Academic economists long for proof that their theories and beliefs actually work. In the absence of policy power, researchers are left to pick through historical databases in search of correlations that may support their economic views. Can you imagine, therefore, the gleeful anticipation that salt water economists experienced when one of their heroes, Ben Bernanke, was given the US economy as his private laboratory to experiment with!
Ben set about his business slowly at first. He inherited a healthy US economy that was not in need of any major surgery. This was abruptly altered when the global financial crisis reared its head in 2007, triggered by falling housing prices and rising mortgage defaults. What did Ben do?
The textbook response to a financial crisis is to keep the system liquid. The Federal reserve is in a unique position in that it can create almost unlimited credit and price their loans as low as they want. The Fed did this and was arguably successful.
The subsequent recession in the United States was more challenging for Bernanke. There is no textbook response to a weakening economy. In fact, there are two very opposite points of view in academia. The less popular view is that active monetary policy cannot systematically influence real variables such as GDP and unemployment. The more popular view is that it can. Bernanke belongs to this more popular camp, and so he set about proving the effectiveness of active monetary policy using QE1.
QE1 flooded the money supply but there was no increase in GDP. One would have thought that this was sufficient evidence against the active policy camp. But no, they argued that the US economy would have been worse had QE1 not been implemented. Further stimulus was needed, they argued, and hence we got QE2. Alas, still no surge in GDP. One would have thought that this second experimental failure would have been heeded as proof that active policy does not work. But no, can you imagine what catastrophe would otherwise have occurred! Two Experiments with two negative outcomes was not enough.
And so we were treated to QE 3. This entailed an hitherto unimaginable expansion of the money supply through asset purchases. For reasons unknown to most of us, banks, businesses and consumers simply did not pick up this money and spend it in the way that the active monetary economists had expected.
Now, Bernanke has had his turn at bat. Three swings and three misses. Surely the message must be clear? Active monetary policy does not work, right? Not so if you are a Central Banker…
The great majority of central banks continue to actively target short-term interest rates in the belief that they can systematically influence banks, businesses and consumers spending habits. Janet Yellen, Bernanke’s successor, confirmed that the Fed will continue in this endeavour last night. The global monetary policy community have simply ignored the outcomes from Bernanke’s experiments and swept it under the carpet.
The danger of conducting policy without a reasonably predictable outcome is that this uncertainty causes volatility. Investors hate volatilty, and during high periods of volatility they are likely to demand higher risk premia, in turn marking down asset prices.