Global Policy Forum

Central Bankers: Stop Dithering. Do Something.

In this op-ed, Adam Posen, a member of the Bank of England’s Monetary Policy Committee, argues that the global economy is needlessly suffering due to the premature abandonment of stimulus policies, or, “policy defeatism.” In order to “rebalance” economies from tax breaks to public investment and “from the financial sector to everything else,” central banks should expand instead of tightening monetary policy. According to Posen, central banks fear that not appeasing markets by “fighting inflation” will threaten their reputation of stern independence. However, Posen argues, every major financial crisis in modern economic history was exacerbated by this mistake. Instead of doing what they think is expected of them by markets, central banks should do what works for the millions of people around the world who have been targeted by painful austerity measures.

By Adam S. Posen

November 20, 2011

Both the American economy and the global economy are facing a familiar foe: policy defeatism. Throughout modern economic history, whether in Western Europe in the 1920s, in the United States in the 1930s, or in Japan in the 1990s, every major financial crisis has been followed by premature abandonment — if not reversal — of the stimulus policies that are necessary for sustained recovery. Sadly, the world appears to be repeating this mistake.

The right thing to do right now is for the Federal Reserve and the European Central Bank to engage in further monetary stimulus. Having lowered short-term interest rates, they should buy (or in the case of the Fed, resume buying) significant quantities of government securities to help push down long-term interest rates and encourage investment.

If anything, it is past time for the Fed and its European counterpart to act. The economic outlook has turned out to be as grim as forecasts based on historical evidence predicted it would be, given the nature of the recession, the cutbacks in government spending and the simultaneity of economic problems across the Western world. Sustained high inflation is not a threat in this environment.

As many have observed, we need to rebalance the economy from imports to exports, from private consumption to savings, from tax breaks to infrastructure rebuilding and from the financial sector to everything else. The process of rebalancing will require movement of capital from older industries and activities to newer ones — that is, investment. Moreover, a lot of what was termed “investment” during the boom years was misallocated — wasted — capital, so many productive projects were ignored.

But investment has been held back because of uncertainty over the economy’s future prospects. And the ability to attract investors is being limited by the giant burden of private-sector debt. In other words, a financing problem is inhibiting the restructuring of our economy. Alleviating generalized financing problems and low investor confidence is precisely what monetary stimulus does.

Some claim that monetary easing will impede restructuring. But this makes no sense. For all the talk that monetary austerity promotes the “creative destruction” necessary for the economy to recover, it does not work that way.

In Japan in the 1990s, a period of insufficiently aggressive monetary stimulus fed lending to “zombie companies” — unproductive borrowers on whose loans the banks could not afford to take losses. It was only when macroeconomic policy led a recovery in Japan in the first decade of this century that capital flowed out of the places it had been trapped and into new and growing businesses. Similarly, after the American savings-and-loan crisis, real reallocation of credit from bad banks and borrowers to worthwhile investment began in earnest only when monetary policy eased in the late 1980s.

Another source of policy defeatism is the widespread but false belief that our previous “unconventional” efforts to stimulate the economy either were not terribly effective or are unlikely to be effective if extended today. The fact that the American economy has not fully recovered after previous rounds of stimulus is not evidence that those failed to work at all.

We know that infusions of central bank money to the economy have been closely associated with falling long-term interest rates. We know that the relative price of riskier assets has gone up, indicating greater demand for them, when stimulus has been undertaken. And we know that banks have received increased deposits, and that investors and households have expressed increased confidence, after prior rounds of quantitative easing. That combination has had a stimulative impact, just as a cut in the interest rate would have in ordinary times.

Scientific research tells us that high blood pressure and cholesterol are associated with a higher risk of heart disease and stroke, and that certain prescription medications reduce cholesterol and blood pressure. Yes, it is difficult to prove directly that taking these medicines prevents heart disease and stroke, and taking them is no guarantee of health. But still we should take them, and our doctors should prescribe them if they are indicated. This is the same situation we are in now, with our economy’s financial circulation at risk, and quantitative easing the indicated medicine.

In my opinion, we can go further. Central banks and governments can engage in forms of coordinated action that will target the burden of past debts that is hanging over the global economy. In the United States, that means resolving the distressed mortgage debt that is weakening our financial system and reducing labor mobility, thereby constraining not only our growth but also our ability to grow. It is time for the Federal Reserve and elected officials to explore ways to jointly tackle that housing debt.

Independent central bankers tend to become very squeamish about expressing support for any particular government proposal, especially when it involves agreeing to buy government bonds. Tragedies have occurred, however, when independent central banks let worries about the perception that they were too close to the government prevent them from doing something constructive in times of crisis.

Such passivity led to the prolonged recession in Japan in the 1990s. It was only when the Bank of Japan and the Ministry of Finance abandoned their mutual distrust and worked together publicly in 2002-3 that Japan had a sustained recovery. The same kind of distrust between monetary and fiscal officials, and concerns about being perceived as too close to each other, is bringing the euro area to the brink of disaster today.

Central bank independence is not primarily a matter of reputation, but of reality. What matters is what central banks do, not whether they maintain an appearance of disdain toward the messy realities of economic and political life. The inflation-fighting credibility of central banks is not vulnerable to voluntary purchases of bonds, public or private, made with reference to clear and long-held economic goals. Therefore, if the Federal Reserve and the European Central Bank respond to the crisis with available tools, including large-scale bond purchases (as the Bank of England has already begun to do), they will enhance their credibility and independence for the future.

Almost certainly, even if we were to do everything right on monetary policy (and we certainly will not get everything right, despite the best of intentions), some economic suffering will continue. But it is the responsibility and duty of central bankers to make things better if we can.

Central bank officials have wasted too much time over the last year worrying about how their institutions would appear to markets, to politicians and to the public, were they to undertake more stimulus. Sometimes you have to do the right thing even if the benefits take time to become evident. If we do not undertake the monetary stimulus that the grim outlook calls for, then our economies and our people will suffer avoidable and potentially lasting damage.

Adam S. Posen, an American economist, is a member of the Monetary Policy Committee of the Bank of England.


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