The guardians of monetarism are flummoxed. With almost no evidence, but supreme faith, they believe that there is a direct and (more or less) proportionate relationship between the stock of money and the level of prices. Thus, they assume that the ‘printing’ of money just creates inflation. Now, after several years of quantitative easing (QE), we can see that this supposed link between the money supply and inflation is obviously false. Rather than acknowledge their past errors, these merchants of monetary probity now interpret the present environment as a major break in the laws of finance, much as apples falling up would represent a reversal in the laws of physics. They were convinced that QE would lead to substantial inflation.
Yes, in individual countries, an increase in one kind of money (eg an increase in Pesos in Argentina) will lead to a fall in the exchange rate for Pesos, and inflation in that country (Argentina). It does not follow (contrary to monetarist belief) that an increase in the supply of US dollars or Euros or Yen would necessarily have a similar inflationary impact on world prices.
In reality, these beliefs about money were never anything like science. Rather they served particular interests over others. (Keynes would have said that ‘dear money’ served the ‘rentier’ interest; a scarcity of money would enrich people who already have more money than they can or will spend; and that cheap – abundant – money would be adverse to the rentier interest. So there was a systemic bias in favour of dear money.)
The real purpose of interest rates in market economies is to set a price that balances saving against investment. In the 2010s’ environment, to achieve this free-market purpose, interest rates would probably need to be around minus five percent. At or just under zero percent (as they are in the major world economies), interest rates continue to be substantially overvalued when considered in terms of this price mechanism that’s central to capitalist economics. At zero interest, the world economy in 2016 continues to experience a glut of saving and an aversion to the debt expansion that easy monetary policies seek to stimulate.
Yet (and ignoring the issue of people stashing cash under the mattress) negative interest rates cannot revive the world economy on their own. This is because, their direct effect on prices is deflationary; not inflationary as the present monetarist backers of zero-interest-rate policies believe. Very loose monetary policies (google ‘helicopter money’), in themselves, will not facilitate inflation climbing from zero to two percent. (See Bernard Hickey on helicopter money last week. I suspect that the New Zealand public, if adequately exposed to this phrase, will wonder whether economists were always from another planet.)
It’s not rocket science. Inflation (and deflation) may have both demand elements and cost elements. When interest rates rise (commonly associated with tightening monetary policy) costs also rise; the direct effect on prices is inflationary. However, rising interest rates also have an indirect effect on prices. They cause reduced business investment, economic contraction, and unemployment which further reduces spending. Thus, rising interest rates may appear to be counter-inflationary if they (indirectly) generate sufficient unemployment to more than offset their direct inflationary impact. To advocate raising unemployment as a means to counter inflation (which is what the monetarists did) is a somewhat cynical form of pseudo-macroeconomics.
The obverse of 1980s’ monetarism is what we see today; falling interest rates (through reduced financial costs) aggravating the deflationary forces that now grim the global economy. Very low interest rates can only counter deflation if there are strong demand forces (countering the cost forces) facilitating spending, reducing unemployment, and encouraging people to work fewer hours.
Very low interest rates can become counter-deflationary if governments are willing to run very large deficits; even larger than present Japanese-style government deficits. As we (economists) say, fiscal policy is the key. Alternatively, very low interest rates can become counter-deflationary if we – the public – come to be able to finance some of our own spending on such a deficit basis. Counter-deflationary (also known as ‘reflationary’ in historical texts) conditions can only arise when saving (deflationary) is more than balanced by consumer, business and/or government borrowing. Increased consumer spending by poor people has no chance, however, when consumer credit remains very expensive. And when governments are pig-headedly striving for Budget surpluses despite their being able to borrow at zero (or lower) rates, deflation is as predictable as the sunset.
Deflation unheeded causes businesses in general (and banking in particular) to fail. And it aggravates indebtedness relative to GDP, creating the so-called debt-deflation spiral that characterised global finance in the Great Depression of the 1930s. Even zero-interest debts (such as student-loans) become near-impossible to service when deflation rates exceed five percent (as I think they will in many countries before the end of this decade) and when good income-earning opportunities are few.
Very low interest rates are part of the solution. But only a part. The bigger part of the solution is the indirect demand effect that must more than counter the falling costs directly associated with falling interest rates. Governments should spend the cheap and abundant money that is now available to them; or governments should become a conduit, channelling at least some of the unspent global hoards of cheap new money to their shareholders, the people. The people can then spend a bit more, choose to work a bit less, and can bargain more strongly for higher wages; effects that can help to counter or prevent deflation.