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Between policies and crises: flow and reflow in monetary policy


It is more and more obvious that economic policies are not only anti-cyclical, as theory indicates us they should be. Very often, for various reasons, usually political ones, economic policies end up rather deepening the cyclical fluctuations of the economy instead of mitigating them. In this context, economic policy becomes strongly pro-cyclical, and this is valid both for monetary policy, and especially for the fiscal one.

Therefore, we do not find clear differences between anti-cyclical and pro-cyclical policies. In fact, in the absence of any rule regarding the intensity of stimulus, anti-cyclical policies aimed at stimulating the economy end up being the most reactive germs of the next boom-and-bust sequence. To put it differently, as in other areas, ‘better’ becomes the enemy of ‘good’.

The crisis that started in 2008 in the US represents a very good opportunity for methodological reflection on economic policy. For the sustainability of economic decisions, it is extremely important to distinguish between what happened before and after the economic and financial crisis, both in terms of economic performance, and especially in terms of economic policy decisions.

At first, we had conventional monetary policy. This is mainly characterised by a strong medium-term volatility of the monetary policy interest rate. In other words, the entire decade that preceded the crisis involved an “up-and-down” movement in terms of interest rate policy.

As we can see in the graph below, the 2000s started with large declines of the monetary policy interest rate, which somehow intertwined with the so-called dot-com crisis. But this “up-and-down” movement of the monetary policy interest rate is not only reactive, but also prospective. Low interest rates for 3-4 years, as anti-cyclical policy, planted the seed of a financial and real estate boom that was, in fact, the other side of the 2008-2009 bust.

After the crisis, we entered the “zero interest” paradigm by reducing the monetary policy interest rate to values that were very close to zero, first by the Fed, and after also by the ECB. Of course, it cannot be a magical recipe that disregards the laws of rarity or the invincible manifestation of people’s time preferences, as immutable sources of the interest rate phenomenon.

In the economy, as the graph below shows, the dynamics of the real GDP relative to the movements of the monetary policy interest rate are suggestive.

This “up-and-down” management of the monetary policy interest rate overlaps perfectly with the logic of anti-cyclical policy that seeks to stimulate the economy in times of crisis and mitigate its overheating in times of economic boom.

Afterwards, we had the unconventional monetary policy. Beyond the classical management of monetary policy interest rate, the post-crisis period opened new horizons in terms of expansionary monetary policy, in an innovative way. I am talking about Quantitative Easing (QE), which central banks used to launch massive acquisitions of financial assets, leading to an unprecedented increase of liquidity on financial markets.

The graph below shows the magnitude of QE policy conducted by the three main central banks as the crisis unfolded, in 2009, as well as the share of total financial assets in the GDP of those economies.

Compared to pre-crisis years, we can notice that the share of total financial assets in the GDP has almost tripled. We are therefore facing an unprecedented expansion in terms of liquidity on financial markets, which can translate as an explosion of “the nominal economy”, i.e. of the financial-monetary component of the economy.

What is important, however, is the extent to which this expansion of “easy (quantitative) money” has become real capital that represents sustainable investment in the real economy, which would support a healthy economic growth.

Beyond solving a short-term problem of rapid recovery of financial markets, this unconventional policy has further relaxed the framework of institutional and public budget constraints. Financial markets and governments were the main beneficiaries – through easy channels that supported public debts and, to a lesser extent, the real economy.

We can notice the existence of a significant discrepancy between the increase in the stock of financial assets as a share in GDP, which tends to reach 40%, and the developments in the economy. For instance, the nominal GDP registered relatively modest evolutions, as shown by the graph below.

This monetary retention in financial markets indicates a certain strain at the level of the financial system, a fact that anticipates a new bubble on the financial markets. And it is obvious that this cannot break without collateral damage in terms of economic performance and structural adjustments in the real economy.

As we can see in the graph below, financial markets indices are currently 25% above the record levels registered in the years of economic booms and speculative bubbles before the crisis.

These developments indicate an increase in the gap between nominal and real economy – whose performance is still below the pre-crisis level. The global exponential monetary policy flow remained far away from real economy markets. It generated, with the same intensity, “inflationist” bubbles on financial markets by increasing the quotations of financial assets.

For instance, in the case of developed economies, which benefited from the highest rates of monetary and financial expansion, post-crisis economic growth is approximately one third (1 percentage point) weaker than the – pro-cyclical – growth in previous years.

Such a divergent dynamic between the nominal and real economy is likely to raise questions about the effectiveness of recent monetary policy solutions, unless there have been doubts from the very beginning. The fact that monetary dosage was not followed by anticipated monetary accommodation effects shows that the financial strain accumulated in this way will be released through a new bust-type correction on the financial markets.

Hence, the imperative need to return on reasonable grounds in terms of interest rate policy, as Fed’s policy to (re)open the cycle of interest rate growth since last year and to reduce asset holdings is well known. Moreover, other central banks will also soon decide to abandon the policy of low interest rates.

At the same time, inflation expectations gradually become more and more present in the economy. Once inflation starts to rise, be it only in macroeconomic forecasts, the “zero interest rate” policy also vanishes, a policy that is, in fact, in contrast to the real nature of the interest rate as an economic phenomenon.

Ultimately, despite “whatever it takes” financial dosages, healthy economic growth transcends the stop-and-go cycle in the field of monetary, fiscal and budgetary injections. Major risks are about to materialize as anti-cyclical policies have, in fact, became the pro-cyclical policies of the next crisis.

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