Taking Down a Take-Down: the James Montier edition

After eight drafts of your book, an unsettling dread creeps up on you. Certain parts that once seemed genius now strike you as half-baked. Your writing is meandering and unstructured. You can spot the places where you resisted the urge to think deeply. You shove in quotes and calls to authority more than you should, all the while laughing obnoxiously at seasoned “experts”— never, ever forget the ironic quotation marks.

Why? Because, well, it feels pretty good to be a gangster.

James Montier, in his latest white paper, tries very hard to be a gangster. But he fails – miserably. I know because I’ve been there. In fact, I often go there. Even so, I know a huckster when I see one. And in his “exposé” on the “myth” of the natural rate, James Montier is nothing more than a charlatan.

Despite Montier’s claims, the natural rate framework is a very useful concept. It reveals why a monetary economy such as ours is prone to frequent calamities, and why the central bank will never consistently achieve its full employment goal.

The natural rate framework starts in the highly unrealistic world where goods and services are traded under barter. In this world, for reasons I explore in my book, the economy has a tendency towards full employment. Simply put, saving and borrowing always match at full employment in a barter economy, and interest rates always adjust to where they need to be.

But – as James helpfully points out – we don’t live in a barter economy. In fact, we may never have. So the model, as per Montier’s advice, goes a step further: it says a monetary economy works entirely differently from a barter economy. More precisely, when money is introduced, interest rates have no automatic tendency to converge to the natural rate – which is the mechanism required for full employment.

Who cemented this line of thinking in economic thought? It was John Maynard Keynes, someone Montier bizarrely channels in support of his argument. Keynes was a real gangster. He lived in a world dominated by economists who believed money didn’t change the underlying workings of the real economy. Keynes argued otherwise. And he was right. Money changes everything. That’s why we need a central bank to smooth our business cycles. The job of central banks is to ensure that interest rates converge to the natural rate, when in fact they have little reason to do so.

So when Montier chortles at the silliness of the barter model, and then asserts it is in fact the central bank that controls rates, he is arguing in favour of the very concept he tries so sarcastically to dismiss. The central bank is supposed to manipulate rates. That’s its mandate. The natural rate is only an ideal. It’s what the money rate should be. Even so, it is useful. The natural rate framework helps central bankers understand in what scenario they need to cut rates, and in what scenario they need to hike them.

Oddly enough, the framework also reveals why the central bank’s job is so hopeless. There are countless factors affecting the natural rate, which make it impossible to know. What’s more, the natural rate is always shifting – borrowing and saving preferences change all the time. Then there’s the possibility that interest rates don’t affect spending as we believe. Montier himself makes this point in the much better second half of his paper. What if a rate cut from 7% to 5% doesn’t boost spending, but actually diminishes it? How can we be certain of the link between spending and interest rates in every corner of the economy?

The problems, alas, don’t stop here. Even if the central bank did know the natural rate, its very actions may cause it to shift again. If a prospective home buyer sees a rate cut, she may delay a purchase in the anticipation of further loosening. This is what’s known as expectations – a nebulous area of economics. Another possibility is that there’s more than one natural rate. Perhaps both 7% and 0% may lead to full employment. The most brutal truth of all is that the everyday work of the central bank is harder than we generally believe. Their job is to manipulate an entire set of money rates, not just one. It’s unlikely even a robot, let alone a human, will reliably achieve this goal.

For all these reasons, our central banks fight an unwinnable war in our current monetary system. They achieve their dual mandate of price stability and full employment more by accident than by choice, and then only fleetingly. This is why it’s vital to pair monetary policy with fiscal policy.

So please, please, please don’t believe that James Montier’s “take down” of the natural rate is the inviolable truth. Sometimes the establishment is right. This is one of those times.

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