New prescriptions needed

Economic commentators have been talking about the “Yellen put” after the U.S. Federal Reserve decided to stay steady on interest rates in September citing jitters on overseas market. A put option is a contract that gives an owner the right, but not the obligation, to sell an asset at preset price within a certain time period. It is a kind of insurance for investors against stock price declines. Federal Reserve Chairman Janet Yellen previously sounded resolute about lifting interest rates from near zero percent, where they’ve been for nearly a decade, as early as September to normalize monetary policy.

But upon signs of persistent market instability, the Fed turned cautious and delayed the tightening as a way of sustaining equity markets. Yellen denied outside pressure had any influence, but admitted that the “situation abroad bears close watching,” specifically citing heightening concerns about China and other emerging market economies that have increased financial market volatility. But analysts believe there was a bigger reason behind the Fed’s chickening out, which is that inflation has stubbornly remained low for the last seven years despite unprecedented stimuli action. The discrepancy in monetary action and its effect on the real economy has long posed a conundrum for mainstream economists.

According to the quantity theory of money, money supply in theory should have a direct proportional relationship with price levels. Mainstream economists work with the formula M (money supply) x V (velocity of money) = P (corresponding price value) x Q (nominal money value of output). This is the Fisher equation developed by Irving Fischer, author of “The Money Illusion,” which discussed the fallacy of thinking of currency in nominal values rather than its real value to be exchanged for payments.

The velocity, or the frequency of money being spent, does not change dramatically. The real value of final expenditures reflecting the macroeconomic fundamentals also cannot be moderated in the short run. What is left, therefore, is monetary supply and price value, supporting the theory that if the currency in circulation is increased, price of goods should rise and vice versa. The Fed has been printing money every time the economy sank with a firm belief in the quantity theory.

But that longstanding belief was seriously challenged since the global financial meltdown broke out in 2008. When lowering the benchmark interest rate to near zero percent did not work, the Fed pumped in $4 trillion to artificially boost liquidity and inflate assets. Japan and European Union mimicked the so-called quantitative easing to revive their own economies. The Bank of Korea joined along by cutting the key rate four times since last year. Yet consumer prices have failed to go up. The Fed lowered this year’s inflation target to 0.3 percent to 0.5 percent from last year’s estimate of 0.6 percent to 0.8 percent. Inflation is still far from the desired 2 percent target. Inflation has dipped below zero percent in some economies in the euro zone.

The quantity theory also was questioned in 1930 during the Great Depression. British economist John Maynard Keynes coined the notion of a liquidity trap, in which injections of money by the central money fails to have any effect on interest rates. The monetarist school of economics, which emphasizes the role of money supply on output and price levels, basically perceives companies and individuals as reasonable spenders. Its argument is that it made sense to invest in homes or stocks if bank savings do not yield low returns. The equation does not work in a protracted slowdown. People want to hold onto cash thinking home and stock prices will depreciate further. Since everyone keeps cash stashed away instead of spending, money circulation is slow. No matter how much money supply is increased, it doesn’t help the economy if the circulation velocity is in slow motion under the Fischer equation.

Keynes, who questioned the quantity theory, advised the government to expand fiscal spending to boost infrastructure supply and revive demand in the economy rather than resorting to monetary policy. His prescription led governments around the world to spend on pork-barrel projects starting with the New Deal in the U.S. But the Keynesian prescription has long lost its effect. Japan now sits on a mountain of debt, having spent in vain to stimulate the economy over the last two decades. It sank into a deflationary cycle. The U.S. and European governments are also straining under colossal debt and deficits. Fiscal policy no longer has any ammunition left. Monetary policy helps little. Economists are at a loss.

The assumption that companies and consumers move in reasonable ways may be wrong. We are living in highly insecure times amid an aging population with a low birth rate. Young people cannot find jobs. Because of uncertainty about the future, both companies and consumers are unwilling to spend. No matter how much the central bank unleashes money, it only flows into certain areas, forming bubbles in real estate and stocks.

Different times require different prescriptions. Fiscal or monetary policies cannot be relied up. The government must create new channels for growth and opportunities for investment and spending through structural reforms.

JoongAng Ilbo, Sept. 21, Page 34

*The author is the business news editor of the JoongAng Ilbo.

by Jung Kyung-min