QE1 : End of (His)story

Monetary policy – end of history?  by  Sabine Lautenschläger

(with caw commenting) In 1992, the political scientist Francis Fukuyama announced the end of history. The cold war had just ended, and in Fukuyama’s view, this marked “the endpoint of mankind’s ideological evolution”. Liberal democracy had prevailed; the final form of government had been reached. There was no need for history to continue.

Similar claims were made about monetary policy. The great moderation, for instance, was traced back to better monetary policy. With this in mind, some argued that monetary policy had reached a perfect and final stage. There was no need to evolve further; history had come to an end.

Or had it? Well, it seems that the unexpected always happens. And when it does, it tends to push the end of history a bit further away. This is true for politics, and it is true for monetary policy.

Note that the economic system is now like the political system, not like the weather system often referred to by economists as a similarly complex system. This is relevant because no one except some naively crude Marxists have ever claimed to know of any laws of historical motion, let alone claim to wield an explanatory mechanistic model taking quantitative inputs.

The unexpected happened in 2008: the global financial crisis struck and undid the great moderation. History took a sudden turn and this threw long-held beliefs overboard.

So now the economy has become a sub-system of history, as perhaps in “political economy?”. Or is it an example of an extreme “external” shock like the outbreak of war? Fact is: the 2008 crisis was not universally unexpected at all, unless your universe is the silo of DSGE mainstream.

Academics as well as policymakers had to adapt their thinking and their doing – monetary policy was no exception. Central banks around the world came up with new tools to keep the financial system and the economy afloat. They became key players; some observers even referred to them as the only game in town.

If the central banks became the main players and had to indulge in unorthodox improvisation it was because the academics have not had to adapt their thinking, have not adapted their thinking, are unlikely to adapt their thinking and are mostly incapable of adapting their thinking.

Now, ten years later, there is one thing that weighs on many people’s minds: When will unconventional monetary policy end? When will it return to normal?

Would normal be the equilibrium of the great moderation?  Rehashed neo-liberal finanzialisation”? A remake of  monetarism?  Tweaked real, neo or new Keynseanism? Or how about some virtualized gold standard? 

It seems that many look no further than the exit from our unconventional measures. But what will happen once we have reached the exit? Will we return to the end of history?

Wasn’t the “end of history” something that actually never happened? Like some “golden age” that lasted a nanosecond?

Well, I don’t think so.

That’s ok then

First, there are still many questions that need to be answered.

Yes, like   1) why did the mainstream “not see it coming?” 
2) why are the same main-streamers still employed as experts? 

And second, the unexpected will happen again at some point. History does not end.

So, just to recap, economic events are but a subplot of the historic narrative. They do not operate on the basis of autonomous “laws of motion” or, indeed, any laws?

But before we discuss what will happen tomorrow, let’s take a look at today.

Jolly good

Approaching the exit – slowly but surely

For many months, we have been discussing the conditions for a gradual exit from our extraordinarily loose monetary policy. But some might now point to the latest economic data indicating that growth has lost some momentum and wonder if this is reason to be concerned, or even to change plans?

Actually we have been discussing exiting “extraordinary” measures pretty much from the day we started them. Not least because some have never agreed with starting them in the first place. As I recall this is at least the second cycle of “shall we maybe get back to normal” since 2008.

Well, first of all, we need to put the latest developments into perspective. Growth in the euro area exceeded potential growth for a couple of quarters. In 2017, the euro area economy grew by 2.5%, compared with potential growth estimates of 1.5% for the year.[1] Against this backdrop, one could expect to see it to slow down. And that’s what happened. In the first quarter of 2018, year-on-year growth was 2.5%, compared with 2.7% in the fourth quarter of 2017. We saw industrial production, excluding construction, decline in the first two months of the year. And both the composite output Purchasing Managers’ Index and the European Commission’s Economic Sentiment Indicator eased in the first quarter. But both are still well above their long-term average.

So we are seeing that the pace of growth has become more moderate, but we are not seeing a turning point. We remain confident in the strength of the economy.

After all, the things that are currently holding back growth seem to be temporary. There was the early timing of the Easter break, there was a strong outbreak of flu in some parts of the euro area, there was cold weather and there were strikes in some countries. All this weighed on growth, but it won’t do so permanently.

We need to keep a close eye on all this, and we will. But for now, there is no need to rewrite the story. The economic expansion remains solid and broad-based. Financing conditions are good, the labour market is robust with a historically high increase in jobs, and income and profits are growing steadily. In short: the real economy is doing well.

We are now in the register of an incumbent politician’s election speech : the real economy is doing well. Jolly good then. By the canonical measures of mainstream economics it may or may not be doing well. But frankly who cares, given most of their numbers are as vacuous and imaginary as GdP itself. Not to mention the holy cow of growth, as expressed by that crappy aggregate GdP. Little under-educated girl Greta is ahead on this learning curve when she refers to the fairy tales of eternal growth as lies. Meanwhile main-streamers are bound to do all their recycling very nicely, of course.

By contrast, inflation so far does not seem to be recovering as convincingly. This has left many observers scratching their heads as to why the current level of low inflation does not match the current state of the real economy.

Let’s face it: main-streamers have been scratching their heads about inflation so much they are going bald. Nothing would be more embarrassing than to republish endless predictions about hyper-inflation bound to occur as a result of monetary easing. And the main inflation we actually have had in the last 10 years doesn’t really have a place in mainstream analysis, i.e. “asset price inflation”, also known as capital gains?

It seems that inflation is responding less to the slack in the economy than would be expected. This disconnect between the real and nominal sides of the economy is the subject of intense debate.

You can say that again…

In very general terms, there might be two forces at play.

First, the Phillips curve might have changed. It might, for instance, have flattened, or it might have shifted downwards. Empirically, it is very hard to determine which – if either – of the two things has happened.

Ah, the beloved  Phillips curve, as close as you get to an “economic law” a la mainstream. Typically these economic law-like curves differ from physical laws in that they tend to shape shift and grow epicycles as they encounter reality, let alone glide through history. Just like the famous law of demand and supply – but let’s not digress into fundamentals.

And that brings me to the second point, which is that we cannot be sure whether we are measuring slack correctly in the first place. The unemployment rate, for instance, is based on a narrow definition. Just think of people who work part-time. Officially, they are employed, but they could work more, of course. So, the amount of slack could be larger than we think. If that is the case, it’s no surprise that inflation has not kicked in.

Hmm yes, measurement problems. That rings some old church bells…

That said, the economy is still expanding and, at some point, any remaining slack will be used up.

Ah there is another law, Say’s law, I believe. Like all economic laws, not exactly based on observation but deduction from The Model. Itself not based on observation but, hmm, what was it? Revelation?

As a consequence, pressure on wages will increase, and we are indeed already seeing wages edging up.

That’s lucky then. Not that economic laws have to be modified in face of contradictory evidence. Ever. It tends to be the “real” economy” that has got it wrong.

Wage growth increased from 1.1% in mid-2016 to 1.8% in the fourth quarter of 2017. In Germany, wages even grew at 2.7% in the first quarter of 2018. This, in turn, will prompt inflation to pick up. So I believe that all we need is a bit of patience. All the conditions for inflation to kick in are in place.

I gather “patient” savers are all the rage these days?  And faith is a fine thing. A mind boggling sign of the times that the German (ex) member of the board now joins in the prayers for inflation ?

So, June might be the month to decide once and for all to gradually end net asset purchases by the end of this year. But please do not misunderstand me here: I am just referring to the net purchases. There is still the stock of assets we have already bought. And we will still reinvest any proceeds from maturing bonds. Just to put it in perspective: each month we buy assets worth €30 billion. This compares with a stock of assets worth €2,400 billion.

What I want to say is this: even when we end net purchases, monetary policy will still be extraordinarily accommodative.

You can say that again…

And, at the same time, other tools will remain in place. The Eurosystem has, for instance, committed to granting banks unlimited access to liquidity against a wider range of collateral. With our targeted longer-term refinancing operations, we provided credit institutions with funding for up to four years. Finally, interest rates are still historically low and will remain so for some months to come. A first hike around the middle of 2019 is not entirely out of the ballpark.

Expectation management has got quite tricky these days, hasn’t it?

So, we are slowly but surely moving towards the exit.

Brexit sort of exit, with destination unknown?

This is the next big thing to happen. But it will not be the end of the story, let alone the end of history. Monetary policy will continue to evolve, new challenges will arise, and many questions still need to be answered.


I will discuss three of these questions now: First, does monetary policy need to refine its targets and update its toolbox? Second, how should it treat financial stability? And third, what is the relationship between monetary policy and the distribution of wealth and income?

As a “concerned citizen, saver, investor, worker or average person in the street, ie nobody, I shall permit myself to answer the above questions in a slightly unorthodox manner prior to engaging, or actually rather not, with the board member’s answers:

First – refine targets and update toolbox? Absolutely yes!
Private financial institutions should cease to be targets at all. Full stop. All new money issued directly or indirectly by whatever procedure should go directly to the constituency of the relevant currency. Probably the easiest way would be to directly issue central bank money into citizens’ central bank/tax account?

Second – financial stability. No problem. At least not for the “real” economy which, after all, according to the textbooks, is served by the financial industries and not the other way round. So the new remit of the Central bank should continue to be 1) “control” of inflation within whatever bandwidth, but also  2) to (OMG !) maximize the “basic income” of all  citizens. Meanwhile the state’s guarantee of deposits in private banks is removed and the central bank offers savings accounts at some (just-) above inflation rate. Given that under the status quo so-called “private” pensions are ultimately more or less guaranteed by the state anyway, it shouldn’t be rocket science to come up with some hybrid system where state pensions equal state guarantee and private pensions are the discretionary additional  risk reward schemes.

Third – see consequences of above.

So there! What’s wrong with all that Ms Lautenschläger and Mr Weidmann?  Ah damn, I forgot to take care of The Market, meaning the Money Markets, didn’t I?  Oh dear…  Better stick with orthodox unorthodoxies then (see below).


Read some of the above or continue reading the speech by Sabine Lautenschläger here