Monetary String Theory

Writing in the 1930s, J. M. Keynes explained how the state of the economy depends upon the “animal spirits” of entrepreneurs: much of our positive economic activity derives from our optimism about the future. It was therefore the difficult task of governments to help ensure that this optimism was the rule, rather than the exception. But for Keynes, monetary policy could only play a limited role in establishing this convention. In times of economic uncertainty, actors in the marketplace are liable to hold such large reserves of cash that, no matter how much liquidity a central bank makes available, the economy is not going to get the stimulation it needs. The solution, Keynes suggested, was to be found in fiscal policy: government spending to offset lack of private investment.

We have been witnessing something similar unfold since the so-called “credit crunch” of last year. As Irwin Keller at MarketWatch explains, the US Federal Reserve has been attempting to offset tight credit by lowering the bank rate from 5.25% last September to its current 2%. This has been as effective as “pushing on a string.” Overall, consumers in America now have even less access to credit as bank lending has tightened up and the issue of non-financial commercial paper has dropped through the floor. Now the Economist is reporting that, after some delay, the animal spirits are flagging in the euro-zone as well. As the economic future becomes less certain, companies are beginning to retrench their investments.

Back in February, the US Congress took Keynes’ advice and approved a fiscal stimulus package. According to a member of the White House’s economic team, the impact of the stimulus package is already being seen through in higher consumption; the effect on investment will take longer and remains to be seen. There is even talk of a second stimulus package, probably motivated by Congress’ desire to spend more money on its constituents before the upcoming election, but it faces a number of obstacles.

What are we to make of all of this? It’s hard to say. Central banks are charged primarily with controlling inflation but the prospect of uncoordinated fiscal and monetary policy is not a pleasant one - this happened early on in the Reagan years and was an all around mess. Probably the best we can hope for is that central banks aim to ‘do no harm.’ Recent decisions by the major CBs to hold their interest rates steady is likely an attempt to do just that. This is going to be an interesting ride, so stay tuned. The immediate lesson – the one Keynes would have pointed out – is that we shouldn’t look to the central banks to deal with the slowdown.