflect the real economy
The sense at the Davos World Economic Forum this year was one of complete confusion – worse than the sentiment of 2009, and possibly the worst it’s been in 30 years. There was much rapid reporting of negative financial news.
However, one should keep in mind the fact that the real economy is a very heavy tanker, and does not change at the same pace as financial markets. Financial markets are occasionally a mirror of the economy, occasionally an indicator of the real economy, and occasionally (they) are completely unrelated to the real economy. Financial markets play a very important function when they function. They can be very distorting when they are distorted.
It is important to be aware of financial markets, and they can be extremely valuable to the real economy. But it would be a mistake to base your assessment on the real economy exclusively through the lens of financial markets.
The real economy reflects Mark Twain dictum on Wagner’s music – “it is actually better than it sounds.”
Unconventional can become conventional
When the G20 met in London in 2008, they made one important decision: to give license and resources to a programme of quantitative easing (QE), and for unconventional monetary policies. It succeeded in putting a floor underneath the world, which was collapsing.
When the word “unconventional monetary policy” was coined, it implied something that was an aberration, to eventually be returned to the conventional. Nobody remotely believed that the unconventional strategy would be the new paradigm for the next eight years. Only now does one talk about exit, which started with a tiny interest rate move in December 2015.
The fact of the matter is that we have gone into unchartered territory of unconventional policy, and the longer unconventional is practiced the more conventional it becomes. There are distortions that arise when you have an economy that is forced to have practically zero interest rates. People will chase after yields somewhere else, and the somewhere else means higher risk. More risk, more return, more risk.
This risk is not always properly priced, because it is not always apparent. The Bank of International Settlements just came out with a very interesting study on this. One point they make is that resources are pushed to activities that are stimulated by the low interest rate, and they happen to be activities that are of low productivity, like housing construction. Basically one creates a new equilibrium that has low productivity, because you have expanded those unproductive sectors.
Then comes the second damage, of the undoing. The undoing of an excess expansion in that particular sector is almost invariably happening with noise. Very few bubbles are created in an environment of high interest rates – most of the bubbles occur when interest rates are very low. So we need, therefore, to price the cost of delaying normalization.
Monetary policy can be a potent catalyst
The effectiveness of monetary policy itself depends very much on two major factors: first, the strength of a country’s financial system, in particular the banking system, because that’s the mechanism by which monetary policy is imparted on the real economy. Second, the flexibility of the real economy, so that once monetary policy is implemented, it has the intended consequence.
It is in this regard that the U.S. is in the best place. The U.S. banking system, especially after the crisis, has strengthened itself significantly. More capital, less leverage, everything that we are talking about. And the U.S. economy is more flexible than other countries are.
In Europe, in a very similar vein you are asking yourself, how come Germany has the best performance? How come unemployment is 4.5 per cent? How come youth unemployment in Europe, which is almost a disaster, 50 per cent in Spain, 45 per cent in Greece etc. is just 11 per cent or 7 per cent in Germany? The answer is not because the Bundesbank was strong, relatively speaking, but because former German Chancellor Gerhard Schroeder implemented structural policies, even if he lost his political power. But the lesson is that while a flexible economy can be a kiss of death for a politician, it is the right thing to do for the economy, so structural policies really are the name of the game.
No clear choices when dealing with distortions
If you go today to Europe, the only headline that you have is “ECB”; basically, the implicit feeling is that the central bank has become the only game in town. There is an issue here. In the U.S. also, the central bank has expanded itself into the unconventional policies, which were justified at the beginning, into areas that are normally not the domain of central banks.
It’s really a delicate issue. What do you do when you have an orchestra – every instrument needs to play its tune according to the music. If the violinist does not play its music, what should the conductor do? There are two possibilities. Either all the other instruments should play according to the script, but if this guy who is so important is not playing, we know that there is no harmony in the music.
Do you validate a distortion that somebody does not play well, or do you do something else? Should everyone else who is playing the script then modify to conform to the fact that somebody is playing off key so there will be a quasi-harmony? If you do this, real harmony will never be restored. This is a major issue of policy.