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On the Record

Remarks at the IMF’s Fifteenth Jacques Polak Annual Research Conference

It is humbling to be asked to be the lunch-time entertainment at an institution with the stature of the IMF at a conference with so many smart people who have done such impressive work. I have to admit that I find the IMF—and particularly Olivier Blanchard’s research department—increasingly frustrating. When I first came to Washington as a WSJ reporter, IMF research reports were so turgid and technical that reporters who could understand them could easily make news by writing about them. Now the IMF has a blog of its own that is quite good and often provocative, and the IMF communications unit puts out a twice-a-day news summary that is nearly as efficient at Twitter at keeping up with global headlines. At the Hutchins Center on Fiscal and Monetary Policy at Brookings, my first instinct when we are considering commissioning a paper or convening a conference is to make sure the IMF hasn’t already done it. Often, it has. It was, after all, at last year’s Jacques Polak conference that Larry Summers re-introduced the term “secular stagnation” into the vernacular and, despite Ben Bernanke’s attempts at that same conference to use the teachings of Larry’s uncle Paul Samuelson to knock down the argument, Larry started a global debate.

The theme of this year’s Polak conference—spillovers—is very timely. It is also a very old topic. Barry Eichengreen’s forthcoming book—Hall of Mirrors: the Uses and Misuses of History—reminds us of the catastrophic spillovers that triggered and prolonged the Great Depression. Tensions between the U.S. and Germany over exchange rates helped provoked the 1987 stock market crash—which we all thought was a very big deal at the time. The 1997 Asian financial crisis produced an uncounted, but large number of speeches, newspaper accounts and research papers on the phenomenon of “contagion,” which I think is the technical term for spillovers that we can’t otherwise explain. All this research and these memories were one reason that leaders of the global economy and particularly the world’s central bankers were so determined to join hands during the early chapters of the recent global financial crisis, an imperfect effort to be sure, but one that helped prevent the Great Depression 2.0. As Eichengreen writes, “If the collapse of international cooperation had aggravated the world’s problems [in the 1930s] then they [policymakers] would use personal contacts and multilateral institutions to ensure that policy was adequately coordinated this time” (page 2).

It’s clear, though, that coordination was much easier when everyone was rowing in the same direction. Today’s environment is sharply different—as the divergence among monetary policies in the U.S., Japan and Europe demonstrates.

So though the notion of spillovers isn’t new, the channels and challenges may be. The same might be said about central banking in general. In some sense, the basics are the same, the lessons of Walter Bagehot as relevant today as they were in 1873. But the channels and challenges are different, and that’s what I’d like to talk about today from the standpoint of a journalist and a novice think tanker. I’d like to offer what you all often call “stylized facts,” a term I’ve always admired…and often considered using as a defense when an economist complained that a WSJ reporter had oversimplified something.

So what does make this time different for central bankers?

1. In the wake of the extraordinary period we’ve just come through, central bankers loom larger than ever in the political and public mind, and for good reasons—even though a recent Pew Research poll found that given a list of four possibilities, only one in four Americans identified Janet Yellen as the Fed chair. Seventeen percent picked Greenspan and 11 percent picked Supreme Court justices John Roberts or Sonia Sotomayor. The other half of respondents volunteered that they hadn’t a clue. Central banks have taken on more responsibility for regulation and supervision in the wake of the crisis. The paralysis of fiscal policy has added to the pressure on central banks to deal not only with the familiar task of short-term economic stabilization but also with severe downturns—and with the possibility that budget deficits will be persistently large as advanced economies cope with aging populations. And that doesn’t even begin to describe Mario Draghi’s role in holding the euro zone together.

All this attention and responsibility carry some substantial risks for central banks. Chief among them: The unrealistic expectations of policymakers, elected politicians and the public about how much monetary policy can accomplish; an issue, in various forms, in the U.S., Europe and Japan today.

2. Monetary policy is more likely than ever to involve what we still call “unconventional monetary policy,” though it’s becoming increasingly conventional: the possible persistence of low inflation rates, the possibility that the equilibrium real interest rate has fallen and the likelihood that we’ll find ourselves at the zero lower bound more often than anyone thought likely a decade ago. Central bankers are going to have some ‘splaining to do and that is going to put a premium on central bankers who communicate well.

Once upon a time, Alan Greenspan used to say with a straight face that the Fed controlled short rates and the bond market set long-term rates. No future Fed chairman will be able to get away with that argument.

All this highlights the growing importance of central bankers’ words. The spread of forward guidance as a tool of monetary policy has been evolving for some time. It’s certainly come a long way from Volcker’s mumbling and Greenspan’s quip that if I made myself clear you must have misunderstood me. Mario Draghi has demonstrated just how much weight the markets put on a central banker’s words, especially in light of the fact that has yet to spend a single euro to back up his “whatever it takes” line. This has, of course, led to inflation… inflation in the length of the FOMC statement, that is. And as the Bank of England and the Fed have demonstrated, this tool still needs some fine tuning. When Mario Draghi was at the Hutchins Center in September, he was asked why the ECB didn’t strengthen its forward guidance. He acknowledged the ECB has deliberately avoided the precise thresholds or horizons of the BoE or Fed. Why? He gave two answers: “we are aware that it’s harder to communicate at the beginning, but it’s also easier to get out at the end.” And, second, he joked that Europeans are “simpler folks” and “in our complex situation, simplicity has some benefits.” He did argue the ECB has achieved the same results on long term rates with vague guidance as the Fed and BoE did with more precise guidance. My point: The importance of the art and craft of using words to shape expectations is rising.

3. Central banking will be different in a world on the edge of deflation—or “lowflation” as the IMF has dubbed it—and persistently closer to the zero lower bound than most economists and policymakers thought likely not so long ago. Not only does this mean more attention to forward guidance, it means QE will be around for some time, certainly in Europe and Japan and as a potential weapon in the Fed’s arsenal. This raises political and economic challenges. This time IS different. Let me mention just a few of them. (I have to warn you point three has a lot of subpoints.)

3.1 How exactly does QE work? That seems like a simple question that you all ought to be able to answer. Ben Bernanke drew laughs at Brookings when he said QE works in practice but not in theory and I confess to quoting him every time National Public Radio asks me about QE. I get away with telling listeners that by buying up a lot of Treasury securities, the Fed has chased investors into other assets like stocks in the hopes that will make the economy stronger, a crude version of the portfolio balance channel. But I have a hard time convincing listeners about the signaling channel, the notion that the Fed had to shell out $3 trillion to convince the markets that it’d keep credit easy for a long time. Really? $3 trillion. Andy Lo at MIT has observed that there is no coherent narrative about what led to the crisis. I’d add that the same might be said of QE.

3.2  Does QE widen inequality? Many ordinary people—and even some current and former Fed officials, Dallas Fed President Richard Fisher and former Fed governor Kevin Warsh among them—are convinced it does. The logic is appealing: The gap between winners and losers have been widening. QE pushes up asset prices. Rich people hold more assets than poor people. So that’s why there is more inequality. I believe this accounts for some of the unpopularity of the Fed and skepticism about QE. But surely this is too simple a story, one that ignores the impact of easy money on debtors and creditors, and one that ignores the counterfactual…so what would have happened without QE?

Nevertheless, the belief that QE has widened inequality is becoming one of those popular beliefs has political consequences, especially for central bankers. This may account for what strikes me as a new challenge to central bank independence: I was taught that the rationale for an independent central bank is to prevent politicians from pursuing policies that create too much inflation; politicians can gripe that the Fed is too stingy but they don’t (usually) do anything about it. Now we have a different situation: The Fed worries that there isn’t enough inflation and is getting pressure from politicians to be tighter sooner. There may be more than one reason for this—the rise of an anti-intellectual populism, perhaps—but one explanation is the widespread sense that the rich are doing better and the Fed played a role in that.

3.3  Is QE a polite euphemism for “currency war”? Which is to say, is it a policy that helps the country that practices it at the expense of other countries? Did the U.S. do to Brazil with QE what the U.S. accuses China of doing with its currency? Conceptually, this is a very simple question to answer. Is the central bank pursuing policies that are demand-augmenting or that are demand-diverting? If it’s the first, it’s kosher. If it’s the second, it isn’t. In practice, this strikes me as a bit tougher question, and it’s not ONLY about looking at whether a government is intervening in the currency markets. When fiscal authorities are excessively tight fisted, there’s a temptation to cheer a depreciating currency and perhaps see it as a substitute for expansionary domestic policies. One might describe the recent behavior for ECB, unable to move fiscal policy and unable to move quickly on QE, as relying heavily on rhetoric to push down the euro.

A variant of this is the Raghu Rajan critique, which is central to the “spillover” theme of this conference. As he put it in April at a Hutchins Center speech: “in April at a Hutchins Center speech…“In a world where debt overhangs and the need for structural change constrain domestic demand, a sizeable portion of the effects of such policies spillover across borders, sometimes through a weaker exchange rate,” and thus the unconventional monetary policies of the Fed, ECB and BoJ were hurting India and other emerging markets , particularly by triggering massive capital flows. Notice the careful construction of the sentence in which Rajan implies that QE isn’t demand -augmenting at all, a point on which Ben Bernanke and Rajan differed. The two agreed that this is an empirical question; namely, do ALL the effects of developed country QE—both those that increase domestic demand in the country deploying it and those that influence global capital flows—produce a net benefit for emerging markets or not? Such questions were barely a footnote in serious monetary policy discussions 20 years ago. For one thing, emerging markets represented a much smaller slice of the world economy.

More broadly, in an increasingly globally integrated economy, and especially given the globalization of financial markets, spillovers are increasingly important to understanding how monetary policy works—and it may be that spillovers are different at the zero lower bound, when unconventional monetary policies are used, than they are at other times, when central banks move short-term rates. Larry Summers has suggested that if interest rates can’t be cut to the level where they bring us back to full employment, central bankers may—deliberately or not—be blowing serial bubbles. I’m not fully convinced, but this wasn’t a question that even occurred to me 10 years ago.

4. Finally, the broadened and, in some cases, explicit role of the central bank in maintaining financial stability raises a host of new issues.

The origins of central banking in Bagehot’s time and in 1913 here in the U.S. had more to do with preventing and responding to financial instability than inflation or unemployment. The pre-crisis mantra was that the central bank should adopt an inflation-targeting strategy and everything else would work itself out. The new one is that the central bank should use its interest rate tool to meet its inflation and unemployment targets and rely primarily on “macroprudential tools” to maintain financial stability. This has an appealing simplicity to it, but I think it raises a lot of questions in practice—and political challenges. Take housing. I was taught that housing was one of the primary channels by which conventional monetary policy affected the economy, and that’s certainly true of the Fed’s unconventional monetary policy, especially the MBS purchases. OK. But when the Bank of England’s Financial Policy Committee moves loan-to-income ratios to restrain borrowing for housing and, indirectly, housing prices, that’s macroprudential? But that’s only one rub. For better or worse, you have models that help the Fed gauge the likely impact of a 25 basis-point move in short-term rates and you’re developing models that gauge the effects of QE on long-term rates and, thus, on the economy. As far as I know, there’s no good way for the Fed to calibrate macroprudential tools, even if they can decide when to use them and what exactly they are. Minutes of the FOMC suggest that the staff reviews financial stability issues with policymakers at each meeting, observes that there are scattered pockets of excess but nothing big to worry about, and then the Fed turns to more familiar discussions about macroeconomic conditions. But even if the staff someday sounds the “financial instability” alarm , there’s no good way for the Fed to calibrate macroprudential tools, whatever they are….

Macroprudential tools raise all sorts of new political challenges. By their nature, targeted macroprudential tools—unlike interest rate increases—have, well, targets…and those targets aren’t likely to be quiet and compliant. Any concerted effort by the Fed and other regulators to use macroprudential tools, whatever they are, to restrain the next housing bubble is certain to trigger a huge and bipartisan political backlash, perhaps one that the regulators cannot withstand.

And even if central bankers and supervisors figure out how to use macropru domestically, we surely have a lot to learn about how to use them to limit adverse cross-border spillovers, or how macropru tools are going to work in globally integrated financial markets.

I could go on, but you get the gist: The arrival of unconventional monetary policy is accompanied by new economic puzzles and significant new political challenges for the world’s central bankers. Things HAVE changed.

Let me end with a plea to you, the thoughtful policy-minded economists. I recognize that consensus takes time to forge—how many decades did it take before there was a coherent narrative of the Great Depression? I recognize that some questions can be answered only with the passage of time. Other questions you can answer, but you’ve only done it with jargon and equations that limit your audiences to your peers. The public, the press, the politicians and even some policymakers are desperately seeking understandable explanations…and they really can’t wait for your PhD students to finish their dissertations.

So wearing my journalist hat, let me list a few:

  • How does QE work? As I said, it would be helpful if you all could come to consensus on this and then explain it.
  • We could use some help teaching the public and the politicians about the concept of notion counterfactuals. Such as why we might need less monetary stimulus if we had better fiscal policies…particularly in Europe and the U.S. Or what would have been the distributional effects if the Fed had decided to do less QE and Congress had done more fiscal?
  • How should we evaluate the complaints from the banks that there are too many new regulations and that capital and liquidity rules are reducing credit and strangling the economy, particularly in light of the notion that we had a wrenching economic crisis because there was much reckless borrowing and lending. If there’s a case for less credit, make it.
  • What exactly are macroprudential tools and how do they work in practice, and how do they work differently in different economies, a task on which the IMF has made a substantial down payment.

There is a lot of ignorance loose in the world, and there is a whole lot of ignorance about monetary policy. It’s unrealistic to think that economists, think tanks or journalists can eliminate it; some of it is based more on belief than facts or reasons. But getting the narrative right does play a very big role in political economy. And I choose to believe that there is a reverse Gresham’s law at work here…that sound thinking and clear explanations can help crowd out silliness and stupidity. And that is what makes our work—your work and mine—so important.

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