(A continuation and re-examination of my earlier work on animal spirits and policy fragility)
When I wrote Playing With Fire: Animal Spirits Ensconce Progress and Trepidation in Economies in 2019, the world was already operating beyond the comfort of economic textbooks. Five years on, the uncomfortable truth is that the themes articulated then have not merely persisted—they have metastasised.
The global economic environment continues to traverse unfamiliar terrain. Trade wars have not resolved; they have mutated. Monetary policy divergence has given way to reluctant convergence. Emerging market inflation remains polarised. Global growth continues to be revised down. Political fractures—from Brexit to the re-shoring impulse to rising geopolitical antagonism in Asia and the Middle East—now form the structural backdrop rather than the exception.
If anything, what has become clearer since 2019 is that monetary policy is not only a blunt instrument—it is a delayed one, operating with long, variable, and often asymmetric lags that are profoundly mismatched to the speed of modern economic transmission.
Milton Friedman famously warned that monetary policy works with “long and variable lags,” cautioning that by the time policy takes effect, the economy may have already moved on (Friedman, 1961). Decades later, central banks continue to operate inside this constraint, now amplified by algorithmic trading, instantaneous capital flows, and sentiment-driven financial markets. What once took quarters to transmit now takes milliseconds—except for policy itself.
Central banks are, in effect, fighting supersonic markets with subsonic tools.
This was already evident in 2019. It is indisputable today.
Monetary Policy as a Blunt Tool in a Precision Economy
Monetary policy was designed for an industrial economy—one where demand cycles were slower, labour markets more rigid, and capital allocation less reflexive. Today’s economy is none of those things. It is digital, financialised, globally integrated, and sentiment-sensitive. I argued prolifically on its fallacies in this article, which was very well received at the time and invited zero comments – because no one could argue about its contention! Ever since high school, I was perplexed as to why monetary policy is so prominent yet it operates almost counter-intuitively – i.e. the lags. Usually, price mechanisms and efficient market hypothesis foreshadows where monetary policy should be heading e.g. US10Y versus US10Y etc.
Yet the primary lever remains the same: a short-term interest rate – the quintessential reference rate that is the nexus of a variety of multifactorial models (valuation, interpolation or esxtrapolation)
As Ben Bernanke later conceded, interest rate adjustments are an imprecise mechanism for influencing heterogeneous sectors of the economy, particularly when financial markets respond faster than real economic variables (Bernanke, 2020). John Taylor and Michael Woodford similarly highlight that monetary transmission depends critically on expectations, credibility, and institutional context—factors that are neither uniform nor controllable in real time (Woodford, 2003).
This explains why we repeatedly observe asset prices responding violently to policy signals long before any tangible effect materialises in wages, productivity, or inflation.
We are not stimulating the economy; we are stimulating animal spirits.
The result is familiar: distorted risk pricing, capital misallocation, speculative excess, and a growing disconnect between financial conditions and productive investment. The fire is being stoked—not controlled.
The Lag Problem: Fighting Yesterday’s War
One of the most underappreciated constraints in contemporary macroeconomic policy is temporal mismatch. Monetary policy lags—often estimated at 12 to 24 months—render central banks structurally reactive rather than proactive (Mishkin, 2019). By the time inflation moderates or demand contracts, policy is frequently still leaning in the opposite direction.
This creates a destabilising feedback loop:
- Tightening continues into slowing growth
- Easing persists into speculative excess
- Asset markets overshoot in both directions
The Bank for International Settlements has repeatedly warned that prolonged reliance on accommodative monetary policy inflates financial imbalances while doing little to raise long-term productivity (BIS, 2021). In other words, we are borrowing growth from the future while convincing ourselves we are stabilising the present.
Lawrence Summers’ concern—raised both before and after the Global Financial Crisis—that the real danger is not slowdown but policy impotence now feels prescient. When rates approach the lower bound, the capacity to respond to shocks collapses just as fragility peaks.
We are living in a flammable building—again. Modern markets move at algorithmic speed. Capital reallocates instantly. Sentiment travels faster than data. Yet monetary policy still operates with long, variable, and poorly measurable lags.
Milton Friedman identified this flaw over sixty years ago, warning that monetary actions influence the economy only after delays long enough to destabilise the cycle they aim to smooth (Friedman, 1961). The irony is that central banks acknowledged this constraint—and then proceeded to ignore it.
Today, policy tightening or easing typically transmits to the real economy over 12 to 24 months (Mishkin, 2019). By the time its effects materialise, the economy has already changed direction.
This is not countercyclical policy.
It is retrospective interference.
Animal Spirits in a Hyper-Connected World
As I argued in 2019, our collective capitulation to animal spirits is not irrational—it is evolutionary. What has changed is the amplification mechanism.
Twitter sentiment now moves markets. Algorithms arbitrage inefficiencies in milliseconds. Cryptocurrencies trade as both speculative assets and macro hedges. Market makers deploy vast balance sheets to inject liquidity, while passive flows dominate price discovery.
The consequence is a system where perception precedes fundamentals, and policy announcements often matter more than policy outcomes.
This is not an “open economy” in the classical sense. It is a knowledge-driven, digitally integrated, reflexive economy, where feedback loops between narrative, capital, and confidence dominate.
Attempting to fine-tune such a system with interest rates alone is not just insufficient—it is dangerous.
The Persistent Policy Failure: Innovation Avoidance
Lower interest rates are not the enemy. As I noted previously, they reduce benchmark funding costs, expand credit capacity, and enable productive investment—from commercial real estate to venture capital. In that sense, they are a necessary condition for growth.
But they are not a sufficient one.
The deeper failure lies in policy imagination.
Governments continue to defer structural reform, productivity enhancement, and inter-sectoral innovation, outsourcing economic stewardship to central banks. This abdication has allowed monetary policy to become the default stabiliser, despite being ill-suited for the task.
Australia’s continued reliance on iron ore and coal exports exemplifies this inertia. Services—accounting for roughly 70% of economic activity—remain under-measured, under-strategised, and under-leveraged in trade frameworks, precisely because they do not pass through customs offices.
Human capital, intangible assets, and innovation ecosystems are the true engines of sustainable growth. Monetary policy can enable them—but it cannot create them.
Control the Fire, Don’t Feed It
The lesson from 2019 still holds: we are playing with fire. But the answer is not to extinguish it—it is to control it.
That requires recognising the limits of monetary policy, respecting its lags, and re-centring economic strategy around productivity, innovation, and human capital formation. It requires fiscal courage, structural reform, and a willingness to invest in assets that compound rather than speculate.
Economic systems are not homogeneous. Quantitative easing affects Asia, the United States, and Australia differently. Monetary policy cannot be one-size-fits-all in a world that clearly is not.
Animal spirits will always exist. The question is whether we allow them to destabilise the system—or harness them to build something enduring.
References
Bernanke, B 2020, The New Tools of Monetary Policy, American Economic Association Presidential Address.
Bank for International Settlements (BIS) 2021, Annual Economic Report.
Friedman, M 1961, ‘The Lag in Effect of Monetary Policy’, Journal of Political Economy, vol. 69, no. 5, pp. 447–466.
Mishkin, FS 2019, The Economics of Money, Banking and Financial Markets, 12th edn, Pearson.
Woodford, M 2003, Interest and Prices: Foundations of a Theory of Monetary Policy, Princeton University Press.
Wolf, M 2019, ‘Global economic policymakers are playing with fire’, Australian Financial Review, 16 October.
Fowler, E 2019, ‘Monetary Policy Has Run Its Race, Says Costello’, Australian Financial Review, 16 October.