Monetary policy is a useless collective noun

At the time of the financial crisis of 2007 and 2008 it was commonplace to say that modern economics, especailly the macroeconomic variety, was in crisis, and needed a fundamental rethink. Alas, the vested interests of established economists have prevailed. Very little rethinking has occured, and this mainly tweaking rather than anything big. This is most striking in the area of monetary policy. The debates now going on in Japan and Britain remind me of the academic papers and discussions that I read about while an economics undergraduate at UCL in 2005-08. Circumstances have changed (in Britain anyway) but not the economics.

Economists of complain that amateurs are guilty of the fallacy of composition: to assume that was is true for a household, say, is also true of all households grouped together in a single economy. It may sensible for a single household to save more of its income to repay debt: but if a whole economy tries this at once, it could be disastrous. But economists are guilty of their own fallacy, though one for which I have not found a commonly used name. I will call it the fallacy of collective nouns. It is idea that by collecting together a group of disparate elements and giving them a name, that you have created a new entity that allows you to ignore its component parts. Most macroeconomic concepts are such collective concepts: GDP, inflation, and so on. Such collectives are useful only up to a point, and then you have you have to look at their component elements. And yet most macroeconomists, even very intelligent and distinguished ones, can’t bear to let go of their collective concepts and carry on using them long after their usefulness has ceased.

This is clearly the case with the idea called “monetary policy”. The conventional idea is that an economy has something called a “money supply”, which can be manipulated through policy instruments under the control of a central bank. In turn this money supply affects the behaviour of the people that form the economy with fairly predictable effects on things like consumer prices,wages, investment and output. All of this is very questionable in a modern economy. It is much more helpful to think of the particular components of “monetary policy”: central bank interest rates, state purchases of its own and other bonds, bank regulation, and so forth, and how these affect the various parts of the economy acting through the financial markets.

The conventional economic thinking runs something like this: the economy (Britain and Japan in particular) is stagnating with relatively low levels of inflation, but high or rapidly rising levels of government debt. In order to pay back this government debt you need to break out of the stagnation and grow, or (whisper it) let inflation make the debt more affordable. To do this you need to “loosen” monetary policy and increase the supply of money. With more money in their pockets, people go out and spend more, leading either to growth or inflation. To do this the central bank lowers interest rates, and where this does not work, use other measures like Quantitative Easing. Cue lots of debate about the relevance of inflation targeting and its alternatives (nominal GDP targets for example), all well within the comfort zones of economists.

There are very many problems associated with this line of reasoning. It is far from clear what money is. However it is clear that commercial bank accounts form the most important part of it, and this is a function of commercial bank policies, not those of a central bank, whose influence is increasingly marginal. It isn’t clear that large bank balances lead to increased spending, least of all on constructive economic things like consumption or proper investment (as opposed to chasing up the value of assets in fixed supply). Rising prices do not necessarily make debt more affordable: that requires rising income for the people holding the debt. And it goes on.

All the verbiage around “monetary policy” is clouding the issue. There are two problems being faced the British and Japanese economies: weak output and excessive debt. Weak output in turn has two components: using spare capacity (i.e. that created simply because of slow demand) and strucural problems. In Britain there is a big argument about how much of the problem is spare capacity and how much is structural. If it is largely spare capacity then simple macroeconomic solutions may have merit: you just need to boost confidence a bit to lift demand. But even here it is not self evident that any of the loose money policies will be much help. In Japan there seems to be even less spare capacity.

I can’t help thinking that what policy makers really mean by “loose monetary policy” is higher wages. Increasing consumer spending power through increasing wages will lift confidence, and even if it is not based on increased productivity, it will make debts easier to pay off, including public debt through higher tax revenues. This lurks behind a lot of the talk about greater tolerance for inflation. But in Britain we have the wrong sort of inflation: rising import costs through a lower pound, and increased government charges. This really isn’t helping. If policymakers want higher pay it would be better to throw away the weasel talk about loose money, and talk about pay. There is some evidence for that in Japan, but this only serves to show how difficult the policy is in practice.

The Japanese government also deserves some credit for the fact that it is not advocating looser monetary policy by itself, though you wouldn’t guess that from much of the coverage here. It is one of three prongs, the other two being fiscal stimulus and structural reform. There is plenty of scope for structural reform in Japan, and this gives their economic policy some hope for ultimate success if they follow it through. But it is the prospect of quick and easy solutions through fiscal and monetary policy that is exciting people.

In Britain a chronic trade deficit shows major structural problems, no doubt partly as a result of reduced North Sea oil. This requires the economy to be producing different things, not just more all round. Loose talk using economic collective nouns is making this harder to see and address.

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