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IMF confirms that monetary policy is an incentive for speculation

Hector McNeill1

One of the positions of the Real Incomes Approach is that Bank of England interest rate policies provide an incentive for a growth in the grey financial markets and asset speculation as opposed to productive investment. This has not been fully taken up by policy-makers as a serious issue.

The IMF confirmed this fact in its October 2014 "Global Financial Stability Report".

However the IMF now needs to do a little more homework to extend its analysis of the impact of monetary policy on real incomes so as to complete the story.

The recent IMF Global Financial Stability Report (October 2014) 2points out that low interest rate policies are exacerbating instability by creating a global imbalance with too much risk taking in asset positions as opposed to investment for growth according to José Viñals a financial counselor of the IMF in Washington. Risks to global stability are stated to no longer come from conventional but from the so-called shadow banking or grey financial market in which hedge funds, financial market funds and investment banks participate and who are not dependent upon savings deposited from the public.

The IMF had analyzed 300 large banks that hold something like 40% of total bank assets in developed economy all of which lacked adequate critical mass to provide credit for investment for recovery. In the Euro Zone this precariousness affects 70% of the banking system. There has been a massive rise in financial transactions within the grey financial markets where low interest rates are providing a direct incentive for investors taking higher risks in asset investments leading to significant liquidity risks on par with 2007 compromising the current state of global financial stability.

The IMF Report considers the prolonged period of very low interest rates to be building up a high risk status for the economy and the likelihood of a new financial crisis by encouraging excessive risk taking on global markets. The IMF Report goes further in classifying the character of the growth in financial positions to be speculation.

The IMF recognizes the trade-off between economic benefits of low interest rates and quantitative easing and the associated financial stability risks. In the UK and the USA, some economic benefits have become apparent but at the same time market and liquidity risks have increased to levels that could compromise financial stability if left unaddressed. High yielding corporate bonds, high share prices and over-valuation of real estate are symptoms of the issues. However, the IMF does not come up with specific propositions but simple repeats the mantras of the need for policies to enhance monetary policy to transmit benefits to the real economy and address financial risk through macroprudential measures including stricter supervision of banks, increased capital holding requirements and reductions in lending to specific activities such as real estate purchase.

According to Viñals it is time for a bank business model overhaul including changing lending targets, consolidation through reduction in size to an operational and efficient core.

And price stability?

The IMF conveniently overlooks the combined effect of monetary policy's toleration of a 2% inflation as representing "price stability" leading to a more that 18% devaluation of the purchasing power, and therefore real incomes, or wage earners and thereby reducing real consumption. The IMF drew attention to a limited "window" of assets affected by speculation and therefore made no mention of the knock-on effect of such speculation in the food, commodities, minerals and energy markets all of which have a direct impact on the cost of living. Asset appreciation is a fundamental objective of monetary policy as a basis of avoiding asset price deflation which would undermine the collateral used by financial intermediaries and raise their risks. Therefore the current counter-deflationary policies provide the ideal conditions for speculation based on assets.

Real Incomes

The impact is an overall reduction in real incomes and aggregate demand under the conventional aggregate demand model ADM3 of the economy but which could be effectively attenuated under the Real Incomes Approach Production, Accessibility & Consumption model (PACM) of the economy 4 which provides the basis for the operation of PPP.

Unfortunately the IMF sees central bank reform as a solution, but it is the central bank policies promoted worldwide by the IMF as conditions for reducing debt in Europe that are exacerbating the state of affairs. Interest rates need to be based on returns to investment in the productive sector rather than be spun out of the air by "monetary committees" thereby providing more incentive for saving and higher returns rather than policies that substitute savings by debt. As usual parts of the social and economic constituencies suffer under KMS policies such as pensioners and savers and those in the productive economy looking for lower input prices and hoping for higher real incomes to increase the consumption of their output.

Whereas austerity is considered to be a state of reduced spending and increased frugality within the financial sector, the sectors suffering are not the financial sector but rather business, public services and the public. There is considerable evidence being analyzed by the IMF that supports the position that the UK financial sector at 10% of GDP is around twice the size that it should be to avoid it being an overhead that only drags productivity down in the economy as a whole. The limp appeal to more effective fiscal policies and "restructuring" will achieve nothing. The Bank of England should be working harder to reduce the overall size of the financial sector and PPP might be applied to stimulate on-shore engineering and the generation of employment in higher value occupations.

1 Hector McNeill is the director of SEEL-Systems Engineering Economic Lab.

2 "Global Financial Stability Report", IMF, Washington, October 2014:
Chapter 1 concludes that although economic benefits of monetary ease are becoming more evident in some economies, market and liquidity risks have increased to levels that could compromise financial stability if left unaddressed. The best way to safeguard financial stability and improve the balance between economic and financial risk taking is to put in place policies that enhance the transmission of monetary policy to the real economy—thus promoting economic risk taking—and address financial excesses through well-designed macroprudential measures.
Chapter 2 examines the growth of shadow banking around the globe, assessing risks and discussing regulatory responses. Although shadow banking takes vastly different forms within and across countries, some of its key drivers tend to be common to all: search for yield, regulatory circumvention, and demand by institutional investors. The contribution of shadow banks to systemic risks in the financial system is much larger in the United States than in Europe. The chapter calls for a more encompassing (macroprudential) approach to regulation and for enhanced data provision.
Chapter 3 discusses how conflicts of interest between bank managers, shareholders, and debt holders can lead to excessive bank risk taking from society’s point of view. It finds that banks with boards of directors independent from management take less risk. There is no clear relation between bank risk and the level of executive compensation, but a better alignment of bankers’ pay with long-term outcomes is associated with less risk. (Source IMF, Washington).

3 ADM-Aggregate Demand Model - this is the main deterministic model used by Keynesians, Monetarists and supply side economists to predict the impact of a wide range of impacts arising from the operation of centrally imposed monopolistic market interventions by the state in relation to interest rates, money volumes, taxation, public spending (40% of national economic activity) and government debt. The track record of this approach is cycles, lack of traction and the creation of winners, losers and those who remain in policy neutral impact states. Usually in a crisis these policies exacerbate the differentiation of impacts creating significance prejudice for some in the social and economic constituencies. These policies based on the ADM are characterized by a systemic inconsistency in the distribution of benefits arising from policy. Conventional policies also ignore th eimpact and distortions that arise from the profit paradox (see "The profit paradox").

4 PACM-Production Access Consumption Model - this is the main deterministic model deployed by the Real Incomes Approach to economics to trace the impact of price performance ratios on real incomes of corporate ownership and employees and purchasing power of consumers as a result of investment in higher physical productivity and price setting. As a dynamic short-term margin-enhancing incentive-based policy cycles are reduced and the differentiation in impacts across the social and economic constituencies are reduced gaining a positive systemic consistency in the distribution of benefits arising from policy (see "The PAC Model of the Economy")

Updated 24th June, 2015.

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