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!

  • Milton Churchill

    "This assumption is important because monetary authorities are supposed to track natural interest rates when they set policy."

    It is really comical. You have the government supposedly trying to guess what the natural rate of interest should be, which is like saying the government is trying to guess what the price of pears or oil or water should be on an open, free and unfettered market, then fixing the price of those goods in relation to whatever price they think those goods would trade for, without government in the equation! Of course, they have no intention of pricing according to free market conditions. If they did, their jobs would be superfluous. No central planning is required for money or credit. A free and open market will determine "natural" rates all by itself.

    • joebhed

      ""It is really comical. You have the government supposedly trying to guess what the natural rate of interest should be,……….. ""

      This was in reference to a quote that ……. " monetary authorities are supposed to track natural interest rates when they set policy." .

      So, not sure which government actually has "monetary authority" powers in setting 'base' money cost targets, but in the USA, that is a function tasked to the private FRBS, but the prime fallacy of this policy is to think that these changes in money costs have any dramatic effects on real economic output trends, which require a change in the supply of money.

      At ZIRP and NIRP, where does the 'natural' rate of interest play a role in increasing the money supply so as to effect achieving the economic well-being of GDP potential?

      At some point, perhaps Borio and company will realize that it is the supply of money, and not its cost , that they should be considering on how to influence national economic throughput (increasing aggregate demand), at which point in time it might indeed be worthwhile to get up and go to work in the morning.

      For the Money System Common.

      • Milton Churchill

        I do not subscribe to the, "the Fed is privately owned," line of reasoning. The FRS is controlled by the government, or I should say people in government.

        Also, nominal money interest rates are not the cost of money, they represent the cost of money loans. The cost of money is the goods and services required in an exchange for a given quantity of money, the inverse of the cost of goods and services.

        I would say that interest rate policies, as it is practiced in every developed country, has a dramatic impact on the distribution of capital and wealth globally, but to your point, no positive impact on real output. In fact, it would be difficult to conclude anything other than the opposite, that real output is less than it would be otherwise.

        Lastly, the key to prosperity for a vast majority of the population is increasing production of real goods and services demanded by the public through free choice. Force feeding of aggregate demand through direct government, or government-backed "investments" through taxes, loans, or an additional supply of money, make those in governments and their private partners rich at the expense of everybody else.

        • joebhed

          Another monetary-climate denier.
          Do yourself a favor.
          Learn some history – like about the Warburg National "Citizens" League, earlier the National Businessmans Monetary Policy League..
          On Warburg and his Bankers – They won.
          We, those people you seem to believe actually control THAT government (LOL) , lost.

          From right here at Cato:

          EVERY institution of the FRBS is PRIVATELY owned.
          Each generates PRIVATE profits.
          They live off PUBLIC DEBT.

          I subscribe to that.

          • Milton Churchill

            Where to begin?

            Of course, the big bankers got together and wrote the law, just like the big companies and special interests get together today and write the laws (The Affordable Care Act). Nothing has changed. But, Congress passed it, and is solely responsible for the existence of the system to this day. I think you would agree that nothing like the Federal Reserve System would, or could, exist without government enforcement.

            Congress and the executive branch represent their financial backers, not "the people" or "the public interest". "Public" and government are not the same thing. Public debt is NOT government debt. The government owes the money, not "the people".

            Government is a for-profit enterprise no different than banks, technology or insurance companies.

            Lastly, the United States is a socialist country, owned and controlled 100% by the federal and state governments. The ONLY reason the governments let you keep anything is that it maximizes their revenues, and ultimately their profits.

          • joebhed

            Thanks, Milton, but ….. you're obviously confused.

            17 hours ago … MC
            ""I do not subscribe to the, "the Fed is privately owned," line of
            reasoning. The FRS is controlled by the government, or I should say
            people in government.""

            Then 5 hours ago ….. MC
            "" Of course, the big bankers got together and wrote the law, just like the
            big companies and special interests get together today and write the

            So, Milton, what you are selling here is that the PRIVATE bankers got together and wrote a law that put the entire Federal Reserve
            Banking System under the control of the people (public) and their

            To say NOTHING about what part might be PUBLICly owned ,,,,,,

            REALLY ?
            What about the faux independence of the Fed? LOL

            Of course, Congress approved the law and could amend it anytime they
            want( per U.S. Constitution) – like whenever they don't NEED the
            bankers' money to get re-elected. LOL.

            I suggest a couple of asprin and some rest to get your poli-sci logic re-seated.


          • Milton Churchill

            The banking system is not under the control of the public. It is under the control of the federal government. It is not the publics government. It is the governments government. Publicly held private, non-government, corporations, or other entities, are publically owned.

            Though both are prevalent, I believe you vastly underestimate the role of extortion vs bribery, in the development of laws and regulations, and the greed of government officials.

          • joebhed

            How, pray tell, is the Federal Reserve Banking System – the FED in its entirety – under the control of ANY government? Please stop with the jingo-isms..

          • Milton Churchill

            The two prior US central banks were awarded initial charters, ultimately left to expire. The current Fed is the third, longest lasting, central bank, in US history. Like the previous ones, this one could be shut down tomorrow given the proper political climate. The Fed lives at the mercy of Congress, not the other way around.

            Its not that I don't get what you are saying. Many people, including people like David Stockman, share your view, and do their best to malign and undermine the banking industry. I am not here to support big Wall Street bankers, but without a mandate from Congress, Wall Street would be cut down to size through free competition and price discovery. That cannot and will never be done through regulation, absent outright nationalization.

            I support a system of free banking and money issue, which would necessitate an end to the current Fed charter. Running down bankers and the banking industry only serves to perpetuate state socialism, not solve the problems it has created.

          • joebhed


            First of all, thanks for the news about the FRBNY having
            received a Central-Bank Charter, I never knew that before.

            That all governments have, through sovereignty, the national
            money power, means that the government’s money-system laws can (perhaps illegally) convey money-issuance powers, and “control” over that issuance, to anybody, even the PRIVATE bankers who run the FRBS ….. which is what Congress has done with the FRA of 1913..

            Every legal case brought has found that the government,( Congress)
            exercises no control over the FRBS, and that, as such, they are not to be considered a part of the government, being non-governmental in nature.

            Your vague connection between Congress’ “supreme authority”
            (sovereignty) over money, and any actual “control” is fiction. That Congress CAN change the laws, and actually put the government in control of money issuance is undeniable.
            All they NEED is the requisite spine.
            That is what SHOULD happen.

            But to imply actual control, because they CAN change the law
            to give the government control, is ludicrous.

            You never answered my question from above.
            That’s all the proof I need that you know the truth, yet resort to dissembling.

            For the Money System Common.

          • Milton Churchill

            So, what system would you support? I assume shut down the Fed. What after that?

          • joebhed

            Simply open the link I sent in my last reply.

            Put the Fed under Treasury.
            An end to fractional reserve banking.
            Government issues all money without debt.
            Depositors Rule.
            It's all in there.


          • Milton Churchill

            That will take an act of Congress ;) See you around…

  • W. Ferrell

    The natural interest rate is that produced by the interaction of the supply of real savings and the demand to borrow those savings. But since central banks massively distort the "supply of real savings" by lending out thin-air money, the natural rate is unknowable. A fundamental problem of fascist banking systems. Solved by having free market money & banking, to wit, what you would have in a free society.

  • bitspec

    One conclusion that balance and equilibrium are holistic therefore constitute the reference point of all (re)sources that make up a system rather than an individualist and separatist approach for balancing "just the monetary"

  • Bonnie

    It's hard to imagine that the logic from the first point doesn't appear to carry over to the second point. What do "low interest rates" really mean? Does that mean low nominal rates compared to the historical trend or as compared to the Wickselian rate? What does it mean in terms of economic performance if the central bank raises the short nominal rate while the Wickselian rate is plunging? Or suppose the central bank does nothing while the Wickselian rate is plunging. Might that condition in itself produce the appearance of a "bust"? If so, would one say it's a bust that need not to have happened, or simply follow the flock that says economic freedom is a terrible thing because people cannot be trusted to do wise things with their individual resources?

    For all of the individual freedom thumping that occurs in Cato circles, I find it astounding that this bit of monetary dogma keeps running the rounds like a broken record – like the gift that keeps taking.