While central bankers of the world struggle to prevent a deflationary spiral the solution has been to print more money. In the past money printing worked by forcing interest rates down, attracting consumers and businesses to borrow money thereby stimulating investment, consumption and the economy. The theory behind why this works is the IS-LM model developed by Sir John Hicks. The IS-LM model is like a simple demand / supply chart where more demand requires more supply short of which prices rise until the supply catches up. Too much supply swamps demand pushing prices down driving companies out of business, thereby limiting supply and the equilibrium price returns.
The first line of the IS-LM graph is the downward sloping line IS which stands for investment and savings. On the vertical axis is the interest rate. Therefore the independent variable is the interest rate and the dependent variable is income. As interest rates drop income falls, investment increases and savings fall moving the line to the right and increasing GDP (which is on the horizontal axis). The upward sloping line is the LM line or liquidity-money line. The dependent variable is the interest rate while the variable input is income. This says that the more money that is placed into circulation the lower the interest rate. Lower interest rates should therefore stimulate the economy as the IS line should move towards more investment.
Based on this theory the Federal Reserve can control the economy and GDP growth by increasing or reducing the supply of money into the economy. The point at where the two lines intersect should show the level of GDP growth associated with the input of additional funds and the corresponding interest rate. There is a problem to this theory though. When there is general pessimism about the economic outlook the IS line shifts to the left and no matter how low interest rates fall or how much money is input there is no growth as the two lines are disconnected - the so called Liquidity Trap.
At this point conventional monetary policy is worthless. As far as I can see and as I have explained in previous blogs, the reason that economies get to this level is that governments do not want to do the full Keynesian Monty - that is they are too scared to take all of their clothes off for fear that everyone else leaves their on and they are left to explain why they are naked. To put it another way if they use all the various aspects of Keynesian stimulus, fiscal and monetary policies (low interest rates, print money, lower tax rates and throw money at shovel ready projects), and they do not work (for whatever reason) they would have no tools with which to try to repair the mess and the mess would be far greater. Talk about egg on your face! Additionally, if they use all of these stimulants and they work better than expected then inflation could potentially run out of control once again creating a problem that might be too difficult to control. More egg, same face!
For these reasons the central bankers of the world seem to feel that it is better to leave a few stimulants on the table for use at a later date. Make sure the broth is not too hot, cold or worse still too salty before taking a big swallow. If it is too hot cool it off by removing more stimulants and if too cold add a few more stimulants continually testing it to ensure it is going according to plan. If you get it too salty then watch out as there is nothing to do but let market forces work it out and that is their worst nightmare.
Now this may seem sensible but economies do not heat up in a few minutes, they can take months if not years to show a sign that the additive is working. Also once the heat is turned off, the economy can continue to accelerate reaching levels of inflation that become very uncomfortable very quickly. So in essence it is impossible for a central banker to truly tinker with these levers without creating economic shocks which is what continues to plague all economic theory and which is why barring another global catastrophe my hope for 2015 is that they leave their hands off the switches.
No comments:
Post a Comment