Four reasons why central bankers ignore Scott Sumner’s good advice
Scott Sumner and other Market Monetarists forcefully argue that monetary policy can and should be used to return nominal GDP (NGDP) to it's pre-crisis growth path. In the US that is around 5% yearly NGDP growth from a level 12-14% above the present level. However, so far the Market Monetarist arguments have failed to convince central bankers to use monetary policy to close the NGDP gap (that is to return NGDP to its pre-crisis growth path). In my view there are four overall reasons for that (To Scott: none of them are stupidity). These four reasons are all variations of what Milton Friedman termed the Tyranny of the Status Quo – policy makers tend to prefer what they know contrary to the unknown even though the unknown might actually work better. Market Monetarists argue that there is no liquidity trap in the Keynes-Krugman sense, but I would argue that there is what we could call an institutional liquidity trap which is to blame for the continued status quo in monetary policy. The institutional liquidity trap can be found in four versions: 1) Currency union 2) Fixed exchange rate policies 3) Foreign currency lending 4) “Bubble paranoia” Obviously, if a country is in a currency union it can naturally not pursue an independent monetary policy without leaving the currency union. So even if the solution (if such a thing exists…) for Greece is a massive loosening of monetary policy to lift NGDP back to the pre-crisis growth path then that is not possible given Greece’s euro membership. Similar institutional restrictions on monetary policies exist in countries with fixed exchange rate policies in place - countries like Lithuania or Latvia. A fixed exchange rate policy is easier to give up than membership of a currency union, but for countries like Lithuania and Latvia the fixed exchange rate policies have a quasi-constitutional status, which is after all why these policies have successfully remained in place for now nearly two decades in the Baltic countries (Estonia has joined the euro). A third and also challenging restriction on monetary policy is the widespread existence of foreign currency lending in certain countries in especially Central and Eastern Europe. Central bankers in countries like Hungary and Romania where foreign currency lending (in especially Swiss franc) is widespread rightly or wrongly feel that they cannot loosen monetary policy and weaken the currency without endangering financial sector stability as a weaker currency would sharply increase household and corporate debt levels. Finally, from a Market Monetarist perspective the most frustrating institutional liquidity trap is what we could term Bubble paranoia. Even the most diehard Market Monetarist will acknowledge that the three institutional limits described above can be hard to get around, but in many countries such restrictions on monetary policy do not exist. Rather the restrictions primarily exist in the heads of policy makers. It is very common these days that central bankers around the world will warn against low interest rates on the grounds that there is a risk of new bubbles emerging. In fact no fear seems to bigger among central bankers these days than the fear of bubbles. Paradoxically enough back in 2005-7 very few central bankers seemed to think monetary policies had become overly loose. Now it is all many central bankers can talk about. So even if Scott Sumner is right on the medicine (NGDP path level targeting etc.) then there are four institutional liquidity traps, which limits central bankers to follow Scott’s advice. Therefore, it might be time for Market Monetarist to consult public choice theorists (and maybe even psychologists!) on how to convince central bankers to do the right thing.