Monetary Policy in an Age of Radical Uncertainty (reposting)

This commentary was originally posted on July 25th, 2016.

Central bankers in all major developed economies have adopted NIRP, ZIRP, or near ZIRP policies.  The Bank of Japan and the European Central Bank now “offer” negative interest rates (NIRP) on deposits and project to do so for the foreseeable future.  The Bank of England and the Federal Reserve Bank of the United States remain committed to targeting interest rates slighted above zero (near ZIRP).  10 year government bonds offered by these countries range from -0.225% in Japan to -0.027% in Germany to 1.57% in the U.S. Such policies are not consistent with sustainable economic growth.

In a recent book entitled The End of Alchemy, former Bank of England Governor Lord Mervyn King argues that the policies we have employed in the past (and present) to stabilize our economies – such as keeping interest rates low until economic growth returns to its long term rate or unemployment falls below some designated benchmark (full employment? natural rate of unemployment?) – are inconsistent with sustainable economic growth.  Furthermore, he suggests that central bank and regulatory policies adopted post Great Recession (December 2007 – June 2009 in the U.S.) fail to address the potential for a repeat of the financial failures witnessed during that period. King provides many insights including the following:

  1. In the contemporary world economy, many shocks to the economy are unpredictable; thus, one cannot use probability-based forecasting models to design policy to stabilize economies. As he puts it, “stuff happens;” we can’t plan in advance for failures in large, highly leveraged investment banks, country defaults, common market dissolution, or other disruptive political forces.  He labels these forces as “radical uncertainty”, and, as characterized by Frank Knight almost a century ago, such circumstances cannot be addressed as one would risk, for which reasonably employable probabilities might be posited.
  2. Policies designed to stabilize economies in the short run, such as aggressive monetary and fiscal policies, leave a residue inconsistent with long run economic growth unless stagnation is viewed as the desired norm. In the contemporary developed world, this traditional Keynesian prescription yields low interest rates that discourage savings and encourage debt build-up but not necessarily with productivity inducing investment that can generate sustainable economic growth consistent with that featured in the 20th century.  Some economists (such as Robert Gordon and Larry Summers) argue that we need to learn to adapt to such secular stagnation in our economies.  Other economists (including Eric Brynjolfsson and Andrew McAfee) are much less pessimistic.  For King, policymakers face the stark trade-off of short term stability for long term sustainable economic growth.  This parallels the Triffin dilemma the U.S. faced in the 1960s when inflation dictated more restrictive monetary policy but expanding world trade, predominantly in dollars, argued for more accommodating monetary policy.
  3. Central banks that serve as “lenders of last resort” may evolve into “lenders of continuous resort,” as seem to be the case for the Bank of Japan and the European Central Bank. King offers the innovative idea of “pawnbroker for all seasons” as a constructive substitute.  In short, central banks would evaluate the assets of banks on a regular basis and indicate what would be acceptable as “good collateral” – consistent with what is required by the Federal Reserve Act (1913) and Walter Bagehot’s prescription in Lombard Street (1873.)  Such an approach reminds me of how cash strapped Monopoly players must mortgage their properties at 50% of list price and forego rent collection to obtain immediate cash.

Each of the above points demonstrates how King views central banking and bank regulation in a world characterized by radical uncertainty.  In short, policy makers need to find viable coping strategies to reduce the downside cost of economic recessions in general and financial meltdowns in particular. With radical uncertainty, the “forward guidance” offered by central banks lacks credibility and fails to address such uncertainty.  Charles Plosser, recently retired President of the Federal Reserve Bank of Philadelphia, argues that the Fed should replace its discretionary implementation of policy and the confusing “guidance” about the future with a clear set of robust rules that would be operative unless the Fed publicly made the case that such rules should be overridden (  Robust rules are one example of King’s desire for “coping” strategies that reduce at least one dimension of radical uncertainty. In the words of Michael Lewis ( of Liar’s Poker, Moneyball and the Blind Side fame), “if his book gets the attention it deserves, it might just save the world.” (

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