On the Illusion of the Perpetual Money Machine

I recently stumbled upon a paper by Sornette and Cauwels of the ETH Zürich strikingly named “The Illusion of the Perpetual Money Machine” (.pdf). It makes for great reading and presents a solid case for rethinking the way we do things policy wise, particularly with regards to monetary policy. I’m not going to discuss much of it, for I wouldn’t know where to start. But maybe some thoughts. To use their words

Rather than still hoping that real wealth will come out of money creation, an illusion also found in the current management of the on-going European sovereign and banking crises, we need fundamentally new ways of thinking.

At first sight this may seem as an argument that should be shelved somewhere close to the crazy gold bug crowd. But it is not, for it is carefully argued and backed up by evidence rather than just some badly articulated gut feeling. Still, I feel like that argument needs some qualification: while indeed it is impossible to create real wealth out of money creation alone, it is very much possible to destroy real wealth due to a lack of money creation – and I would argue that we have seen that happen plenty of times in the past already, and not just in the past 30 years. Another seemingly key passage:

The discrepancy between the exuberant inflation of the financial sphere and the more moderate growth of the real economy is the crux of the problem we are currently immersed in.

In a sense this seems to be all part of a much bigger debate regarding the relationship between monetary policy and financial markets. And even though I’ve done quite a bit of reading over the past couple of months and in part even years, I still feel like I’m only scratching the surface here. Scott Sumner, for instance, makes a fairly decent case for “keeping finance out of macro“. I can find myself agreeing with a lot of it, even though it might seem overly simplistic. Basically, it is a central bank’s role to stabilize NGDP growth, and it should do whatever it takes to do so. As noted also by Sornette and Cauwels, monetary policy should not respond to “the vagaries of the stock market”, yet unfortunately it has too often done so in the past. On the other hand, the recent crisis has shown us that it might be difficult if not impossible to stabilize NGDP growth over a long period of time without taking the financial sector into account – so from that reasoning alone there seems to be a strong case to be made that finance cannot remain entirely out of “macro”.

In some way there seems to be little doubt that our modern financial system, while performing absolutely invaluable functions to the economy as a whole, has been working and continues to work in a fashion that some might argue is simply unsustainable. Yet it’s an entirely different argument to make that the almost 60% youth unemployed in Spain, just to name an example, should simply sit back and hope for the best while Europe faces incredibly tight monetary policy just because governments have spectacularly failed in the past and continue to spectacularly fail to this very day to regulate a financial sector that’s often based on (and extremely successful at) an enormous amount of rent-seeking that delivers little real benefits. Central banks have a role to play here through macroprudential regulation, for instance, and they should do so. But to argue that we need to keep money tight even though the real economy is in shambles just because the financial sector that we purposefully (and wrongly) deregulated would go on squandering any stimulus away makes no sense at all. It’s basically admitting that we screwed up, but since we screwed up all we can do it to continue to screw up.