Central banks make an historic turn

September 19, 2012

When the economic history of the 21st century is written, September 2012 is likely to be recorded as a defining moment, almost as important as September 2008. This month’s historic events – Ben Bernanke’s promise to buy bonds without limit until the U.S. returns to something approaching full employment, Angela Merkel’s support for the European Central Bank bond purchase plans and the Bank of Japan’s decision to accelerate greatly its easing program – may not seem earth-shattering in the same way as the near-collapse of every major bank in the U. S. and Europe. Yet the upheavals now happening in central banking represent a tectonic shift that could transform the economic landscape as dramatically as the financial earthquake four years ago.

To see why, we must go back in history 40 years, to the early 1970s. Maintaining full employment was at that time regarded as the main objective of all economic policy, and this had been the case for roughly 40 years, since the Great Depression. But by the early 1970s, voters had enjoyed decades of more or less full employment and were starting to focus on inflation rather than depression as the main threat to their prosperity. Economists and politicians were responding to this shift. Milton Friedman led a monetarist “counterrevolution” against the Keynesian obsession with unemployment, designing new economic models to challenge the Keynesian view that market economies were naturally prone to long-term stagnation. By restoring the pre-Keynesian assumption that market economies were automatically self-stabilizing, the monetarist models produced two powerful policy prescriptions directly opposed to the Keynesian views.

First, the monetarists insisted that price stability, rather than full employment, was the only legitimate target for monetary policy and government macroeconomic management more generally. Second, they argued that central bankers should not accept any direct responsibility for unemployment, since sustainable job creation depended solely on private enterprise – full employment would be achieved automatically if inflation were conquered and market forces were allowed to operate freely, with the minimum of government interference or union constraints. A few years later, Margaret Thatcher and Ronald Reagan turned Friedman’s intellectual revolution into practical politics. On top of its economic impact, monetarism had huge ideological effects by absolving government macroeconomic management of any direct responsibility for jobs and instead attributing unemployment to regulations, unions, welfare policies and other market distortions.

The historic significance of this month’s central bank decisions should now be clear. The Fed has promised to keep printing money until full employment is restored – and it has committed itself to even bolder measures if those announced last week prove inadequate. The ECB has undertaken to “do whatever it takes” to preserve the euro and specifically to buy Spanish and Italian government bonds with newly created euros in unlimited amounts.

In making these announcements, the Fed and the ECB were not just demoting their previously inviolable inflation targets to near-irrelevance. They were breaking intellectual and political taboos that had dominated central banking for four decades. This iconoclasm has prompted an extreme reaction from the one remaining bastion of traditional monetarism in central banking, Germany’s Bundesbank. On Tuesday the Bundesbank’s president, Jens Weidmann, described the new central banking quite literally as the work of the devil; Mephistopheles, he recalled, had used just such policies to create chaos and hyperinflation in Goethe’s Faust.

And indeed, the attempts to use monetary policy to restore full employment will need to overcome the two main objections presented by monetarist theory and repeated his week by the Bundesbank. Will printing more money produce intolerable inflation? And what happens if businesses fail to respond to monetary expansion by creating more jobs – won’t that lead to ever more desperate and risky efforts to artificially stimulate employment?

Most of the admonitions against using monetary policies to achieve full employment focus on the risk of unleashing inflation. On this score, the Fed and the ECB have a very credible response, offered most recently from Ben Bernanke and Mario Draghi last week: As long as unemployment and industrial excess capacity remain anywhere near present levels, generalized inflation is very unlikely. Even if some commodities, such as oil or food, experience inflation, this will be offset by others goods and services whose prices fall.

The more insidious danger is that the Fed will simply fail in its efforts to stimulate job creation and accelerate economic growth. Disappointment was, after all, the outcome of the last two rounds of QE. So why should this one be any different, even if the Fed keeps increasing the amount of new money printed? This is the troubling question that Bernanke has so far failed to answer or even seriously confront.

It may turn out that just injecting money into banks and bond funds is not sufficient, regardless of the amounts. A genuine economic stimulus may require newly created money to be distributed directly to businesses or households as suggested here in the past. Imagine, for example, that the extra $40 billion the Fed will pump every month into the bond market were spent instead on a $130 monthly payment to every U.S. citizen, repeated until the economy returned to full employment. With the taboo against central banks accepting responsibility for unemployment now completely broken, such truly radical monetary policies may just be a matter of time.

PHOTO: U.S. Federal Reserve Chairman Ben Bernanke addresses U.S. monetary policy with reporters at the Federal Reserve in Washington, September 13, 2012. REUTERS/Jonathan Ernst


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One way or another, isn’t the whole purpose of QE precisely to create hyper inflation without calling it by the name? Can’t be a devil’s work, surely, if it’s to create jobs?

Direct cash handouts, as an alternative method, might perhaps be just a bit too obvious (and scary) to the general public?

Posted by Mirogram | Report as abusive

…won’t that lead to ever more desperate and risky efforts to artificially stimulate employment? Does anyone truly believe that the fed hasn’t been in a state of desperation since the financial crisis and actually before? Bernanke’s bloated ego is at stake since according to him this money creation is the solution. If it is not then all his musings of economic theory don’t amount to much more than a lot of gas to put it succinctly. These guys are creating more phony wealth by stealing from one group and giving to another. This used to be socialist dogma redistribution of wealth – but in the case of the fed they take from the poor and give to the wealthy. What arrogant as***.

Posted by keebo | Report as abusive

Remarkable, in-depth article.
Injecting liquidity doesn’t create jobs, because there is essentially no liquidity problem that needs solving. The problem is Trust (I.E. lack thereof), and lack of confidence in the business community.
Inflated stock prices don’t boost business people’s confidence.
Tax cuts don’t work that well, because not too many people in the US pay taxes to begin with…
Entitlements such as welfare and unemployment benefits don’t work to create jobs, because workers with low skills may decide they’d rather get paid little for doing nothing, than be paid a little more for working hard.
So, going back to the Trust-Confidence problem, central bankers don’t seem to realize that by inflating a debt bubble bigger than anything we’ve known before, they’re directly contributing to the malaise in the business community. We business people, feel that this farce can’t go on forever, and it doesn’t seem to be going in the direction that we’d like to see it go, at least judging by the results of QE1 and QE2.

Posted by reality-again | Report as abusive

Great propaganda piece!

As with all great propaganda, it contains just enough elements of the truth to make it believable to those who don’t know better.

Not even Adam Smith thought markets were self-correcting, going so far as to detail the reasons why not in his Wealth of Nations — collusion among the wealthy to subvert the government to their desires and against free trade.

By the way, I don’t think Mr. Bernanke realizes that by printing money (sorry, unlimited bailouts forever through QE programs) that he is doing EXACTLY what Mr. Keynes warned against in such a situation.

“A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.”

The only adjustment necessary in that description is to including “hoarding cash by the wealthy”, simply because that is what the wealthy do with excess profits (reference Adam Smith) to the detriment of society.

The fact is that the central bank CANNOT generate jobs or lower inflation without the appropriate federal legislation to support it.

THAT is what is missing and why this effort is doomed to fail.

You would think Mr. Bernanke would know and understand this, but apparently not.

The real underlying problem is decades of job outsourcing — especially manufacturing jobs that bring in real revenue to the US economy — plus trade and tax legislation that favors capital investment virtually anywhere but in the US.

By Bernanke giving more money to the wealthy, he is simply contributing to the already desperate problem of job loss for decades, especially since the beginning of free trade with China.

Congress MUST REVERSE what it has wrought over the past 30+ years in terms of trade and tax legislation that favors capital investment outside of the US. ONLY that can turn this country around.

Bernanke in the meantime is simply “tilting at windmills”.

Posted by Gordon2352 | Report as abusive

Very well written. Great article

Posted by fabioaraujo | Report as abusive

An important assumption the author makes is that Bernanke no longer intends to control inflation. However, the only evidence for this is that Bernanke has not specified an end date for this round of QE.

This may merely be an attempt to talk up the stock market, or increase inflationary expectations, to counteract deflationary forces. It is by no means a commitment by Bernanke to embark on reckless monetary expansion.

Anyway, the Fed’s dual mandate is to maximize employment AND minimize inflation. Bernanke does not have the authority to abandon this. So this article is based on a false premise. And the sky is not falling.

On the other hand, if the author is somehow right, and Bernanke and the entire Fed are actually going wild, consider how commodity prices would rise, and how that would heat up inflation in China — which pegs the Yuan to the USA dollar, in effect.

Sharply higher Chinese inflation would either force China to raise interest rates or curb lending to cool their inflation, which could significantly slow their growth. If a sharply slower economy led to internal unrest, China would be forced to allow significant appreciation of the yuan, to make imported commodities cheaper in Yuan terms. This yuan appreciation would help the USA economy, and reduce the cost of Chinese imports in Yuan terms, encouraging domestic consumption in China.

Posted by DifferentOne | Report as abusive

Mr. Kaletsky,
I read your article in its IHT format, and want to thank you for providing sense in a subject one would otherwise have a hard time not to categorize as a ‘systemic problem without solution’ since all economic parameters indeed are intertwined. I believe, though, that in order for this policy to take its effect, main-stream companies and business leaders will need to be better briefed and communicated to.

Posted by HansVanMingroot | Report as abusive

The Fed’s two jobs – price stability and employment. Big FAIL on both. Due to the drought, our food prices on anything having to do with grain – feed for animals, baked goods and more – will go up next year. Our fuel prices go up, then down, then up again, then down again – like a roller-coaster affecting anything needing to be trucked or flown to markets.

We hear talk of the “recovery”, but many are facing loss of homes due to foreclosures, loss of jobs or cut in hours and benefits, rise in healthcare costs including insurance, and we have 42 million of our people having to depend on food stamps and welfare while hunger and poverty are still on the rise.

I do wish someone in these “economist” circles would send me a pair of the rose-colored glasses they seem to be wearing or some of the wacky-tobacky they must be smoking. Just keep the printing presses going full speed, pushing out more bills that will soon be worthless. Why not just give each of us our own printing press with a limit of about $5,000? That might help.

Posted by AZreb | Report as abusive