By an almost unbelievable quirk of fate all the important Central Bankers in 2008 (Ben Bernanke, Mervyn King and Mario Draghi) were in fact all neo-Keynesians. The moment Lehman Bros went under the “Great Accommodation” began – interest rates were slashed, money was printed and taxes were cut to generate demand and public debt spiral upwards– and thank God they acted as they did. Miraculously depression was averted, growth returned and all looked to be set fair, until the realisation crept in that the huge government debts might spoil the party.
Since 2009 the economic consensus has fallen apart as bankers and pundits try to offer solutions to low growth, low productivity, spiraling debts and more recently the spectre of deflation. At the heart of this debate has been the interpretation of employment markets. Initially, Central Bankers in the US and UK linked their forward guidance on interest rates to falling levels of unemployment, there was unanimity that demand shortfall was the one and only problem. But as employment has risen without earnings growth or productivity improvements Mark Carney and Janet Yellen have been happy to move the goal posts so that a broader view of the employment market is now the driver for forward interest rates.
In her recent speech, at Jackson’s Hole, Janet Yellen was able to spread the suspicion that she can find an endless number of reasons for continuing with negative real interest rates.
• Structural changes to the global employment market
• Nominal wage rigidity
• Depressed labour force participation
Without breaking into a sweat Ms Yellen was able to provide ample proof that these co-conspirators could only be dealt with by continuing the current “highly accommodative” policies. I guess if you believe that a shortfall in demand is the only problem we need to solve - then we might all jump to the same conclusion. However despite Yellen "evidence" there is a growing sense that Central Bankers are now barking up the wrong tree and that we are destined for years of pain if we continue with these ultra-dovish policies.
For me the question is whether we are addressing the problems in the right order or indeed whether we are addressing the right problem at all. Perhaps we have forgotten that “Great Recession” is the result, not of the “business cycle” which drives employment, but of market failure in financial markets. Over-leveraged Banks provided too many unsuitable loans to families and businesses, driving up asset prices and creating an unsustainable bubble in homes and other asset prices.
In the immediate aftermath of the credit crunch Central Banks applied the necessary liquidity into markets to save us from depression but they did not fix the problem of broken banks and sky high asset prices. The follow-on policies of QE, negative real interest rates and bank reform (Dodd Frank and Basel 3) have had the combined effect of:
• Leaving un-addressed the mountain of distressed debts – almost any business can service loans at today’s interest rates
• Squeezing liquidity out of the market for investment capital – Banks sit tight on over-priced assets and have no slack (due capital adequacy rules) for new loans
• Which in turn reduces investment in new technology driving up employment but suppressing wages
By addressing the business cycle without dealing with the unresolved issues created by the financial crisis the world’s central bankers are making the same mistake that the Japanese made in 1990. Rather than propping up asset prices and squeezing investment capital out of new ventures we need polices that have the opposite effect. This will be painful in the short term but it is the only way for us to avoid two lost decades that the Japanese economy has endured.