David Dodge's growth plan

Something that's been evident since the great global experiment with ultra-loose monetary policy began almost a decade ago is that no-one at the major central banks has any clear plan for getting policy back to "normal".  It might have been easy to do so if low rates and QE had quickly restored growth to pre-crisis levels, but of course that didn't happen.  We now have a world of low interest rates, low inflation (apart from asset prices) and stagnant growth, and central banks have little or no ammunition available in the event of another crisis.

Enter, with an important speech last week to the CD Howe Institute in Canada, former Bank of Canada Governor David Dodge.  The media have focused mainly on his call for the Fed, and if possible other central banks, to abandon their current data-driven policy approach, in favour of a pre-announced schedule of rate hikes, designed to bring rates back to a more normal level.  This would certainly create room for easing the next time things head south, but Dodge's rationale is a lot more subtle and complex than that.

Dodge characterizes the macro policy paradigm that served the global economy well from the early 1980s until the onset of the financial crisis as "leaning against the wind".  Monetary policy, and to a lesser extent fiscal policy, were aimed at keeping economies on a path of steady growth and stable inflation.  However, in the past few years, that paradigm has proved ineffective:

"In large part, changing demographics, slower technological progress, and inadequate structural policies have contributed to lower potential growth. In addition, deleveraging by households and banks in the wake of the financial crisis, the structural debt crisis in the eurozone, and the slowdown of trend growth in China are factors that hampered global growth. In addition to lower potential growth, the “natural rate” of interest is lower today than it was in the decade that ended in 2007."

Dodge's explanation for the lower "natural rate" of interest is heavily driven by demographics. An aging population naturally starts to save more, thereby increasing the supply of investible funds. At the same time, that shift from consumption to saving serves to reduce profitable investment opportunities within the economy, driving down the demand for funds. The real "natural rate" of interest may now be 1 percent or even lower, as against 3 percent two decades ago.

One of Dodge's key arguments is that low interest rates, and especially the expectation that they will stay "lower for longer", are now in and of themselves holding back growth, in  a variety of ways.  Low rates work in part by "pulling forward" investment and consumption plans -- borrow while you can afford it -- but if, as is now the case, those low rates are expected to persist indefinitely, that incentive is reduced. Moreover, an aging population sees low rates as a clear signal to save more for retirement.  A low rate, flat yield curve environment makes it difficult for banks to make profitable long-term loans, because mismatching (using short-term deposits to fund longer-term assets) is no longer effective.

To this one could add (though Dodge does not) the demonstration effect of central bank policies themselves. If central banks are constantly signalling their lack of confidence by extending their ultra-loose policy settings, why should consumers or businesses feel confident enough to spend and invest?

Dodge's solution to this dilemma is to throw out the paradigm.  On the monetary policy side, get away from the current data-driven approach and announce a schedule for future rate hikes to get the Fed funds rate up to 1.5-2.0 percent.  To offset the negative impact of such a strategy on economic growth, fiscal policy should be loosened, with a focus on public sector investments designed to boost the longer-term growth potential of the economy.  (Dodge duly notes that this is the approach that the Canadian Federal Government seems to be taking).

It would, of course, be foolhardy for the US to undertake such a course, particularly on the monetary policy side, on its own.  Higher US interest rates, without corresponding moves elsewhere, would inevitably serve to strengthen the US dollar, which would crimp US exports and also pose potentially severe problems for emerging economies.  This is probably the major flaw in Dodge's plan: it all makes good sense, but in a world where governments don't trust one another and central banks prize their independence above all else, how can you ever expect to make it happen?  

In point of fact, something along the lines that Dodge is bravely advocating here may be about to unfold in the US anyway.  Nobody seems to doubt that the Fed will raise rates this month and will continue to tighten through 2017.  On the fiscal side, Republicans always run bigger deficits than Democrats, whatever their campaign rhetoric may have been, and Donald Trump's infrastructure renewal plan seems to be one of the few things that all sides are willing to support.  What's lacking here is any kind of international co-operation, which is something that Trump seems to go out of his way to alienate.  How will a rebalancing of US policies work when most of the rest of the world is sticking to the old paradigm?  We may be going to find out.