Unedited from the WSJ.
The three major democratic advanced economies—the eurozone, Japan and the U.S.—continue to experience significant economic challenges. The eurozone is weak and vulnerable; Japan has been in recession again; and while recent data have been better, the American recovery is still slow by historical standards, with stagnant median real wages and a labor market that is weaker than the official unemployment rate indicates.
The particulars of these economic challenges differ, but in each region one thing is constant: endless focus by the media, analysts and investors on the yellow-brick road that leads to central banks. Will the European Central Bank’s quantitative-easing program have major impact? How will the Bank of Japa n proceed? When will the Federal Reserve raise interest rates?
Monetary policy is important, but it is not omnipotent. The relentless focus on monetary policy creates serious moral hazard by taking attention away from elected officials’ failure to act on the fiscal, public-investment and structural issues that are the key to short- and long-term economic success. Commensurately, focusing on central banks reduces public pressure on elected officials to act. And monetary-policy decisions themselves require a rigorous balancing of benefits and risks.
ECB President Mario Draghi ’s famous promise to do “whatever it takes” to preserve the eurozone was a masterly move to buy time. But monetary policy cannot solve the currency union’s problems. In the eurozone, as in Japan, sovereign-bond yields have been very low for an extended time, especially when eurozone yields are viewed on a risk-adjusted basis. Even lower interest rates would probably have little impact on investment and consumer decision-making. ECB policy has generated a decline in the value of the euro that could go further, but the impact on the economy is likely to be limited and certainly not sufficient to revive the eurozone.
Given the limited transmission mechanism, QE in the eurozone is unlikely to raise inflation expectations significantly—though inaction could have reinforced deflation concerns and disrupted markets that already had reflected the prospect of policy action.
In the U.S., the risks from QE3—the most recent phase of quantitative easing—persist even though that round of bond buying is over. QE3 created comfort that the Fed could and would keep bond yields low. That, in turn, may have led political leaders to feel less pressure to act—political moral hazard—and exacerbated investors’ reaching for yield through riskier assets, contributing to excesses in the U.S. and globally.
The U.S. stock market has been roughly at an all-time high. Leveraged buyouts are being done with minimal or no covenants. Italian, Spanish and French yields on sovereign 10-year debt are lower than U.S. Treasurys. If these are excesses, the markets are at some point likely to destabilize, perhaps severely. Market fluctuations associated with theSwiss National Bank ’s ending of its cap on the franc against the euro could provide a glimpse of the destabilizing effects that central-bank currency actions can have, though in the Swiss case it was an appreciating currency after a long effort to maintain a capped exchange rate.
Moreover, the vast and unprecedented increase in the Federal Reserve’s balance sheet heightens the risk of a policy error—either too little or too much restraint—as the Fed manages the process of tightening. Some argue that risk can be minimized if the Fed tightens not through selling assets but by increasing interest rates on excess reserves or using instruments like reverse repos. But there is no magic solution here. The response of markets, banks and businesses to the use of such alternative tools is untested and unknowable. And the risk of economic slowdown or inflation may be about the same, though with different dynamics.
The greater these risks are, the more imperative it is that elected officials do what is needed for a successful economy. In the U.S., that agenda should include a sound and well-constructed fiscal regime, robust public investment, and structural change in areas like immigration, education, trade liberalization and much else. The fiscal regime should consist of upfront job-creating infrastructure spending, enacted simultaneously with somewhat deferred structural fiscal-discipline measures on the spending and revenue sides. And sequestration should be canceled.
In the eurozone, leaders of key troubled countries—including Italy, Spain, France and, most immediately, Greece—need to undertake structural reforms, further strengthen banking systems, and strike a fiscal balance between sufficient discipline to win market and business confidence and adequate fiscal room for growth. As to Japan, the fundamental requisite is structural reform.
In all three major advanced economies there should be a clear-eyed view of the moral hazard created by disproportionate focus on central banks. Monetary policy should be treated with a pragmatic analysis of all its attendant risks and rewards. Instead of looking for a wizard at the end of a yellow-brick road, we should demand that elected officials take the difficult fiscal, public-investment and structural actions that could do so much good now and that are imperative for the longer term.
Mr. Rubin, a former U.S. Treasury secretary, is co-chairman of the Council on Foreign Relations.
The three major democratic advanced economies—the eurozone, Japan and the U.S.—continue to experience significant economic challenges. The eurozone is weak and vulnerable; Japan has been in recession again; and while recent data have been better, the American recovery is still slow by historical standards, with stagnant median real wages and a labor market that is weaker than the official unemployment rate indicates.
The particulars of these economic challenges differ, but in each region one thing is constant: endless focus by the media, analysts and investors on the yellow-brick road that leads to central banks. Will the European Central Bank’s quantitative-easing program have major impact? How will the Bank of Japa n proceed? When will the Federal Reserve raise interest rates?
Monetary policy is important, but it is not omnipotent. The relentless focus on monetary policy creates serious moral hazard by taking attention away from elected officials’ failure to act on the fiscal, public-investment and structural issues that are the key to short- and long-term economic success. Commensurately, focusing on central banks reduces public pressure on elected officials to act. And monetary-policy decisions themselves require a rigorous balancing of benefits and risks.
ECB President Mario Draghi ’s famous promise to do “whatever it takes” to preserve the eurozone was a masterly move to buy time. But monetary policy cannot solve the currency union’s problems. In the eurozone, as in Japan, sovereign-bond yields have been very low for an extended time, especially when eurozone yields are viewed on a risk-adjusted basis. Even lower interest rates would probably have little impact on investment and consumer decision-making. ECB policy has generated a decline in the value of the euro that could go further, but the impact on the economy is likely to be limited and certainly not sufficient to revive the eurozone.
Given the limited transmission mechanism, QE in the eurozone is unlikely to raise inflation expectations significantly—though inaction could have reinforced deflation concerns and disrupted markets that already had reflected the prospect of policy action.
In the U.S., the risks from QE3—the most recent phase of quantitative easing—persist even though that round of bond buying is over. QE3 created comfort that the Fed could and would keep bond yields low. That, in turn, may have led political leaders to feel less pressure to act—political moral hazard—and exacerbated investors’ reaching for yield through riskier assets, contributing to excesses in the U.S. and globally.
The U.S. stock market has been roughly at an all-time high. Leveraged buyouts are being done with minimal or no covenants. Italian, Spanish and French yields on sovereign 10-year debt are lower than U.S. Treasurys. If these are excesses, the markets are at some point likely to destabilize, perhaps severely. Market fluctuations associated with theSwiss National Bank ’s ending of its cap on the franc against the euro could provide a glimpse of the destabilizing effects that central-bank currency actions can have, though in the Swiss case it was an appreciating currency after a long effort to maintain a capped exchange rate.
Moreover, the vast and unprecedented increase in the Federal Reserve’s balance sheet heightens the risk of a policy error—either too little or too much restraint—as the Fed manages the process of tightening. Some argue that risk can be minimized if the Fed tightens not through selling assets but by increasing interest rates on excess reserves or using instruments like reverse repos. But there is no magic solution here. The response of markets, banks and businesses to the use of such alternative tools is untested and unknowable. And the risk of economic slowdown or inflation may be about the same, though with different dynamics.
The greater these risks are, the more imperative it is that elected officials do what is needed for a successful economy. In the U.S., that agenda should include a sound and well-constructed fiscal regime, robust public investment, and structural change in areas like immigration, education, trade liberalization and much else. The fiscal regime should consist of upfront job-creating infrastructure spending, enacted simultaneously with somewhat deferred structural fiscal-discipline measures on the spending and revenue sides. And sequestration should be canceled.
In the eurozone, leaders of key troubled countries—including Italy, Spain, France and, most immediately, Greece—need to undertake structural reforms, further strengthen banking systems, and strike a fiscal balance between sufficient discipline to win market and business confidence and adequate fiscal room for growth. As to Japan, the fundamental requisite is structural reform.
In all three major advanced economies there should be a clear-eyed view of the moral hazard created by disproportionate focus on central banks. Monetary policy should be treated with a pragmatic analysis of all its attendant risks and rewards. Instead of looking for a wizard at the end of a yellow-brick road, we should demand that elected officials take the difficult fiscal, public-investment and structural actions that could do so much good now and that are imperative for the longer term.
Mr. Rubin, a former U.S. Treasury secretary, is co-chairman of the Council on Foreign Relations.
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