Mervyn and the Monetarists

If there were such a thing as a supergroup of economists, this would be it. Ben Bernanke, chairman of the US Federal Reserve, Mervyn King, governor of the Bank of England, Larry Summers, former US secretary of the Treasury, Olivier Blanchard, chief economist of the International Monetary Fund, and Axel Weber, former head of the Bundesbank and now chair of UBS, gathered at the London School of Economics yesterday to discuss: “What should economists and policymakers learn from the financial crisis?” It’s an ambitious question and one that calls for Mervyn and the Monetarists to answer it.

King started out with a warning. “The crisis is far from over,” he said. “There will be many twists and turns before we can truly say that the crisis is over.” All the speakers were keen to stress how the situation in Cyprus shows we are not yet in the clear. “The rally in financial markets that we have seen has been a misleading signal,” Weber said. “Cyprus is a reminder that the eurozone economies have not been stabilised,” and the rally in sentiment was “too good to be true.”

This caution was apt, given a second theme of the afternoon: that economists had been complacent before the crisis. Blanchard saw it as a challenge to the received wisdom that “financial crises were not going to happen anymore—at least not in developed nations, and of course we see the irony of that now”—an echo of Anne Applebaum’s article (£) in this month’s Prospect.

Was there anything special about this particular crisis? Bernanke argued that, “despite its many exotic features, [it] was in fact a classic financial panic—a systemwide run of ‘hot money’ away from assets whose values suddenly became uncertain… The response to the crisis likewise followed the classic prescriptions.” But he admitted that this classic panic “took place in a novel institutional context”—for example, in the US, run pressure was experienced not only by banks but by a diverse collection of institutions, and “the complexity of globalised financial institutions and markets made it difficult to predict how the crisis might spread or to coordinate the response.” Blanchard, too, spoke of the “complexity of the cross-border nature of the crisis.” Countries that thought they were not exposed turned out to be. In light of this, “traditional monetary and fiscal tools are just not good enough to deal with the very specific problems within the financial system,” he said, talking about the importance of macroprudential tools instead.

Some argue that the traditional tools haven’t worked because they haven’t been used with enough conviction, and there may be some truth in this, Blanchard said. Nonetheless, there has been a widespread easing of monetary policies in recent years and, as a result, Bernanke wanted to tackle the question of whether countries are trying to recover at the expense of others, through competitive depreciation of exchange rates. Competitive depreciation is a double-edged sword, however—exports become more attractive but imports become more expensive. This matters for export-oriented economies too because importing raw materials for production becomes more expensive.

“Like other aspects of the crisis, the notion of competitive depreciation has strong classical antecedents, particularly in relation to the global Great Depression of the 1930s,” Bernanke said. Prior to the Depression, the exchange rates of most industrial countries were determined by the rules of the international gold standard, under which the British pound was overvalued, contributing to the UK’s weak economic environment at that time. Montagu Norman, then-governor of the Bank of England, commented that, “only God could tell whether it [the value chosen for the pound sterling under the gold standard] was or was not the correct figure,” to which a commentator replied, “but of course the deity may not be an economist.”

The UK would eventually exit the gold standard in 1931, followed soon after by most of the world’s industrial nations. This “gave rise to the idea of ‘beggar thy neighbour’ policies,” said Bernanke. This theory suggests that, because exchange rate depreciations help the economy whose currency has been weakened by making them more competitive, this comes at the expense of its trading partners, who become less competitive. It is thought this may have prolonged the Depression, “leading to an ultimately fruitless and destructive battle over shrinking international markets.”

Is the same thing happening now? In short, no, said Bernanke. Since the supply of money is being boosted in most developed countries, this does not constitute competitive devaluation and the benefits of loose monetary policy “are not created in any significant way by changes in exchange rates; they come instead from the support for domestic aggregate demand in each country or region. Moreover because stronger growth in each economy confers beneficial spillovers to trading partners, these policies are not ‘beggar thy neighbour’ but rather positive-sum ‘enrich they neighbour’ actions.”

But there was some disagreement over this. Weber argued that, “domestic currency weakness is desirable for those central banks [that use it] but overall just redistributes global resources.” He also said he was concerned that long-term use of loose monetary policy might be unsustainable “and have detrimental consequences for future generations.”

But Summers stepped in with a firm and decisive response: “Yes I am the father or step-father of six children,” he said. “And yes on their behalf I am concerned about the possibility that an overly inflationary psychology will develop in my country. Yes on their behalf I am concerned that an excessive debt will be placed upon them.

“But I am vastly more concerned, because I care about their long run future, that a slack economy will not provide them with satisfactory jobs when they leave school. I am more concerned on behalf of their future that they will live in a country with decaying infrastructure that will not permit investment that maintains leadership. I am more concerned on their behalf that inadequate resources forced by counter-cyclical austerity will stunt the ability of their generation to be educated. I am more concerned on their behalf that excessively austerity oriented policies will lead to slower economic growth and, as a consequence, to an ultimately higher debt-to-GDP ratio and more pressure in terms of higher tax burdens in the future.” Those concerns, argued Summers—and Bernanke with him—can only be tackled through the necessary evil of expansionary policy.