Hanging Out at the Lower Bound- Otmar Issing Welcomes The BGSE

(Originally posted at Econ Point of View)

After three weeks of math brush-up courses and a week of fall term, it is nice to know we can “start” the year here at BGSE. While cava and food were incentives to attend, there was another reason. Professor Otmar Issing, President of the Center for Financial Studies and former member of the Executive Board of the European Central Bank, was giving the opening lecture on monetary policy. While there are about as many opinions about monetary policy as people, Otmar Issing has the academic and policy credentials to deserve a serious listen. He isn´t some no name student on a blog.

Life at the Lower Bound

It is not easy being a central banker, especially at the zero lower bound (ZLB). The models used for the last 80 years (arguably) lose their relevance once the rates central banks directly control drop any more. Instead, central banks (specifically the Federal Reserve System of the United States) choose unorthodox policies, such as quantitative easing and forward guidance.

Professor Issing correctly warns of the inherent problems of unorthodox policies. Central banks are breaking new ground and, as with anything new and exciting, it is impossible to know the full risks. The known risks are scary enough.

Quantitative easing, through direct purchases of assets, is bound to have a distributive affect as Professor Issing notes. If the Federal Reserve is purchasing mortgage-backed securities, this will inevitably direct real assets and liquidity into this market. This could be good or bad, but clearly central banks directly impact specific markets and firms more than traditional interest rate manipulation.

Another unorthodox policy that Professor Issing addresses is so-called “forward guidance.” The Federal Reserve attempts to lower long-term interest rates by assuring the public it will continue to force rates down in the future. Since short-term rates cannot fall any more at the ZLB, forward guidance intends to encourage more investment and close the “output gap.” It hopes to make longer term investment “cheaper.” Therefore, investments, specifically long-term investments, will be undertaken which would not be profitable without this intervention by the Federal Reserve. This is a concern with artificially low rates in general and especially for artificially low long-term rates.

Improved Models in this Difficult Time

Central banks find themselves in a very difficult spot. They are at the ZLB, but think that the economy still needs “stimulus.” How does it know how much to simulate and when to stop, or at least slow down? It is the question that keeps central bankers up at night. Issing does not believe that GDP or inflation targeting is possible or will give correct guidance to central bankers. Central banks cannot target real variables, only nominal. Professor Issing suggests something easy to say, but hard to do.

By incorporating money and credit into economic models, Professor Issing argues that banks can have a better understanding of the nature of the data.

Monetary developments are a kind of summary indicator of asset price development. A thorough analysis of monetary aggregates considering also e.g. the old concept of inside versus outside money can deliver valuable information on risks emerging in the banking sector. Money and credit – more than real variables – contain information for signaling asset price booms which later might turn out to become very costly. Hence, a central bank which integrates the analysis of monetary developments into its strategy will have a compass for how to deliver its best contribution to preserving financial stability, too.1

Professor Issing seems hopeful that concern for money and credit in models can help central bankers respond to the problems addressed earlier. He makes one.

1. For more on Professor Otmar Issing´s speech, check out his paper on the same subject.

3 thoughts on “Hanging Out at the Lower Bound- Otmar Issing Welcomes The BGSE”

  1. Hey Brian, welcome to Voice! Thanks for the post, I missed the speech so it’s very nice to read about it!

    I just had wanted to hear your thoughts on a couple things.

    Issing’s beef with these unconventional tools the Fed and other CBs are using seems to be possible asset bubbles or high inflation. We all agree on the possible destructive effects of bubble bursts on the economy, but isn’t 12% EU unemployment, +25% in Spain and Greece, still high unemployment in the US more of a pressing issue? Every month these people go without work diminishes their chances of getting another job and having a better life. People are getting less healthy, their children have a worse education, etc: high long-term unemployment has long-lasting effects on economies.

    So why worry about a low-probability bubble when we have a high probability disaster on our hands? Especially given that CBs are always wary of asset bubbles and could possibly ‘prick’ them.

    Economists and politicians in the US have been predicting runaway inflation ever since QE started and the Fed started aggressively expanding its balance sheet but this has not happened (as our good old ISLM models with liquidity traps have told us for decades).

    The downsides of these unconventional measures seem to me so low and improbable that the advantages outweigh them. Although QE wasn’t super helpful, it did have some effects on credit, and forward guidance is a great way of creating inflation expectations which is what you need when you are in a liquidity trap (interest rate doesnt go below ZLB, so we need higher inflation to reach the real interest rate that gets us closer to full employment). Although it is still early to tell, it might already be working in Japan,

    Hope to hear other people’s opinions!

    1. Anonymous,

      Thanks for the comments.

      Issing does not appear worried about inflation. He does mention that banks have no incentive to hold back inflation, because the costs are in the future and the benefits might appear now. He does say that low inflation expectations “might be rather fragile and exposed to abrupt upward shifts once doubts about the orientation of central banks arise”. Yet, I do not think he bases his argument on a fear of inflation.

      Issing is concerned because central banks too focused on the short-term, which necessarily is based on questionable data and models. Issing worries that because of this short term focus “the whole process of allocation of capital is heavily distorted. These undesirable medium-term effects are the unintended consequences of ultra-easy monetary policies.” This effects are redistributive and real.

      You have more faith than Issing or me that asset bubbles can be “pricked.” One can argue that a bubble is worth the costs, such as Krugman has, but the last 15 years in the US has shown the Fed cannot identify all bubbles and stop them.

      Central banks are unable to know when to raise interest rates and have no incentive to know, especially with the models they use. It is really a knowledge problem.

      As far as the inflation/unemployment trade-off, Issing says central banks cannot control real variables such as output or employment. Therefore, it does not make sense to target them. The central bank cannot affect employment, but loosely determines inflation. Issing does avoid any controversy by adding “in the long run.” Therefore, central banks are controlling what they can by keeping inflation low.

      What does everyone else think?

  2. First off, I congratulate you on an excellent article and I thank you for keeping us, your fellow GSE colleagues, informed on this important and relevant theme.

    The CBs are indeed in a tough position as of late. Especially when their intervention in economies, have begun to become not only essential to the very survival of healthy economies, but as Mr. Issing notes, have experienced a radicalization of their tools to where the CBs are no longer a mere framework of implementation with monetary powers but have indeed become a crutch-like apparatus sustaining economic sectors and entire nations from the brink of chaos and collapse The pressure is mounting and central bankers are indeed losing sleep. Perhaps, radical times calls for radical measures, but more often than not, desperation and radicalization are of the same breed and the short-term expands the horizon.

    We all stand on the shoulders of giants, so the famous refrain goes. But what if time proves those giants to have porcelain feet? Afterall, stimulus’ cannot last forever.

    The ancient philosopher Seneca, famously quipped that “luck is when preparation meets opportunity”. CB’s should work closely with governments to strengthening social safety nets which may prove to be a wise move as well.

    Looking forward to reading your next post and update. Thanks!

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