The Costs of Continued Unconventional Monetary Policy


The macroeconomic establishment has been conducted (or justifying) a very dangerous policy. It is up to other people to point out its fallacies and to propose alternatives.

The supply is composed of the suppliers (including the producers) and it determines the productive capacity of the economy in the long run. Keynes has focused on the short run and has demonized the so-called Say’s law. But there is no doubt whatsoever that in the long run, it is the supply side of the economy that determines not only the productive potential of the society but also its purchasing power.

Furthermore, the supply side depends on the country’s institutional system, including property rights, the extent of economic freedom, the rule of law, etc. Compare for example North and South Korea – no amount of monetary stimulation can erase or even mitigate the differences in the productive potential and the purchasing power of the two countries stemming from radical differences in their institutional system. It is therefore an aberration of mainstream economics. It has largely neglected the supply side and has focused on the demand side policies. This has been true since at least the interwar period under the influence of Keynes. After the global financial crisis of 2007, it has become a fixation.

This brings me to the issue of the monetary policy of the Federal Reserve followed by the central banks of other developed countries. This policy, the so-called unconventional monetary policy (UMP), consisted first of lowering the official interest rates close to zero. Once it was charged with sufficient stimulation, an unprecedented expansion of the monetary base has been added, the so-called quantitative easing (QE). UMP has been continued until the eruption of the present pandemic and then it has been intensified.

The main issue neglected by mainstream macroeconomics is that UMP damages the supply side and thus indirectly the demand side. Many economies, even before the global financial crisis have pointed out that accessible low-interest rates induce the boom and then the bust in the asset markets and damages the supply side of the economy and economic growth. Thus, another channel has been discovered in relation to the continued and conventional monetary policy that can systematically damage the real economy, which has two kinds of impact: 1) the UMP and especially interest rates close to zero induce the zombification of the economy due to the fact that extremely low-interest rates incentivize the commercial banks to continue lending to otherwise unwired incumbent firms. This lowers the allocative efficiency of the economy and economic growth. 2) By providing extremely cheap money to the governments, quantitative easing (QE) and very low-interest rates disincentivize politicians to launch the necessary supply-side reforms.

The systematic destructive impact of the UMP on the supply side has been denied so far by the central banks despite growing empirical research. Additionally, in continuing this policy the central bank used two doubtful arguments: 1) the decline of the natural interest rate justifies the radical lowering of the official interest rates 2) inflation has declined since the global financial crisis over time and below the official targets and thus the UMP should be continued.

Both arguments are dubious if not outright wrong. Regarding the natural rate, it should be remembered that it is a theoretical construct that has various empirical estimations. The wrong estimations can lead to costly policy mistakes as was the case with the so-called output gap (another theoretical construct that had wrong empirical assessment). Besides that, the natural rate has been probably lowered by the negative impact of the UMP on the supply side. Regarding inflation, one should remember that the central banks target the consumer price inflation (CPI) and largely neglect the inflation of the financial assets, which is a result of their own policies, especially QE. The inflation of financial assets contributes to the growing income inequalities and increases the risk of the next financial crisis.

Regarding the CPI it is true that it has been lower since the inception of the global financial crisis and lower than the central banks’ inflation targets. Why? Here we come to the issue which has been strangely neglected by the macroeconomic establishment, that is, money supply. Over ninety percent of the money supply is created by commercial banks when they grant credits. This dominating part of the money supply has been growing slower than before the global financial crisis despite the eruption of the monetary base. This phenomenon has been neglected by the monetary establishment although it largely explains the low CPI so far. Since time doesn’t allow me to dwell on the reasons for the strange behavior of the money supply, all I can say is that this phenomenon can be, to some extent linked, to the side effects of the UMP and other policies pursued since 2007. This is another way how UMP policy has created the situations which then has been used by the central banks to justify the continuation of this policy. Isn’t it a vicious circle?

The macroeconomic establishment has been conducted (or justifying) a very dangerous policy. It is up to other people to point out its fallacies and to propose alternatives.

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  • Leszek Balcerowicz

    Leszek Balcerowicz is an economist, professor at the Warsaw School of Economics, author of the economic reforms in post-communist Poland after 1989. Leszek was the Deputy Prime Minister and Minister of Finance in the first non-communist government of Poland after the World War II and President of the National Bank of Poland (2001-2007).

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