Is present monetary policy rational?

While the stance of monetary policy around the world has, on any conceivable measure, been extreme, by which I mean unprecedentedly accommodative, the question of whether such a policy is indeed sensible and rational has not been asked much of late. By rational I simply mean the following: is this policy likely to deliver what it is supposed to deliver? And if it does fall short of its official aim, then can we at least state with some certainty that whatever it delivers in benefits is not outweighed by its costs? I think that these are straightforward questions and that any policy that is advertised as being in ‘the interest of the general public’ should pass this test. As I will argue, the present stance of monetary policy only has a negligible chance, at best, of ever fulfilling its stated aim. Furthermore, its benefits are almost certainly outweighed by its costs if we list all negative effects of this policy and do not confine ourselves, as the present mainstream does, to just one obvious cost: official consumer price inflation, which thus far remains contained. Thus, in my view, there is no escaping the fact that this policy is not rational. It should be abandoned as soon as possible.

The policy and its aims

The key planks of this policy are super low interest rates and targeted purchases (or collateralized funding) of financial assets by central banks. While various regional differences exist in respect of the extent of these programmes and the assets chosen, all major central banks – the US Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan – have been engaged and continue to be committed to versions of this policy. Its purpose is to facilitate exceptionally cheap funding for banks and to affect the pricing of a wide range of financial assets, in particular and most directly government bonds but also mortgage bonds in the US and real-estate investment trusts and corporate securities in Japan. There is an ongoing debate in the UK and in the Euro Zone, too, about directly boosting prices of other, ‘private’ securities, that is, to have their prices manipulated upwards by direct purchases from the central banks.

To the wider public this policy is described as ‘stimulating’ growth, ‘unlocking’ the flow of credit and ‘jump-starting’ the economy. If that is indeed the aim, this policy has already failed.

We have now had almost five years of near-zero interest rates around the world. If such low interest rates were indeed the required kick-starter for the economy, we should have seen the results by now. ‘Stimulus’ is something that incites or arouses to action, a kind of ‘ignition’ that sets off processes, in this case, one assumes, a self-sustained economic recovery. But if the world economy was really fundamentally healthy and only in need of a dose of caffeine to stir it back into action, then dropping rates from around 4 to 5 percent to zero, as happened 4 or 5 years ago, should have done the trick by now.

Defenders of the policy will argue that we would all be in much more of a bind without it, but this is not the point here. This is something we can discuss when comparing costs and benefits. There is no escaping the conclusion that this policy has failed if its aim is to provide a required ignition – the stimulus – to ‘jump start’ the economy.

In support of my conclusion that this policy has failed as a ‘kick-starter’ of self-sustained growth I can quote as witnesses the very officials and experts who advocated this policy in the first place and who are still implementing it. Not a single one of the major central banks is even close to announcing the successful conclusion of these policies or is even beginning to contemplate an exit. 5 years into ‘quantitative easing’ and zero interest rates, the Fed last week began to openly consider increasing its monthly debt monetization programme. Although the week ended on a bright note, at least for the professional optimists out there, as the unemployment rate came in a tad lower than expected, manufacturing data during the week was disappointing and the US economy is evidently entering another growth dip.

Still, many argue that the roughly 2 percent growth that the US economy may achieve this year is nothing to be sniffed at. Yet, for a $15 trillion dollar economy that is just $300 billion in new goods and services. In the first quarter of 2013, the Fed expanded the monetary base by $300 billion alone, and the central bank is on course for $1 trillion in new money by Christmas, while the federal government will run a close to $1 trillion deficit despite the ‘sequester’. That is very little growth ‘bang’ for a lot of stimulus ‘buck’. Self-sustained looks different.

Last week in the Euro-Zone, the ECB cut its repo rate to 0.5%, a record low. If suppressing interest rates from 3.75% in 2007 to 0.75% by 2012, has not lead to a meaningful, let alone self-sustaining recovery, or at a minimum the type of underachieving recovery that would at least allow the ECB to sit tight and wait a bit, what will another drop to 0.5% achieve?

Shamelessly, some economists and financial commentators cite high youth unemployment in countries such as Spain as a good reason to cut rates further. The image that is projected here is evidently one of countless Spanish entrepreneurs standing at the ready with their investment projects, willing and eager to employ numerous Spanish young people if only rates were 0.25% lower. Then all their ambitious investment plans would become potentially profitable, and the long promised recovery could finally commence.

The number of young Spanish people who will find employment thanks to the ECB cutting rates close to zero cannot be known but I suggest a number equally close to zero is a reasonably good guess.

The ‘benefits’ – or are they costs?

This is not to say that this policy has no effects. It even had benefits, for some.

By suppressing market yields and boosting the prices of financial assets this policy has delivered substantial windfall profits for owners of stocks, bonds, and real estate. Those who did, for example, speculate heavily on rising property prices in the run-up to the recent crisis, then were put through the wringer by the financial meltdown, now find themselves happily resurrected and restored to their previous wealth, if not more wealth, courtesy of central bank charity.

The 0.25% rate cut from the ECB may not lift many young Spaniards into employment but it surely makes ‘owning’ financial assets on credit cheaper. For every €1 billion of assets the rate cut means a €2.5 million saving per year in cost of carry, as duly noted by the big banks, ‘investment’ banks and hedge funds. After the ECB rate cut, German Bunds reached new all-time highs as did, a few days later, Germany’s main stock index.

That we are witnessing strange and dangerous deformations of the capitalist system, if we can still even call it capitalist, and that new bubbles are being blown everywhere, is not only evident by the increasingly grotesque dichotomy between a woefully underperforming real economy perennially teetering on the brink of renewed recession and a financial system, in which almost every sector is trading at record levels, but also by the fact that the high correlation among asset classes on the way up to new records is beginning to strain the minds of the economists to come up with at least marginally plausible fundamental justifications for such uniform asset inflation. ‘Safe haven’ government bonds that would usually prosper at times of economic pain are equally ‘bid only’ as are risky equities and the grottiest of high yield bonds. The common denominator is, of course, cheap money. And if cheap money for the foreseeable future is not enough, then how about cheaper money – forever?

A conflicted conscience or outright embarrassment are now stirring some financial economists to suggest that the joys of bubble finance should be brought straight to the economic war zones in the European periphery, and that in order to have a bigger impact on the ‘real’ economy, the ECB should buy private loans and other local assets in these regions and thus more directly interfere in their pricing. The manipulations of the monetary central planners are too blunt, they need to be more fine-tuned. These suggestions are dangerously wrongheaded. Extending the addiction to the monetary crack cocaine of cheap credit beyond the financial dealing rooms of London, New York and Frankfurt and to the economy’s productive heartland is not going to solve anything, at least not in the long run, and that is a timescale that may still matter to some people, at least outside of the financial industry. There is nothing Spain needs less than a new artificially propped up real estate boom. The aforementioned Spanish youth would only swap today’s dependency on state hand-outs for dependency on never-ending cheap-credit policies from the ECB and ongoing asset-boosting price manipulations. This has nothing whatsoever to do with sustainable growth, lasting and productive employment and real wealth creation.

The fact that trained economists today seriously contemplate these policies and are willing to dress them up as ‘solutions’ only goes to show how far the new ’entitlement culture’ on Wall Street and in the City of London, where everybody now feels entitled to cheap credit and ongoing asset-boosting policy programs as the universal cure-all, has affected economic thinking. The speculating classes are beginning to feel generous: “Hey, this free cash is great. Let’s extend it to everybody.”

Would a deflationary correction be better?

Back to our cost-benefit analysis. The defenders of the present policy will argue that without it GDP in the major economies would have dropped more, that asset prices and lending would be more depressed, and that we might even be in the middle of some dreadful debt deflation. Maybe so. But to the extent that the present GDP readings are the result of central bank pump priming and not the result of renewed growth momentum, they are simply artificial and thus ultimately unsustainable. In fact, the mere suspicion that this might be so must undoubtedly depress optimism and thus the willingness to engage in the economy and put capital at risk. Nobody knows any longer what the real state of the economy is.

While the unemployed Spanish youth may not benefit – or only very marginally so – from record high German stock prices and their own government’s renewed ability to borrow yet more and yet more cheaply – they may in fact ultimately benefit from a deflationary clear-out that would cause prices on many everyday items to drop. Deflation is not such a bad thing if you have to live on your savings or a modest, nominally fixed payment stream. Additionally, reshuffling the economy’s deck of cards could also offer opportunities. Tearing down the old structures and allowing the market to price things honestly again, according to real risks and truly available savings, may at first cause some shock but ultimately bring new possibilities. The present monetary policy is inherently conservative. It bails out those who got it wrong in the recent crisis at the expense of those who didn’t even participate in the last boom. Some Schumpeterian creative destruction is urgently needed.

I am not advocating deflation or economic cleansing for the sake of deflation and contraction, or out of some sense of economic sadism, or even out of moral considerations of any kind. However, it strikes me that what ails the economy is not a lack of money or lack of a powerful ‘kick-starting’ stimulant, and it may not suffer from unduly high borrowing costs either. Wherever borrowing costs are still high in this environment of ‘all-in’ central bank accommodation they may be high for a reason, maybe even a good one. What ails the economy are the structural impediments that are well established and that had been long in the making, such as inflexible labor markets with their permanently enshrined high unit labor costs and excessive regulation that have always protected current job-holders at the expense of those out of work or entering the labor market. Overbearing welfare systems, high tax rates and outsized public sectors have long held back major economies. Easy money that, for some time, enabled high public sector borrowing and spending, and facilitated local property booms, helped cover up these structural rigidities. Now these issues simply come to the fore again. New rounds of easy money will not make these problems disappear but only create a new illusion of sustainability.

I haven’t even touched upon the growing risk that never-ending monetary accommodation will end in inflation and monetary chaos but it is apparent already that this policy has no convincing claim on rationality. Nevertheless, it is almost certain that it will be continued.

This will end badly.

This article was previously published at

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9 replies on “Is present monetary policy rational?”
  1. I agree with DS that the powers that be have no idea whether they’re coming or going.

    For example, it was obvious to anyone with more than three brain cells three years ago that QE would benefit primarily the rich. But we can’t expect central bank officials to be able to work that out: they have far less than three brain cells each.

    As distinct from monetary policy and turning to Keynsian type stimulus, basically I support Keynsian type stimulus. And contrary to DS’s suggestion in his last sentence, neither monetary nor fiscal stimulus need to “end badly”. However, the powers that be can’t distinguish between Keynesian stimulus and a pile of garbage. They are totally and completely clueless. Rogoff and Reinhart are just two examples of the incompetence in high places.

    So DS is right: this may very easily end badly.

    1. says: George Thompson

      Mr. Musgrave, In his excellent article “Still stuck in the Middle Ages” published by the Cobden Center on 8 May 13 (, Tim Price provides a rather startling proof that Keynes, you and everyone else who believes that stimulus works just may be blowing smoke through your mirrors. All you, or they, need do is ponder the chart Mr. Price provides labeled “Ratios of UK government expenditure (in green), and private expenditure (in black), to UK GDP”. Note that the green and black curves are symmetrical, a line of symmetry between them appears to be flat. This is because stimulus and increased taxes only work in a world where the only thing people do with their money is stuff it in a sock and bury it. But this is not the case as most people, maybe all, spend their money on stuff they want or invest it hoping in vain that given compound interest over enough time, they will have sufficient resources with which to tell their bosses to “Take this job and shove it.” Those who agree with you overlook a true-fact-of-life, what my long ago Calculus Professor termed a TFL: government has no money of its own. What it has it takes by force from those who have. This force can be by conquest (theft) or by law (taxes). Every penny a government takes is a penny whose earner is deprived of his or her right to spend it as he or she thinks best in exchange for the government spending it as it deems best. Like people, governments (which after all are run by people), spends as it deems best. Often the government’s best is based on a mere politician’s personally advantageous ‘investments’ which are ultimately contrary to liberty and prosperity – Solyndra being a prime example. Stimulus is but a form of deferred taxation. There is a cost to the proletariat which must eventually be paid by taxing the tax, as inflated incomes rise the earners move into higher tax brackets, or by inflation which increases the sticker price of stuff while decreasing the value of the currency – too much of a good thing – just because I enjoy a cool glass of water does not mean I want to swim naked across the Arctic Ocean during January. The rigged zero sum game called ‘stimulus’ will end badly and for the reasons given by Mr. Schlichter here and elsewhere.

  2. So we now have to consider realistically that the only groups gaining from the above are Banks (who dont want to be liquidated), Economists (who don’t want to admit they are wrong and spend the rest of their lives in the wilderness as a source of comparative superlative ridicule), politicians (who don’t want to lose control over the people and become part of the former mentioned) and are following this policy in order to create the very crisis they purport to be saving us (themselves) from.
    This game has gone on since the First World War when intellectuals and corporatists displaced the aristocracy and modified a perfectly good system of theft by taxation to their own ends, citing ideology as the basis when greed and self interest were the motive. There is however a perfectly good system out there that regulates greed by leaving the decision as to whether someone is successful down to their customers who freely choose from the competition.

  3. says: Paul Marks

    Lending should be from real savings.

    In this system real savings are an after thought – what matters in this system is money from the Central Banks, money created from NOTHING. Which is then dished out to the banks and…..

    This system will indeed end badly.

    However, we must be careful in what we say “corporatism” (whether it is German “War Socialism” during the First World War or Mussolini in the 1920s and 1930s) we must remember that business is NOT in charge – government is not in charge.

    As for government spending – most goes to the Welfare State, it is NOT for the benefit of business.

  4. says: Paul Marks

    I should have said that government IS in charge.

    Bankers and other such may give money to people like Barack Obama – but they will find out (indeed they already starting to find out) that the politicans can take money and then the politicians do what they want to do anyway (even if their financial backers get hit by it).

    In many ways it like Al Capone and protection money – giving money to these people (for “insurance”) does not give one control over them (it just means a chance of not getting hit by them).

    1. says: Robert Sadler


      I actually don’t really distinguish between “Bankers” and politicians. They work together like a hand in glove. Bankers primary job is to provide another source of financing to the Gov’t.

      In return for a small fee of course.

  5. says: Peter Small

    The economy is a complex system consisting of a multitude of interacting individuals and groups. These individuals and groups both compete and cooperate with each other to create and consume resources.

    The human body is a similar complex system where cells combine, cooperate and compete. However, occasionally, a group of cells become cancerous and begin to grow and expand: consuming more and more resources – reducing the efficiency of the system as a whole to survive.

    Can the state and the central bankers in our economy be likened to cancerous growths that has emerged within our economic system? The parallels are compelling.

    1. says: Robert Sadler

      Peter I essentially agree. The disturbing thing is that without a cure cancers kill their hosts.

  6. says: Paul Marks

    Mr Sadler – I wish I could argue with you, but the facts appear to be on your side.

    Once banking was basically about REAL SAVINGS – with a bit of naughtness (dealing in “money” that wss nothing to do with real savings) on top.

    Now the naughtyness (or rather the corruption) is the centre of the system – REAL SAVINGS are a side show now.

    These people (bankers, Central Bankers and ministers) are not men and women of good will – they know what they are doing is corrupt.

    Those who, at this time, are still pretending that the establishment have good intentions and “know not what they do” are part of the problem.

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