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Sep 8th 2012 | from the print edition
IMAGINE that the world s best specialists in a particular disease have convened
to study a serious and intractable case. They offer competing diagnoses and
treatments. Yet preying on their minds is a discomfiting fact: nothing they
have done has worked, and they don t know why. That sums up the atmosphere at
the annual economic symposium in Jackson Hole, Wyoming, convened by the Federal
Reserve Bank of Kansas City and attended by central bankers and economists from
around the world*. Near the end Donald Kohn, who retired in 2010 after 40 years
with the Fed, asked: What s holding the economy back [despite] such
accommodative monetary policy for so long? There was no lack of theories. But,
as Mr Kohn admitted, none is entirely satisfying.
His question could hardly be more timely. As The Economist went to press, the
European Central Bank (ECB) was meeting to discuss a resumption in purchases of
bonds of peripheral euro-zone members, in a bid to alleviate strains on the
single currency. Ben Bernanke, the chairman of the Federal Reserve, suggested
in his speech in Jackson Hole that a third round of quantitative easing (QE),
the purchase of bonds with newly created money, would be on the table when the
Fed s policy committee meets on September 12th-13th. Mr Bernanke cited research
by the Fed that previous bouts of QE had lowered bond yields and boosted GDP by
as much as 3%. That is good, but not good enough. In America, Britain and the
euro zone, interest rates are at or near zero and central banks balance-sheets
have ballooned, yet unemployment remains high and growth sluggish (see chart).
One school of thought is that a high unemployment rate is structural and immune
to the stimulative effects of monetary policy. Edward Lazear of Stanford
University and James Spletzer of America s Census Bureau argue otherwise. In a
paper presented to the conference, they showed that those sectors and
demographic groups that contributed most to the rise in unemployment in 2007-09
also contributed most to its decline in 2009-12, which suggests that shifts in
relative demand for workers could not explain the high level of unemployment.
The mismatch between the skills of the unemployed and the skills employers
demand did rise during the recession. But by late 2011 the mismatch was back
down to pre-recession levels.
If most unemployment is cyclical, not structural, the Fed could theoretically
help by stimulating demand with easier monetary policy. But how? Michael
Woodford of Columbia University told the conference that with short-term rates
around zero, central banks have tried two broad strategies: forward guidance ,
or promising to keep the interest rate at zero for some time, or expanding
their balance-sheets through QE and the like. Mr Woodford acknowledged these
strategies had brought down expected short-term and actual long-term interest
rates, but was sceptical about their impact on economic output. In his paper he
recommended that the Fed commit to keeping policy easy until the economy
reaches a particular target, such as nominal GDP (ie, output unadjusted for
inflation) returning to its pre-recession path. The Fed is not about to do
that, although it might decide to link future policy action to progress on
unemployment.
Adam Posen, who recently left the Bank of England s monetary-policy committee,
had a different explanation for the apparent impotence of monetary policy.
Since many financial markets are dysfunctional, the monetary medicine isn t
getting into the economy s bloodstream. The solution is for central banks to
buy more assets in the markets that are most obviously impaired. That is what
the Bank of England is doing by providing subsidised credit to banks that lend
more, what the ECB is set to do when it resumes purchasing sovereign bonds, and
what the Fed could do by buying more mortgage-backed securities.
Sages or dinosaurs?
In another paper, Markus Brunnermeier and Yuliy Sannikov of Princeton
University provided theoretical justification for this approach. Monetary
easing usually works by encouraging businesses and households to move future
consumption and investment forward to today. But it also has redistributive
effects. For example, low short-term interest rates redistribute income from
depositors to banks, which allows them to rebuild capital and encourages them
to lend more. Similarly, purchases of ten-year government bonds enrich some
investors while hurting others, such as pension funds, that depend on bond
income to meet longer-dated liabilities. By tailoring their instruments to
sectors most in need of support, central banks can get more bang for their
buck.
One problem is identifying the areas where direct intervention will do the most
good. Amir Sufi of the University of Chicago told the conference that raising
banks profits has not done much to restart demand because the real problem is
that indebted households cannot or will not borrow. He presented evidence that
retail spending and car sales have been weaker in states that entered the
recession with higher household debt.
An even bigger issue is the political controversy that ensues when central
banks favour particular sectors. Fed officials are constantly told that zero
interest rates are hurting savers without helping businesses. ECB purchases of
peripheral countries bonds transfer risk from debtor to creditor states,
prompting opposition from the Bundesbank and voters in creditor countries. Mr
Posen decried the self-imposed taboos and prehistoric thinking that makes
central banks worry that targeted lending will distort the allocation of credit
or turn into politically motivated money-printing. This drew a retort from
Larry Lindsey, a former Fed governor: In a free society, individuals and
institutions don t do unusual things because if you do, and break custom and
happen to be wrong, you re betting the farm.
Economist.com/blogs/freeexchange
from the print edition | Finance and economics