Reply to Larry Summers

An ‘Either-Or’ approach to fiscal and monetary policy is mistaken

Larry Summers has delivered a pointed and sweeping critique of the prevailing consensus among central bankers. He rightly asserts that reliance on further interest rate cuts, asset purchases and forward guidance is likely futile and potentially counter-productive.

I think most of the macroeconomic policy and analysis community would agree with Larry’s diagnosis, as far as it goes. Central bankers, too. They may not say so as bluntly in public, but they do behind closed doors. Mario Draghi’s assertion that a more pronounced downturn in the Eurozone would require a fiscal response is tantamount to the same thing.

My concern with this emerging consensus is four-fold:

1. The assertion that monetary policy is not fit for purpose given existing tools ignores the power of a series of monetary policy innovations, including dual interest rates. Freeing a targeted lending rate from the deposit rate, as the ECB could do with the TLTRO is clearly monetary policy and undeniably effective. Actually doing this requires widespread intellectual support.
2. Central bank independence is a considerable institutional achievement, abandoning it due to a lack of intellectual leadership and political courage could set back macro policy-making for decades.
3. If ever it was clear what the fundamental problems with fiscal policy are, they are evident today in spades. Markets are literally paying governments to ease, and they appear either incapable or aggressively unwilling. The one exception appears to be America’s President who has little regard for constitutional or political checks and balances, the rule of law, or the separation of powers. If America really wants to descend into crony capitalism, arm him with the need for monetary and fiscal cooperation.
4. Our current predicament is a failure of the mind, and a lack of political courage. Macroeconomists who aspire to be Keynes risk rationalising the modern-day Herbert Hoovers in Europe, and global Trumpists elsewhere.

1. Monetary policy has the power

Larry Summers is entirely correct to be sceptical of the effects of further rate reductions, QE or forward guidance. He is right to hammer this home, because markets seem convinced that central banks will continue to pursue these policies despite falling share prices of banks (market-based evidence that negative rates are hampering intermediation), and theoretical arguments why the marginal effectiveness of interest rate reductions and QE diminish.

Yet none of this is true of dual interest rates, which he oddly ignores. The marginal effect of dual interest rates increases. Consider the ECB’s targeted long-term refinancing operation (TLTRO). Under this programme the ECB can make targeted loans to banks at whatever maturity it chooses, at an interest rate it wants. There is no legal, operational or administrative reason why the interest rate on these loans cannot be freed entirely from its deposit rate. In one single monetary operation, all of Larry’s legitimate concerns evaporate.

Two ways in which TLTROs can be used have been outlined. Either the ECB could operate with dual interest rates and announce, for example, a 10-year targeted lending scheme at say -2%, equivalent to 10% of Eurozone GDP, with strict conditions similar to those on existing TLTROs. Alternately, it could make perpetual loans at zero-interest available to all Eurozone citizens, using the banking system to administer the loans.

To be absolutely clear, both of these monetary operations are legal, monetary, and subject to the mandate of the European central bank. They are monetary because they involve the creation of money on the central bank’s balance sheet, there is no involvement of any national treasury, and they are administered through the banking system. That is the definition of monetary policy.

2. An abnegation of duty

Some economists will get hung up on how the Bundesbank will react, or what the effects are on the central banks’ balance sheets. That is precisely the problem we face – an abnegation of duty hidden behind a lack of political and intellectual courage. A central bank’s balance sheet is accounting fiction. Macroeconomists and central bankers need to make this explicit. There are no circumstances where a monetarily sovereign central bank cannot fulfil its mandate, whatever its accounting capital is. Tiered reserves, IOR, and prudential regulations give central banks a complete toolkit to control future inflation, should it ever materialise.

This goes to the heart of the challenge of central bank independence. The best arguments against did not relate to legitimacy (I’ll come back to this) but concerns about priorities. Astute observers feared that academic economists and central bank officials would get lost in arcane and irrelevant debates, fiddling while Rome burns. Examples? Absurdist debates about whether or not cash transfers are ‘permanent’, banal jargon such as ‘state contingent forward guidance’, which roughly means ‘we’ll change our minds depending on what happens’, requesting indemnities against ‘losses’ on asset purchase schemes, and pedantry over the monetary/fiscal distinction – which is in fact crystal clear.

The debate about central bank independence needs restatement. Many seem confused into thinking that because central bank officials are not directly elected this means they lack legitimacy. High functioning democracies have checks and balances, and separations of power. Legitimacy resides in fulfilling mandates determined by democratic process. There are very good and relatively obvious reasons why well-functioning societies decided to give control of money printing to independent central banks. Whatever you think about Boris and Trump you don’t want them to think they can just print at will. There is a difference between money and debt – and it matters. Government bonds, in a market, need to be accepted voluntarily by others. In a free market, potential lenders can say no. Base money, however, can always be created. This is the confusion often created by discussions of MMT. Most well-functioning democracies want fiscal authorities to face constraints, and they want democratically-mandated central banks to produce money subject to the objectives of price stability and full employment.

Loss of legitimacy is a failure to fulfil a democratic mandate. If it really is the case that central bankers cannot fulfil their mandates, they will have lost legitimacy, and our collective cyclical and political fortunes will become entirely subject to the whims, eccentricities and vested interests of whichever small group of politicians hijack elections. There is no evidence that this is either what we want or in our collective interests.

To be absolutely clear, elections are the lifeblood of democracies. But so are checks and balances – otherwise we end up with minority rule, myopia and a grotesque manipulation of public ‘opinion’.

3. Mythical fiscal efficacy

Counter-cyclical fiscal policy now resembles a mythical Greek god – some fantastical winged creature which will swoop from the sky and save us all, if only the community of economists could agree upon it and abandon cutting interest rates. There is nothing to stop governments engaging in brilliantly effective fiscal policy. Honestly, they have not been held back by MIT professors’s equations pointing to the power of monetary policy. The reality is that they are either incapable of doing so, or unwilling. There are huge inherent problems with using fiscal policy to stabilise economies. Party politics is a fight between political vested interests. Policy cannot be changed mid-week by conference call in response to an abrupt change in economic data. Infrastructure spending can take decades of planning. In the Eurozone, effective fiscal policy is illegal.

There is a significant danger that Summers’s arguments simply rationalionise the confused instincts of Northern Europe’s aspiring Herbert Hoovers: negative interest rates are a disaster, recessions are a good thing, and if there’s an economic contraction we’ll look after ourselves with a trivial stimulus.

4. Courageous central bankers need intellectual support

Thankfully, there are a small number of global central bankers to whom most of this is relatively obvious. They need political and intellectual support. There is absolutely no reason for Larry Summers and other policy thought leaders in macroeconomic not to get behind an aggressive and coordinated programme of dual interest rates globally. The debate should be focused on how these lending programmes should be targeted and what their scale should be. An innovative financial structure for the Fed may also be needed, as it increasingly looks hamstrung by post-crisis legislation. But rationalising central bank apathy and fiscal incompetence is an intellectual turn for the worse. We already have failing fiscal authorities, do we want our central banks to fail too?


Just as I finished writing this, an excellent thread from @economistmeg came up on twitter, with similar observations post-Jackson Hole

About The Author

Eric Lonergan is a macro hedge fund manager, economist, and writer. His most recent book is Supercharge Me, co-authored with Corinne Sawers. He is also author of the international bestseller, Angrynomics, co-written with Mark Blyth, and published by Agenda. It was listed on the Financial Times must reads for Summer 2020. Prior to Angrynomics, he has written Money (2nd ed) published by Routledge. He has written for Foreign AffairsThe Financial Times, and The Economist. He also advises governments and policymakers. He first advocated expanding the tools of central banks to including cash transfers to households in the Financial Times in 2002. In December 2008, he advocated the policy as the most efficient way out of recession post-financial crisis, contributing to a growing debate over the need for ‘helicopter money’.

3 Responses

  1. Thorvald Grung Moe

    Interesting post, but think you underplay intellectual obstacles to more active fiscal policy, ref. Mainstream consensus assignment (wren Lewis), I.e. mon pol should do the countercyclical job, while a stable fiscal policy would look after the debt. This has not worked, but pleads for more active fiscal policy fail to catch on in part due to this intellectual blockage. Untraditional mon pol is fine, but fiscal policy needs to come forward

  2. Patrick

    Really interesting. It’s probably covered in these blogs elsewhere, but I would wonder whether a dual interest rate could create distortions in the capital base. How do you ensure that newly created capital finds its way to productive sectors of the economy, rather than just ballooning up asset prices and private debt levels? Maybe this is where targeting the poor comes in, perhaps they are less likely to spend the money on housing or financial assets.


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