Ultra easy monetary Policy and the Law of Unintended Consequences–William R. White Federal Reserve Bank of Dallas..working paper #126
In this paper, an attempt is made to evaluate the desirability of ultra easy monetary policy by weighing up the balance of the desirable short run effects and the undesirable longer run effects – the unintended consequences. In Section B, it is suggested that there are grounds to believe that monetary stimulus operating through traditional (“flow”) channels might now be less effective in stimulating aggregate demand than is commonly asserted. In Section C, it is further contended that cumulative (“stock”) effects provide negative feedback mechanisms that also weaken growth over time. Assets purchased with created credit, both real and financial assets, eventually yield returns that are inadequate to service the debts associated with their purchase. In the face of such “stock” effects, stimulative policies that have worked in the past eventually lose their effectiveness. It is also argued in Section C that, over time, easy monetary policies threaten the health of financial institutions and the functioning of financial markets, which are increasingly intertwined. This provides another negative feedback loop to threaten growth. Further, such policies threaten the “independence” of central banks, and can encourage imprudent behavior on the part of governments. In effect, easy monetary policies can lead to moral hazard on a grand scale17.
Further, once on such a path, “exit” becomes extremely difficult. Finally, easy monetary policy also has distributional effects, favoring debtors over creditors and the senior management of banks in particular. None of these “unintended consequences” could be remotely described as desirable. The force of these arguments might seem to lead to the conclusion that continuing with ultra easy monetary policy is a thoroughly bad idea. However, an effective counter argument is that such policies avert near term economic disaster and, in effect, “buy time” to pursue other policies that could have more desirable outcomes. Among these policies might be suggested18 more international policy coordination and higher fixed investment (both public and private) in AME’s. These policies would contribute to stronger aggregate demand at the global level. This would please Keynes. As well, explicit debt reduction, accompanied by structural reforms to redress other “imbalances” and increase potential growth, would make remaining debts more easily serviceable. This would please Hayek. Indeed, it could be suggested that a combination of all these policies must be vigorously pursued if we are to have any hope of achieving the “strong, sustained and balanced growth“ desired by the G 20.
We do not live in an “either‐or” world. The danger remains, of course, that ultra easy monetary policy will be wrongly judged as being sufficient to achieve these ends. In that case, the “bought time” would in fact have been wasted19. In this case, the arguments presented in this paper then logically imply that monetary policy should be tightened, regardless of the current state of the economy, because the near term expected benefits of ultra easy monetary policies are outweighed by the longer term expected costs. Undoubtedly this would be very painful, but (by definition) less painful than the alternative of not doing so.
John Kenneth Galbraith touched upon a similar practical conundrum some years ago when he said20 “Politics is not the art of the possible. It is choosing between the unpalatable and the disastrous”. This might well be where the central banks of the AME’s are now headed, absent the vigorous pursuit by governments of the alternative policies suggested above - Kevin Ferry