Thursday, the European Central Bank will cut interest rates in Europe, almost certainly by 50 basis points, to just 2 percent. On June 24-25, the U.S. Federal Reserve will meet and might well cut another 25 bps off the 1.25 percent short-term interest rate -- the fed funds rate. And in Japan, where the short-term interest rate is zero (and has been below 1 percent since 1996), the Bank of Japan is seeking new ways to feed money into the system.
Years of ultra-low interest rates in Japan have not got the economy going. Deflation has taken hold. Prices keep falling. What is needed? The central bank now appears to believe that still more vigorous effort to force money into the economy is required, along the lines (though not a literal interpretation) of the throwing-money-from-helicopters idea of Professor Paul Krugman. Speaking to a Brazilian magazine, Exame, in April 1998, Krugman explained his view on Japan:
"What I suggest is a monetary policy as expansionary as possible, something that hasn't been tried yet. As simple as that: to print money. As if loaded helicopters would dump money on the cities. Japan today resembles the developed countries in 1937: a deflationary economy where not even near-zero interest rates can channel savings towards investments. Being responsible, in this case, is the worst they could do."
There we have one proposed solution for Japan's malaise. At some point, Krugman is arguing, readily available money must make something happen. But is that right?
Let us sidle toward an answer.
In the inbox arrives a piece of research from two economists at JP Morgan, the investment bank. James Glassman and John Lipsky have compared monetary policy in the United States and Europe and find the conventional wisdom, that Fed Chairman Alan Greenspan has been much more aggressive than his peer, Wim Duisenberg of the ECB, may not be right.
The so-called Taylor Rule to the "right" interest rate -- the result of research by John Taylor, a professor at the Stanford University -- takes account of the gap between actual output (or growth) and potential output and between targeted inflation and actual inflation. Glassman and Lipsky find that the ECB since its foundation in 1999 has consistently run a more relaxed policy than suggested by the Taylor rule, while the Fed funds rate in the United States has been higher than suggested by it.
It emerges -- though Glassman and Lipsky do not bring out this point -- that in order to comply with the Taylor rule, negative (nominal) interest rates would have been required in the United States as from 2002. Why not also in Europe, where growth has been weaker? In Europe, the potential growth rate appears lower than in the United States and inflation has been higher, producing a very different outcome under the Taylor rule.
But does that mean European interest rates should necessarily have been higher than U.S. ones? And should U.S. ones have been still lower? Only if you believe the prescriptions of the Taylor rule, which this writer doesn't.
But, having established to their own satisfaction, if not ours, that monetary policy in Europe has been closer to Greenspan's policy aggression than thought, Glassman and Lipsky reach a conclusion we do agree with -- that "differing monetary policy is not the most powerful explanation for the U.S./Euro area growth gap and new ECB rate cuts will not close the gap quickly."
So what is? The two economists refer, no doubt rightly, to the highly expansionary fiscal policy of U.S. President George W. Bush. Following the bursting of the U.S. stock bubble, Bush and Greenspan have done everything possible to keep U.S. domestic demand at an inflated level. In Europe, the fact that fiscal deficits were already in place before the downturn and the European rule that the fiscal deficit of any country should not exceed 3 percent of gross domestic product have prevented anything similar.
But another factor raised by Glassman and Lipsky is less familiar and interesting. In the latest data, they point out, "55 percent of net borrowing by U.S. corporations is via bond issuance." By contrast, European corporations still lend heavily from banks. Bond investors react more swiftly to bad corporate news than banks.
The price of a U.S. corporation's bonds may fall heavily if its finances are poor and therefore its cost of fresh bond issuance will rise. European banks meanwhile act as "shock absorbers." Corporations to which they have lent money may not be doing well but they are unlikely to call in the loan or force the company to restructure (unless things become very bad). Thus European firms are under less pressure to restore profitability, Glassman and Lipsky conclude.
Glassman and Lipsky's comparative arguments lead them toward the conclusion that "with the U.S. expansion poised to accelerate in coming months," the dollar will tend to stabilize against the euro. (Again, this writer would not agree.)
But we find Glassman and Lipsky's work useful for other conclusions it might lead us to, if not them. Neither in Europe nor in the United States is monetary policy all that is required to generate growth. If, as in Europe, corporations do not react quickly to financial difficulties, then perhaps new opportunities for profitability and growth will not emerge. If, as in Europe, labor law deters companies from hiring, perhaps companies will not hire.
Economic malaise may reflect -- and usually does reflect -- more than too high interest rates. There is a reason for it. In Japan, the bad loans that are the result of the bust bubble economy are often cited. But corporations in Japan are unwilling to change. They do not dismiss workers, drop loss-making units, restructure and rebuild in the American way.
"Their economy is so wealthy that they still don't feel pressured to act," said Krugman in the same interview referred to above. He was referring to BoJ monetary policy but misses the point that what he says might equally refer to Japanese society as a whole. Monetary policy may easily be changed, at the drop of a press release. Socioeconomic change is more difficult. Japan has shunned it, so far. So has Europe.
And what of the U.S. economy? Can it be repaired by cheaper and cheaper money?
Regular readers will be familiar with our view. We won't go into it now. Let's turn instead briefly to Krugman, for another wrong answer, at least in our view. "The concept of an excess of capacity makes no sense at all."
Really, Paul? Even after all those years when the cheapest of cheap money, stock options and stock price gains, did rain down from helicopters?
Global View is a weekly column in which our economics correspondent reflects on issues of importance for the global economy. Comments to firstname.lastname@example.org
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