Hard money versus soft money

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In the right corner, the Bank of International Settlement and assorted Austrian economist arguing low rates are fuelling bubbles. In the left corner, those that argue that loose monetary policies are necessary because a lack of demand and deflation risks. The prestigious Swedish central bank jumped ship, slashing rates after earlier rising them prematurely (according to the deflationistas), which indeed brought about deflation.

OK, this is fairly amazing. I’ve written often about sadomonetarism among central bankers — the evident urge to find some reason, any reason, to raise interest rates despite high unemployment and low inflation. The most influential hive of this kind of thinking is the Bank for International Settlements, which for some reason commands great respect even though it offers an ever-changing rationale — inflation! Any day now! Or maybe not! Financial stability! — for its never-changing advocacy of tight money. But the place where policy makers most dramatically gave in to this urge is Sweden, where the majority at the Riksbank decided to indulge its rate-hike vice while freezing out one of the world’s leading experts on deflation risks, my friend and former colleague Lars Svensson. Well, guess what: Lars has been proved so dramatically right by events — raising rates didn’t curb rising debt, but it did push Sweden into deflation — that the Riksbank has done an abrupt U-turn, slashing rates (and overruling the governor and first deputy governor). Actually, the drama of this U-turn may be a very good thing, since it might convince investors that this is a real regime change.

Swedish U-turn NYTimes.com

Sweden’s Riksbank has slashed interest rates to head off deflation despite surging debt levels, becoming a world laboratory for a radical monetary experiment. The central bank stunned markets by cutting its Repo rate by 50 basis points to 0.25pc, abandoning efforts to curb asset bubbles by “leaning against the wind”. Governor Stefan Ingves and his chief deputy were outvoted by the executive board in what amounts to a mutiny.

Sweden slashes rates to avert deflation after Riksbank mutiny - Telegraph

The rate cut is a vindication for Lars Svensson, a world-renowned deflation expert who resigned as deputy governor last year after accusing the bank of jumping the gun by raising rates. “But better late than never,” he said on Thursday. Professor Svensson said the attempt to cut leverage by tightening pre-emptively had made matters worse. “Low inflation has actually increased the households’ real debt burden. Riksbank policy has thus actually been counterproductive,” he told the Telegraph.

Sweden slashes rates to avert deflation after Riksbank mutiny - Telegraph

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Krugman has a pretty useful clarification here:

Gavyn Davies takes on the de facto debate between the hard-money men at the BIS and the monetary doves, and frames it as a conflict between Keynes and Wicksell. But I don’t think that’s right. The BIS position is in fact just as inconsistent with Wicksell as it is with Keynes. That doesn’t mean that the BIS is wrong (although I believe that it is); it does mean that its view is much stranger and harder to defend than Davies suggests.

So, for those wondering what this is all about: The Keynesian view of monetary policy is that the central bank should, if it can, set interest rates at a level that produces full employment. Sometimes it can’t: even at a zero rate the economy remains depressed, so you need fiscal policy. But in normal times the Fed and its counterparts should be aiming at the full-employment interest rate.

Wicksellian analysis is an older tradition; it argues that there is at any given time a “natural” rate of interest in the sense that keeping rates below that level leads to inflation, keeping them above it leads to deflation.

I have always considered these approaches essentially equivalent: the Wicksellian natural rate is the rate that would lead to full employment in a Keynesian model. I have, in fact, treated them as equivalent on a number of occasions, e.g. here.

Now, what about the BIS? It is arguing that central banks have consistently kept rates too low for the past couple of decades. But this is not a statement about the Wicksellian natural rate. After all, inflation is lower now than it was 20 years ago.

No, what the BIS is arguing is that there is some other appropriate rate, defined as a rate sufficiently high to discourage bubbles, and that central banks should target this rate even though it is above the Wicksellian natural rate – or, equivalently, that the economy should be kept permanently depressed in order to curb the irrational exuberance of investors.

It’s true that they don’t put it that way – probably because the policy recommendation sounds outrageous when you do. We can’t regulate finance effectively, so we have to accept a permanent slump instead? Really? But that’s what it amounts to.

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And, lest we forget, we wrote several articles ourselves on this topic, the last one here, arguing (amongst other things):

• Interest rates are for regulating the level of economic activity
• There are other means for curbing asset bubbles, depending on where they occur
• There are real-life examples of the latter, more specifically, regulating mortgage markets to dampen housing bubbles.