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It takes a trauma to shake up economics. After the Great Depression, and again during the stagflation of the 1970s, new orthodoxies emerged. Something similar may be under way now, a decade after the financial crisis, as economists and investors start to wonder if it’s time for a different approach.

At the Start of the Central Bank Era, Inflation Was The Enemy

For a half-century or so, there’s been broad agreement in developed countries that monetary policy is the most effective tool for managing the economy.

In the previous, Keynesian era, governments were supposed to fine-tune the engine through taxes and spending. That belief was jettisoned when inflation threatened to surge out of control in the 1970s. Central banks were put in charge of fighting it, with interest rates as their weapon. Federal Reserve Chairman Paul Volcker, who oversaw a boost in U.S. borrowing costs to 20 percent at the start of the 1980s, was the new policy’s emblematic figure.

To free their hand for this battle, the central bankers who waged it were supposed to be immune from political pressures. That would place them above the short-termism that comes with the need to get reelected. The doctrine of central bank independence emerged.

The enemy was routed. In the U.S., inflation averaged close to 5 percent through the ’60s and ’70s; it’s only rarely exceeded that level since the mid-’80s and has mostly been much lower. In other rich countries, it’s been a broadly similar story.

Central bankers and economists who supported them weren’t shy about celebrating their victory. In the mid-2000s, they would boast of having achieved a “ great moderation” that solved the problem of economic depression, perhaps forever.

In one developed nation, policymakers had already encountered a different challenge. Japan’s inflation rate slipped below zero in 1986 and was back there a decade later. But Japan was deemed a special case, with problems that didn’t apply elsewhere.

Viewpoint Ray Dalio

Founder of Bridgewater Associates, in a May note

“I don’t mean that monetary policy won’t work at all; I mean that it won’t work hardly at all in stimulating economic prosperity in the ways that we are used to having it stimulate economic activity, which are through interest-rate cuts and through quantitative easing.”

In the Crisis, the Banks Put Growth First. They Slashed Rates …

The 2008 crisis blew up any claim that central bankers had engineered lasting stability. Economic output slumped, threatening another Great Depression.

The response was the same one the Bank of Japan had tried a decade earlier: cut rates to zero. That’s what the key banks did, though the European Central Bank took longer.

About this time, the “ zero lower bound” entered the daily lexicon of economics. The problem for central bankers who wanted to inject more stimulus was that there was nowhere for rates to go. Negative rates have been tried in some countries, but the general belief was that, with cash available as an alternative, they wouldn’t work.

Central Bank’s Benchmark Rate Sources: {FDTR Index}, {EURR002W Index}, {BOJDPBAL Index}

… and Expanded Their Balance Sheets

Central bankers found another means of stimulus: quantitative easing. They bought securities to hold on their balance sheet, raising prices and lowering yields. Many of them were government bonds. The Bank of Japan now owns almost half the national debt, which is the world’s largest. The Fed and ECB increased their share, too.

Central Bank’s Balance Sheet Share of GDP at end of Q1 Sources: {BSPGCPUS Index}, {BSPGCPEU Index}, {BSPGCPJP Index}

Viewpoint Paul De Grauwe

Economist at the London School of Economics and Political Science, in a March article in Social Europe “Given the existential threat of the degradation of the environment, including climate change, the priority should be to use the ECB’s money-creation capacity towards the support of environmental projects. This can be done without creating inflation.”

Through the Recovery, Inflation Remained Low …

With governments loosening the purse strings and central banks offering cheap money, the scale of economic stimulus after 2008 was unprecedented. Plenty of voices warned that it would bring inflation back.

That hasn’t happened. Central bankers have persistently fallen short of their targets. Steady prices don’t sound like a bad problem to have, but most economists prefer a little inflation. It helps employers manage their wage bills and makes debt servicing easier. And central bankers were hoping that higher inflation would allow them to raise interest rates back toward normal levels.

Inflation Rate Year-over-year change in consumer price index Sources: {CPI YOY Index}, {ECCPEMUY Index}, {JNCPIYOY Index}

… Except in Stock, Bond, and Real Estate Markets

While real-economy prices were stagnant, asset prices took off in the years of cheap money. Stocks and bonds surged. QE works directly via asset channels, bringing a giant new buyer to the market, but it also raised what could be a political problem for central banks.

Disparities in income and wealth, already growing before the crisis in most Western countries, deepened in its aftermath. Financial assets tend to be disproportionately owned by wealthier people. A policy that sent them soaring could trigger a backlash if attempted again.

Wage Growth Lags Unemployment’s Fall

Faster wage growth, especially at the lower end of the pay scale, would balance out the gains for asset holders. That’s what economists expected to happen in response to one of the biggest successes for central banks: the steady decline in unemployment, which in the U.S. has reached the lowest level in a half-century.

Wages have been accelerating lately, but it took longer than the models predicted. That’s called into question a relationship that’s key to central bank thinking: the connection between the jobless and inflation rates. Letting unemployment drop below a certain level was supposed to trigger price rises that would let central bankers know when it was time to tighten. Without that signal, it became harder to chart a course for policy.

U.S. Labor Market Indicators Sources: {USURTOT Index}, {REALYRAW Index}

Growth Has Been Stronger in the U.S.

Although the Fed wasn’t sure what to do next, at least the U.S. was growing at a fair pace. The expansion that began in 2009 will soon be the longest on record. Growth rates have been lower than in past recoveries, but they look good when compared with many peers.

Europe has had a slower recovery. The ECB earlier this year postponed a shift toward normal monetary policy and restarted a cheap loan program for banks.

Real GDP Year-over-year change Sources: {GDP CYOY Index}, {EUGNEMUY Index}, {JGDPNSAQ Index}

Debt Has Risen Everywhere, With Governments The Main Borrowers

The commercial banks, though, were short of customers. Monetary policy is supposed to stimulate the economy by encouraging businesses and households to borrow, spend, and invest. For several decades, they did. Growth was financed by private credit, which rose to unprecedented levels—and it was a private-debt crisis that crashed financial markets and the world economy in 2008.

In the low-rates era that followed, it’s been mostly governments dipping into the red. Households and businesses have been slower to borrow. Measured as a share of the economy, public debt has grown much faster than other kinds.

That’s a problem for the dominant theory that says monetary policy offers a counterweight to deficit-spending governments. Instead, central banks have appeared to be enabling them.

Debt as a Share of GDP Change since Q4 2007 Sources: {FDTGATPD Index}, {CPNFUSNG Index}, {CPNFUSHG Index}, {IGS%EURO Index}, {CPNFXMNG Index}, {CPNFXMHG Index}, {IGS%JPN Index}, {CPNFJPNG Index}, {CPNFJPHG Index}

Viewpoint Kikuo Iwata

Former Bank of Japan Deputy Governor, in a February interview with Reuters “Fiscal and monetary policies need to work as one. … The BOJ’s current policy does not have a mechanism to heighten inflation expectations. We need a mechanism where money flows out to the economy directly and permanently.”

In Another Downturn, Limited Firepower

Even if there were more private-sector borrowers out there, the central banks aren’t in a position to deploy their usual tool of interest-rate cuts to make credit more attractive to them.

Former Fed Chair Janet Yellen estimates that the bank’s typical response to a recession, historically, was to lower borrowing costs by some 500 basis points. But the Fed will probably be able to cut by only about half that amount if a downturn arrives in the coming year or so.

Central banks in Europe and Japan, still stuck at the zero lower bound, could be in even worse shape—unable to cut rates at all.

All Signs Point to Fiscal Policy as the Way Out

For all these reasons, many economists think governments will have to play a bigger role if another recession arrives—or even beforehand.

The loudest case has been made by the proponents of Modern Monetary Theory, which says countries borrowing in their own currencies can’t go broke and can spend so long as inflation is subdued.

Even establishment figures such as Olivier Blanchard, former International Monetary Fund chief economist, and ex-Treasury Secretary Larry Summers say it’s a good time to set aside fears about deficits and debt. The politicians in charge of budgets in the U.S. and Japan have, in effect, already done so. Central bankers could end up as their junior partners.