It’s been a while! I’m back with some thoughts on where we are right now in this business cycle.

First though, as the Federal Reserve meets at Jackson Hole this week, I thought now would be a good time to talk about the limits of monetary policy – and why monetary policy alone cannot restore robust growth. And as I write this I want to make clear the goal of policy and the assumptions I am making.

First, let me say that two primary goals of macro policy everywhere and always should be full employment and stable prices. Why? I am looking at this purely through the lens of the political economy – thinking about how our fellow citizens live and breathe the economy and how government should be designed to respond to their needs. On the jobs side, we have seen that high unemployment leads to political instability, economic turmoil and conflict. When you have masses of people unemployed or unable to earn enough money to sustain the lifestyle they aspire to – especially young males – you have the makings of discontent that leads to political instability, electoral desperation, fringe voting, and even revolt and insurrection.

On the inflation side of things, high deflation and inflation are equally problematic. When you have, say, families with mortgages or businesses trying to expand, doing the things we see as ‘normal’ to get ahead, deflation makes their task harder by unexpectedly increasing the real burden of that debt. That leads to a downward spiral as fire sales force prices even lower, what we now called debt deflation. Now I know the Austrians say just let this play out. But politically, that’s never going to happen. Think about the housing busts of this last crisis. Just as with joblessness, you have the same makings of political discontent that leads to chaos. And as bad as deflation is, we know inflation is difficult too – not just Weimar or Zimbabwe-style inflation but even the moderately high levels of the 1970s.

In the real world of today, when we think of political discontent, we’re talking about electing Donald Trump in the US, voting for Brexit in the UK, electing Syriza in Greece, putting Le Pen in the second round in France.

Now what I just wrote may seem obvious to some of you, but it’s not obvious to everyone. Nor is there any consensus on how policymakers are to achieve their goals. Take the Fed for instance. The Federal Reserve has this dual mandate as its legislative goals unlike, say, the ECB, which is only tasked with looking after inflation. But even though the two regimes differ. It doesn’t mean that policymakers’ goals are any different, just who is pursuing those goals. In the US, you have the Fed pursuing both and the legislative and executive branches also trying to create full employment pre-conditions. In the eurozone, the delineation is more fine with the national governments alone tasked with full employment and the central bank tasked with inflation.

Here’s the problem.

Right now, monetary policy is the only game in town.

We can argue over why this is the case but the fact remains that, after a crisis that exploded government debt and deficits, everywhere in the developed world governments are trying to rein in spending. Have you seen the Martin Wolf chart I have cited a couple of times showing the retrenchment?

(Click on image to enlarge)

What this has effectively meant is that monetary policy has been forced to be looser than it otherwise would have been. Because fiscal policy is now tighter relative to the pre-existing path, monetary policy has been forced to act as an offset and run looser than it would have run. For example, in the US, if the structural government balance between 2010 and 2016 (after the acute stage of the crisis) had been neutral instead of almost 6% tighter, monetary policy would have certainly been tighter. Rates today would be higher. And I think this has real world implications.

First, there is the real economy. That is where people are employed and companies invest to supply consumers with products and services. Understanding what a neutral macro-economic policy looks like, we can imagine what the economy would look like. In a world in which the government has delivered nearly 6% more of gross domestic product to the private sector, unemployment declines more rapidly, and people and businesses have more money to spend. In a very real sense, that’s an economy in which tax receipts expand briskly due to growth and the government deficit, while higher initially, recedes rapidly. But that’s not the economy that Barack Obama delivered to the United States, as the Martin Wolf chart shows you. And monetary policy has been looser as a result.

In the financial economy, looser monetary policy has meant lower interest rates and more Fed purchases of financial assets. This has lowered investment hurdle rates all around, skewing investment decisions toward more marginal investments – the ones that appear marginally profitable in the medium-term in the looser monetary policy environment but are forsaken in a tighter monetary policy regime. Stocks of companies like Amazon, Tesla, and Netflix get bid up. Shale oil investment is more attractive. Subprime auto loans mushroom because they are attractive and there is no post-crisis regulatory burden, as there is in the housing market. Petrobras can issue a 100-year bond in this environment as can Argentina, because investors are starved for yield.

So, in the world we live in, we still have middling economic growth and sighs of labor market slack eight years into a cyclical recovery even as the stock market and the high yield bond market have boomed. This disconnect between the real economy and the financial economy in the US has a lot to do with the over-reliance on monetary policy due to a post-crisis tightening of fiscal policy.

In Europe, the problem is slightly different because national governments have a legitimate fear of defaulting. Fiscal stances must be tighter because eurozone governments cannot run any countercyclical fiscal policy they want. They must heed the bond vigilantes or face the debt revulsion that forced Greece to default. But when the national governments are the only entities actually tasked with trying to achieve any semblance of full employment, it’s no wonder the whole of the eurozone has struggled to get to 9.3% unemployment.

Takeaway: I see every reason to be relatively optimistic about the near term economies in the developed world, especially in Europe. We are at a very good time in the cyclical path right now. But the bigger macro outlook is more questionable for me. The over-reliance on monetary policy means monetary policy is looser than it would be if macro relied more on fiscal stabilizers. And that means that we may have fewer policy choices when the next downturn comes. The risk, then, is that you would have the makings of the kind of discontent that leads to political instability, electoral desperation, fringe voting, and revolt.

That’s my first cut on talking about policy as the Fed meets. Sorry to be a bit alarmist in tone. I just want to point out that we are at the best point in this economic cycle. If we really want our policymakers to keep things on track over the long term, now is the time to reflect and make the necessary changes.