Part 2: Paradox of Monetary Policy in Managing Elastic Currency
Michio Suginoo, CFA (He/Him)
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Background
A sound monetary system has to possess a certain set of qualities as a necessary condition. It has to be ELASTIC and SCALABLE (Suginoo, 2023), apart from satisfying other necessary conditions of money such as a medium of exchange, a unit of account, a store of value and sometimes, a standard of deferred payment.
The gold standard failed to incorporate elasticity and scalability into its prototype architecture. Thus, when it needed those features, it compromised its own principles and degraded into oblivion. When we see the current monetary system in advanced economies as a by-product of historical evolution of monetary system, it has made a reasonably successful advancement in engineering elastic and scalable currencies.
Nevertheless, elasticity and scalability are merely necessary conditions for a sound monetary system to serve the highly interconnected complex global economies. Despite with necessary conditions satisfied, our contemporary monetary system is not perfect. As a matter of fact, it is failing since monetary authorities failed to conduct sound monetary policy decision-making in managing elastic and scalable currency that they had engineered.
In other words, the primary problem of our contemporary monetary system is not elastic and scalable currency itself, but rather our human limitations in managing it.
This essay attempts to shape an empirical understanding on difficulties in managing elastic and scalable currencies. Those difficulties arise due to inherent paradoxes embedded in the architecture of contemporary monetary policy.
In order to contemplate potential solutions of the shortcomings of the system, we need to understand the architectural paradox of contemporary monetary policy.
That is the objective of this essay.
1. Paradox of Monetary Policy
Note: This part of the essay is a revision and reconstruction of my own past work: Shirakawa’s Monetary Policy Paradox (Suginoo, 2017)
Monetary policy, while having an intensive focus on the stability of general price (CPI), has to face a dilemma in dealing with differences in the behaviors among price categories. For example, general price (CPI, PCE, etc.), asset price (productive assets, real estate, land, etc.), commodities price, and equity price—all those four price categories demonstrate different price behavior in response to interest rate dynamics and cannot be managed at the same time by conventional monetary policy alone.
A success in the conduct of conventional monetary policy could defeat itself. Masaaki Shirakawa, the ex-governor of the Bank of Japan from April 2008 to March 2013, expressed his insight of the paradox in the conduct of monetary policy.
Although Shirakawa formulated his insight of the paradox based on Japan’s experience (of asset bubble during the 80s, its bust in 1991, and its aftermath), we can extract out of his formulation general principles which can apply to other cases.
Shirakawa was a highly mindful central banker in the monetary history of Japan. He understood a paradoxical nature of monetary policy and acted cautiously. He is one of my heroes.
Self-defeating Cycle of Monetary Policy: Success feeds its Defeat.
Monetary policy’s success in stabilizing general price level and economic stabilities could feed the very causes of financial crisis: an extension of leverage and its consequence, asset bubble. It is so effective in causing the economic instability. Once its consequential financial crisis unfolds, monetary policy loses its effectiveness in addressing new problems. It creates a self-defeating cycle. In the long-run, monetary policy could only end up transferring economic imbalance from one area to another within the system.
Here I outline the formulation of cycle of paradox.
Victory of Monetary Policy
Once the public confirms central bank’s commitment on price stability and its effectiveness in delivering its objectives, the victory of monetary policy starts shaping a new expectation among economic agents, the confidence in economic stability. Then, the expectation for sustainable growth and stable interest rates also would create an incentive for economic agents to take more risk. It would lead to a time of Euphoria.
Euphoria would result in excess credit expansion beyond a sustainable level. And that would trigger asset bubbles.
As a result, economic imbalance starts shifting from CPI inflation to excess credit expansion and asset inflation. Speculations would bias towards further economic expansion.
Shirakawa characterizes the chain of these behavioral reactions as the cycle of confidence.
In one way or another, when the asset inflation transmits into general price inflation, that would force monetary authorities to raise interest rates. That would break the momentum of credit expansion. That would trigger the burst of the asset bubble. And the time of Euphoria would inevitably end.
Aftermath: diminishing effectiveness of monetary policy under a near zero rates
Once the bubble bursts, the asset prices would collapse. And collateral values in the system would plunge dramatically, while the liabilities in the system would remain fixed in nominal term. That would depress many companies’ net asset (the total assets – the total liabilities). And some would go under water.
To make the already bad situation further worse, now comes with credit spread widening.
Under such a distressed economy, inevitably, risk spread would widen for commercial lending. Despite the decline in risk-free interest rates, the increasing risk premium would make the net effect unfavorable to borrowers, especially those with lower credit ratings.
Distressed net assets together with widening credit spread would annihilate the system’s ability to create credit, which is the primary transmission channel of monetary policy. With its transmission mechanism dormant, monetary easing would not work effectively. This is one consequence of asset price deflation in the post-bubble economy.
As monetary easing continues, the short-term interest rates approach zero rate. Shirakawa points out diminishing effectiveness of conventional monetary policy under a near zero interest rates environment.
Shirakawa’s formalization of the paradox of monetary policy also fits to the narrative of Global Financial Crisis. Furthermore, even unconventional measures of quantitative easing did not work effectively among many countries.
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Difficulties of Managing different price behaviors among different Price Categories
Repeatedly, general prices (CPI, PCE, etc.), asset prices (productive assets, real estate, land, etc.), commodities prices, and equity prices—all those four price categories demonstrate different price behavior in response to interest rate dynamics and cannot be managed at the same time by conventional monetary policy alone.
In a way, the cycle of paradox is a product of different price behaviors among different price categories. Here is a remark by Shirakawa:
“Success breeds confidence which unfortunately turns into over-confidence or even arrogance. Complacency also sets in. The collapse of the bubble based on this over-confidence leads now to under-confidence, which is followed by rebuilding efforts. Then the cycle begins once again.” (Shirakawa, April 22, 2010, p. 486)
Policy makers have a critical role in creating incentives; and the private sector might have no other choice than respond to them. Once public incentive, which is policy maker’s creation, compels the private sector’s economic actors to react, the resulting new chain reaction would be biased toward one single direction—which annihilates balancing equilibrium mechanism of the market. That would become the source of economic imbalance. The interaction between policy incentive and economic agents’ psychology is a driving force of the paradox in creating economic imbalance in the architecture of Shirakawa’s Paradox.
The cycle of paradox will continue. For now, that’s enough to illustrate its mechanism.
There are more insightful arguments in Shirakawa’s thesis.
2. Intervention of Self-defeating Cycle of Paradox
How to intervene the Self-defeating Cycle of Paradox?
One of the most important takeaways here is: once we let Euphoria shape an asset bubble, intervening the self-defeating cycle of monetary policy paradox would progressively become difficult, or even infeasible.
So, it would be imperative to intervene the self-defeating cycle before the formation or the early stage of Euphoria. If the system managed to prevent Euphoria from forming asset bubbles, we could avoid such a situation where monetary policy would become impotent in managing elastic and scalable currency.
In other words, apart from ordinary conventional monetary policy, monetary authorities need to be able to intervene the formation of Euphoria. That determines our first priority of special intervention. For our discussion purpose, we would only focus on this first priority of special intervention.
Now, nevertheless, we would face another layer of difficulty. That is the difference in price behaviors among price categories, especially general prices (CPI) and asset prices.
Proposal for Macro-prudential Risk Spread
As one of our observations in the previous section, the cycle of paradox is a product of difficulties in managing confronting price behaviors between general prices (CPI) and asset prices.
General prices and asset prices demonstrate different behaviors, often toward diametrically opposite directions. While monetary authorities are successful in containing general price inflation, ensuing lower interest rates could drive the asset prices upward with a persistent momentum.
How could the system manage these two confronting price behaviors?
That is a very relevant question that we need to address.
I used to advocate the use of macro-prudential regulation for this purpose. Nevertheless, I no longer regard it as an effective tool, because, more often than we think, it would not be politically palatable. Political biases would make the tool ineffective.
As an alternative solution, I propose that monetary authorities incorporate into their conduct of monetary policy a layer of risk spread target for mortgage rates. In other words, monetary policy set two targets:
With two instruments embedded into the conduct of monetary policy, monetary authorities would have a better flexibility in maneuvering their policy decision.
Of course, this is only at a conceptual level. How to engineer such a spread and its transmission mechanism would involve collective research efforts. In addition, how to implement it would involve regulatory reforms.
Human Error/Biases
Now, we would still face another layer of difficulty arising from human errors/biases. Famously, a former FED chairman, Alan Greenspan, admitted his mistake in his conduct of monetary policy decision making in the past. (Alan & Politi, 2008)
Here comes AI based Data-driven Decision-Making System as a potential solution for the problem.
The next section explores a potentiality of AI based Data-driven Decision-Making System in minimizing human errors/biases.
References