Unconventional monetary policies will inevitably lead to unconventional results

By Andrew Sheng

It is always useful to look back before you look forward. In 2006, when markets appear to be going to the sky, there was a lamentation that monetary policy was not that effective because of the global savings glut (blame the Far East high savers). In 2007, when subprime crisis was first disclosed, the potential losses were pooh-poohed as manageable, because subprime NPLs were estimated at less than 1 percent of GDP. By 2008, when crisis became full blown, the signal call for monetary policy and rescue operations was “whatever it takes (to stop the crisis).” By 2009, central banks were signaling green shoots. By 2010, when the fear of double dip and jobless deflation emerges, the rallying call is “Quantitative Easing 2 (QE2),” as if QE2 is not Titanic. The older generation of economists has started to dust down their books by Keynes and Hayek to see whether lessons of the 1930s Great Depression could bring sanity to the current state of affairs. If the advanced economies are going to slow, would more monetary policy help or should it be the job of fiscal policy? Keynes of course believed that if investor confidence in the economy gets into what he called the Liquidity Trap, then the Government should spend to drive the economy and create jobs. This is where the policy debate is currently in the United States. Paul Krugman is saying that the U.S. should spend more and also blame the foreigners for currency manipulation. The fiscal conservatives say that the public debt is already unsustainable and you should begin to exit the stimulus package. Meanwhile QE2 involves the Fed buying more government securities to try and keep interest rates as low as possible to help the recovery. Frederick Hayek was the Austrian economist who rejected Soviet central planning and propagated open society and free markets. Hayek’s “natural market forces” implied that there was very little that can be done to deal with the reversal of bubbles until the creative destruction eliminates the bad borrowers and cleans the system, so that the market starts anew. In other words, if you are a purist believer in free markets, allow the market to go to a boom and then allow the bust to come. Government intervention will not stop that deflationary forces working and may even harm the recovery.0

To be consistent, you must adopt either Hayek or Keynesian solutions, but not have your cake and eat it. What has happened with free market fundamentalists is that they preach Hayek on the boom up because it benefits them, and then when the bust comes, they bring out Keynes to say why the government should bail them out. The U.S. is in the unenviable position of trying to minimize losses after a period of excess consumption. We all understand that the real reason why the Fed is going all out on QE2 is because the political gridlock is delaying significant action on the fiscal front. QE2 is an attempt to replace private sector credit creation (mostly through the shadow banking system which the policy makers earlier missed) with central bank credit creation. The Fed knows that a sharp rise in interest rates would hurt badly the heavily leveraged borrowers, make the fiscal position even more unsustainable and tip the economy into a debt deflation spiral. Will more debt solve an excess debt situation? If interest rates are zero, can the free market really function? Remember, it was the excessively low interest rates that got us into the soup in the first place, because at lower levels, risk premiums were clearly under-pricing the risks. Bank of Japan Governor Shirakawa has recently tried to explain from the Japanese experience how distortive low interest rates can become: