A little bit of knowledge is a dangerous thing
By Scott Sumner
I’m starting to clean out my office, and I keep finding interesting old articles that I clipped out of the newspaper. Some of the stuff from 2008 and 2009 is absolutely mind-blowing. Here’s a January 31st, 2009 article from The Economist:
The ECB is not hurrying to cut interest rates–mostly for the wrong reasons
THE European Central Bank (ECB) believes it deserves a break. In a flurry of activity it took its benchmark interest rate from 4.25% in early October to 2% by mid-January. Its president, Jean-Claude Trichet, has hinted that interest rates will be kept at 2% when the bank meets on February 5th, though it may act again in March. But the euro-area economy is deep in recession and inflation is falling rapidly. Why delay?
The rationale for holding off seems a bit muddled. One worry is that once interest rates fall too far, it will be hard to lift them again. Low rates make risky assets look cheap, so policymakers may hold off from raising them for too long, for fear of derailing a recovery based on rising asset values. But this is more a plea for wiser policymakers than a case against reducing rates.
Another reason for caution, voiced by Mr Trichet, is to avert a “liquidity trap”. This ambiguous bit of jargon usually refers to situations, such as when interest rates fall to zero, where orthodox monetary policy can no longer affect demand.
That’s an EC101 level error. If the Economist magazine is right, and this was the motive, then the Great Recession in Europe was partly caused by an almost unbelievable level of ECB incompetence. Lowering rates to zero with easy money does not make a liquidity trap more likely, it makes it less likely. A liquidity trap is often assumed to occur when the actual market interest rate is stuck at zero. Actually, it’s a situation where the Wicksellian equilibrium interest rate is zero or below. What Mr. Trichet doesn’t seem to have understood is that lowering the policy rate of interest with an expansionary monetary policy actually tends to raise the Wicksellian equilibrium rate, making a liquidity trap less likely. This is just basic EC101.
In the very next paragraph, The Economist pointed out Trichet’s error:
Some ECB rate-setters seem to suggest that a liquidity trap can be avoided simply by not reducing interest rates. Many economists fear the opposite: if policy is kept too tight and deflation takes hold it will become harder to induce spending by cutting rates. Consumers will hold back if they know that, with prices falling, their cash will buy more goods in the future. The ECB still has scope to boost demand: if it doesn’t use it, it could lose it.
Of course the ECB did eventually “lose it”. But then The Economist starts getting confused:
Yet there may be method in the ECB’s approach. Marco Annunziata at UniCredit thinks it might be a ruse to reassure panicky markets it is in control. A hyperactive monetary policy may sometimes be harmful. John Maynard Keynes thought so: “A large increase in the quantity of money may cause so much uncertainty about the future that liquidity-preferences due to the precautionary-motive may be strengthened.” In other words, people (and banks) may cling to cash more tightly if they are spooked. This might also help explain why the bank seems happy to let market rates drift below 2% (see chart)–to talk one game while playing another.
This is another case where a little bit of knowledge can be harmful. Keynes was referring to situations like the US in the spring of 1932, where an expansionary monetary policy led to fears of dollar depreciation, which led to an outflow of gold. This prevented the policy from having its desired effect. But that problem only occurs when you have two media of account (cash and gold), and is not a problem in a modern fiat money economy. A loss of confidence in cash is exactly what you would wish for if you were stuck in a liquidity trap.
A less worthy reason for keeping official rates on hold is that it delays the day when unorthodox policies are called for.
I’d say much less worthy, as delaying a cut in interest rates actually speeds up the day when Wicksellian rate falls to zero and unorthodox policies are called for.
Such a policy [QE] would make the ECB uneasy. It is the world’s most independent central bank, designed to be aloof from governments, not to soil its hands by buying their debt. Finding a way to intervene in 16 sovereign-bond markets may be hard. But Thomas Mayer of Deutsche Bank suspects that is not the main barrier to unorthodox easing: “The ECB would like to remain pure. They fear that if they go down this route, they will lose their integrity.”
Ironically, because Trichet didn’t want to soil his hands with QE, his replacement was forced to adopt a far more unorthodox policy in 2011 and 2012, relative to what would have been necessary if the ECB had cut interest rates more aggressively in 2008 and 2009.
People with suspicious minds often try to find “public choice” explanations for central bank incompetence. There’s a tendency to think, “Surely the experts cannot be that clueless, there must be some special interest group that benefits from this policy”. I think just the opposite. Most policy errors reflect simple incompetence—thinking that a liquidity trap means that actual interest rates are zero, or thinking that Keynes’s worry about the limits of expansionary monetary policy under a gold standard also apply to the modern fiat money economy.
James Carville famously said, “It’s the economy, stupid.” I say, “It’s the stupidity, stupid.” (Not directed at my readers, of course.)