Cato Journal: Revisiting Three Intellectual Pillars of Monetary Wisdom

Claudio Borio, deflation, natural rate of interest, savings glut, secular stagnation
Claudio Borio and George Selgin at the 33rd Annual Cato Monetary Conference, by Cato Staff

Claudio Borio, deflation, natural rate of interest, savings glut, secular stagnationA new issue of the Cato Journal, which collects the proceedings of last year’s Annual Monetary Conference, was released last week.  Those proceedings include a paper by Claudio Borio, head of the Bank for International Settlement's monetary and economic department, which Alt-M readers may find particularly interesting.

According to Borio, conventional thinking on monetary policy rests on three faulty assumptions:

First, that natural interest rates are those consistent with output at potential and low, stable inflation.

This assumption is important because monetary authorities are supposed to track natural interest rates when they set policy.  Unfortunately, says Borio, the mainstream view of natural interest rates is imprecise, since we know that dangerous financial build ups can occur even when growth is strong and inflation is on target.  Crucially, such build ups—excessive credit, inflated asset prices, and too much risk-taking — may be caused by interest rates that are too low.  Could it be that “natural” rates are themselves sometimes inconsistent with financial stability?  Borio thinks not, and suggests that we need instead to define natural rates more carefully, as rates “consistent with sustainable financial and macroeconomic stability.”  In practice, such a definition would lead monetary policymakers to “lean against” booms when times are good, and also to worry more about the long-term consequences of expansionary monetary policy (which Borio suggests may sow the seeds of future crises) during busts.

Second, that monetary policy is neutral over the medium- to long-term.

By contrast, Borio believes that monetary policy may in fact have significant long-term effects on the real economy.  It is hard to argue, for example, that low interest rates are not a factor in fueling financial booms and busts, given that monetary policy generally operates through its impact on credit expansion, asset prices, and risk-taking.  And when such booms and busts lead to financial crises, the effects can be very long-lasting, if not permanent: growth rates may recover, but output might never catch up with its pre-crisis, long-term trend.  Borio points out that financial busts weaken demand, since falling asset prices and over-indebtedness often combine to wreak havoc on balance sheets.  Financial booms, meanwhile, affect supply: BIS research suggests they “undermine productivity growth as they occur” by attracting resources towards lower productivity growth sectors.  Taken together, these points have important implications: on the one hand, monetary policymakers ought to be more careful about supporting booms; on the other, apart from resisting the temptation to encourage booms, there may not be much that monetary policy can do about busts, since “agents wish to deleverage” and “easy monetary policy cannot undo the resource misallocations.”

Third, that deflation is everywhere and always a bad thing.  

Not so, says Borio (and many here at Alt-M would agree with him).  In fact, BIS research has found that there is only a weak association between deflation and output.  When you control for falling asset prices, moreover, that association disappears altogether — even in the case of the Great Depression.  The key here is to distinguish between supply-driven deflations, which Borio suggests depress prices while also boosting output, and demand-driven deflations, which tend to be bad news all around.  By failing to draw this distinction, monetary authorities have introduced an easy-money bias into their policy decisions: in the boom years, when global disinflationary forces should have led to falling consumer prices, loose monetary policy instead kept inflation “on target”; then, in the bust years, central banks eased aggressively — and persistently — to stave off the mere possibility of a demand-driven deflation.  (Or did they?)

This leads neatly to the broader theory that Borio outlines in his Cato Journal article: that the long-term decline in real interest rates we have witnessed since the 1990s is not, as proponents of the “savings glut” and “secular stagnation” hypotheses suggest, an equilibrium phenomenon, driven by deep, exogenous forces; rather, it is a disequilibrium phenomenon driven by asymmetrical monetary policy, and may be inconsistent with lasting financial and macroeconomic stability.

In a nutshell, Borio believes that the three fundamental misconceptions outlined above have inclined central banks towards monetary policy that is expansionary when times are good, and then even more expansionary when times are bad.  Over the course of successive financial and business cycles, this skewed approach to monetary policy imparts a downward bias to interest rates and an upward bias to debt, which in turn leads to “a progressive loss of policy room for maneuver” as central banks cannot push interest rates any lower, but also cannot raise rates “owing to large debts and the distortions generated in the real economy.”  The result is entrenched instability and “chronic weakness in the global economy,” as well as what Borio calls an “insidious form of ‘time inconsistency,’” in which policy decisions that seem reasonable — even unavoidable — in the short term, nevertheless lead us ever-further astray as time goes by.  This will, undoubtedly, strike many readers as an apt description of the current state of play in monetary policy.

Here again is Borio’s complete article.  I encourage you to read the whole thing.  The entire monetary issue of the Cato Journal, titled “Rethinking Monetary Policy,” can be found here, and features articles from Stanford economist John Taylor, Richmond Fed president Jeffrey Lacker, and St. Louis Fed president James Bullard, as well as from Alt-M’s own George Selgin, Larry White, and Kevin Dowd, among others.  Happy reading!