The diminished role of monetary policy

The paralysis of financial intermediation today means that monetary policy (cuts in the official policy rates) have become largely ineffective in stimulating demand. Such cuts now appear to have little if any effect on either the marginal cost or the availability of external funds to non-financial enterprises and households. For individual open economies, the exchange rate provides a mechanism for stealing aggregate demand from the neighbours. If most of the neighbours are also in a situation of deficient aggregate demand, this redistribution of global effective demand – which is all that changes in exchange rates accomplish – robs Peter to pay Paul and is not part of a global solution at all.

The continuing importance of liquidity policy

Central banks are doing the right thing by massively expanding their balance sheets to put as much liquidity into the economy as possible. The balance sheets of the Fed and of the Bank of England have doubled since the crisis started and the balance sheet of the Eurosystem has expanded by about 50 percent. This has been accomplished through open market operations of various kinds, through which the central banks have increased their holdings of private securities by expanding the monetary base, mainly by increasing bank reserves with the central bank and other central bank loans.

Central banks will have to continue to do this. The private financial sector has to deleverage massively, but would (with credit markets and wholesale financial markets closed for business) do so in an unnecessarily destructive way if left to its own devices. The household sectors in the US, the UK and a number of other European countries have to deleverage (start saving seriously) on a significant scale. Left to its own devices, the short-run Keynesian aggregate demand fall-out from a necessary reconstruction of household financial wealth could be disastrous. So the public sector has to leverage up (borrow) at the same time the household sector is forced to deleverage.

This process of monetisation of private sector financial instruments can continue almost indefinitely. It is restricted only by the total stock of private financial instruments outstanding and by the central bank’s willingness to add private securities with higher and higher degrees of default risk attached to them to its balance sheet.

The central bank as the handmaiden of fiscal policy

With monetary policy almost powerless and with liquidity provision also subject to strongly diminishing returns, a traditional fiscal stimulus is the only show in town that has not yet been tried.

In an earlier post to this blog, I raised the possibility that the UK might face a triple financial crisis: a combined banking crisis, sovereign debt crisis and sterling crisis.  Let me be clearer than I was before about what I mean by a financial crisis.  A financial crisis is a situation where quantity rationing of would-be borrowers and would-be sellers of securities suddenly replaces normal market clearing through variations in interest rates or market prices of securities. 

So a sterling crisis does not require a fixed or managed exchange rate regime for sterling.  It can occur even when sterling floats, that is, when its external value is market-determined, as it is today.