Monday, 26 January 2015

Reflections on Recovery and Reform

As Greece prepares to reject the fiscal austerity that has been imposed on it for the last six years, here are some thoughts on the process of Recovery and Reform that Greece, and others in the Eurozone, have been undertaking in the past few years. They are not mine: the identity of the writer will be revealed later in this post (though many of you will no doubt recognise the writing style, if not the actual words).
"You are engaged on a double task, Recovery and Reform;--recovery from the slump and the passage of those business and social reforms which are long overdue. For the first, speed and quick results are essential. The second may be urgent too; but haste will be injurious, and wisdom of long-range purpose is more necessary than immediate achievement. It will be through raising high the prestige of your administration by success in short-range Recovery, that you will have the driving force to accomplish long-range Reform. On the other hand, even wise and necessary Reform may, in some respects, impede and complicate Recovery. For it will upset the confidence of the business world and weaken their existing motives to action, before you have had time to put other motives in their place......
"Now I am not clear....that the order of urgency between measures of Recovery and measures of Reform has been duly observed, or that the latter has not sometimes been mistaken for the former. That is my first reflection--that....which is essentially Reform and probably impedes Recovery, has been put across too hastily, in the false guise of being part of the technique of Recovery.
"My second reflection relates to the technique of Recovery itself. The object of recovery is to increase the national output and put more men to work. In the economic system of the modern world, output is primarily produced for sale; and the volume of output depends on the amount of purchasing power, compared with the prime cost of production, which is expected to come n the market. Broadly speaking, therefore, and increase of output depends on the amount of purchasing power, compared with the prime cost of production, which is expected to come on the market. Broadly speaking, therefore, an increase of output cannot occur unless by the operation of one or other of three factors. Individuals must be induced to spend more out o their existing incomes; or the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees, which is what happens when either the working or the fixed capital of the country is being increased; or public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money. In bad times the first factor cannot be expected to work on a sufficient scale. The second factor will come in as the second wave of attack on the slump after the tide has been turned by the expenditures of public authority. It is, therefore, only from the third factor that we can expect the initial major impulse......
"Thus as the prime mover in the first stage of the technique of recovery I lay overwhelming emphasis on the increase of national purchasing power resulting from governmental expenditure which is financed by Loans and not by taxing present incomes. Nothing else counts in comparison with this. In a boom inflation can be caused by allowing unlimited credit to support the excited enthusiasm of business speculators. But in a slump governmental Loan expenditure is the only sure means of securing quickly a rising output at rising prices ."
How far removed is this from the policies currently being pursued by governments in Europe under pressure from Brussels and Frankfurt? The SGP and fiscal compact simply do not permit the expansionary fiscal policy that the writer suggests is the fastest way of restoring lost output. No wonder large parts of the Eurozone are in a protracted slump.

But surely monetary policy can do the heavy lifting instead? According to those of a monetarist persuasion, if the central bank increases the base money supply, output will be restored even if fiscal policy remains tight. So the protracted slump is the ECB's fault, isn't it?

The writer doesn't think so:
The other set of fallacies, of which I fear the influence, arises out of a crude economic doctrine commonly known as the Quantity Theory of Money. Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed. Some people seem to infer from this that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States to-day your belt is plenty big enough for your belly. It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor.
And I'm sorry, Professor Krugman, but he doesn't have much time for arguments that deliberately raising inflation will magically restore output, either:
Rising prices are to be welcomed because they are usually a symptom of rising output and employment. When more purchasing power is spent, one expects rising output at rising prices. Since there cannot be rising output without rising prices, it is essential to ensure that the recovery shall not be held back by the insufficiency of the supply of money to support the increased monetary turn-over. But there is much less to be said in favour of rising prices, if they are brought about at the expense of rising output. Some debtors may be helped, but the national recovery as a whole will be retarded. Thus rising prices caused by deliberately increasing prime costs or by restricting output have a vastly inferior value to rising prices which are the natural result of an increase in the nation's purchasing power......
......too much emphasis on the remedial value of a higher price-level as an object in itself may lead to serious misapprehension as to the part which prices can play in the technique of recovery. The stimulation of output by increasing aggregate purchasing power is the right way to get prices up; and not the other way round".
 And finally, he has harsh words for those who think that devaluing the currency is a fine way of restoring competitiveness and growth (I'm looking at ALL of those who argue for QE and its relatives on the grounds that it will weaken the currency):
"In so far as an over-valuation of the dollar was impeding the freedom of domestic price-raising policies or disturbing the balance of payments with foreign countries, it was advisable to depreciate it. But exchange depreciation should follow the success of your domestic price-raising policy as its natural consequence, and should not be allowed to disturb the whole world by preceding its justification at an entirely arbitrary pace. This is another example of trying to put on flesh by letting out the belt."
Now, of course, we have all learned SO much since John Maynard Keynes wrote this letter to Franklin D. Roosevelt, haven't we? These days, "Keynesian stimulus" is widely derided. The 1970s taught us that direct government intervention to restore growth is wholly wrong and very damaging, and Keynes was a charlatan to suggest it. We now know that the only thing that will restore growth is for government to remove obstacles to free trade and private enterprise while putting its fiscal house in order - even if this means unemployment of over 25% and rising poverty and malnutrition among the population. Don't we?

But wait. What exactly was Keynes criticising in this letter?

It was FDR's National Industrial Recovery Programme:
In particular, I cannot detect any material aid to recovery in N.I.R.A., though its social gains have been large. The driving force which has been put behind the vast administrative task set by this Act has seemed to represent a wrong choice in the order of urgencies.
Here's what FDR himself had to say about the NIRA:
"Throughout industry, the change from starvation wages and starvation employment to living wages and sustained employment can, in large part, be made by an industrial covenant to which all employers shall subscribe. It is greatly to their interest to do this because decent living, widely spread among our 125, 000,000 people, eventually means the opening up to industry of the richest market which the world has known. It is the only way to utilize the so-called excess capacity of our industrial plants. This is the principle that makes this one of the most important laws that ever has come from Congress because, before the passage of this Act, no such industrial covenant was possible.

"On this idea, the first part of the Act proposes to our industry a great spontaneous cooperation to put millions of men back in their regular jobs this summer. The idea is simply for employers to hire more men to do the existing work by reducing the work-hours of each man's week and at the same time paying a living wage for the shorter week."
The NIRA was a programme of labour market reforms and public works aimed at ensuring full employment at living wages. Those who think that this is what "Keynesianism" is about should study what Keynes actually said. Keynes was no Keynesian.

Now, it is true that Keynes was writing to the President of a currency-issuing sovereign, whereas Eurozone member states have voluntarily relinquished their right to issue their own currencies. But that does not invalidate Keynes' remarks about the importance of government spending. When private sector agents cannot or will not spend, government must enable them to do so. Keynes is not suggesting that government does it FOR them. He is recommending that private sector agents be provided with more money so that they can spend it themselves. He doesn't specify how that might be done, but helicopter drops, tax cuts and additional government spending funded by borrowing (not tax rises) are all possibilities. Anything, in fact, that increases the purchasing power of the private sector. And no, funny money is not a substitute, however cleverly it is designed. Nor is QE, really, since all it does is substitute one asset for another. John Muelbauer's "QE for the people" is far more in the spirit of Keynes than Juncker's scheme.

Keynes' words still resonate today.

"Oh that today you would listen to his voice: harden not your hearts." - Psalm 95

(H/T @NelderMead for the link to Keynes' letter).

Sunday, 18 January 2015

Banks, bonds and deficits

Lots of you pointed out that in my last post the monetary effect of government bond purchases was unclear. Indeed, I had rather skated over it and thereby created confusion. I gave the impression that government can always sterilise spending (broad money creation) by issuing bonds. But this isn't quite true. It all depends on who buys them and how they finance their purchases.

So I thought I'd do a few scenarios to show what happens when different types of private sector actors buy and sell government bonds.

Firstly, let's look at primary issues. Government issues sufficient bonds to sterilise its entire deficit spending. This is normal fiscal behaviour.

Primary issue: bonds entirely bought by banks

I'm going to consider the banks in aggregate here, rather than as individual entities, and I'm going to assume that the same banks also intermediate government spending. As I noted in my previous post, in the absence of pre-funding, governments will run overdrafts at commercial banks when paying private sector agents. In practice, governments usually pre-fund spending commitments with bond issuance. So there are two versions of this scenario.

Spending precedes bond issuance: Government runs overdrafts at the banks. The proceeds of bond issuance pay off these overdrafts. But in this scenario, the banks that have granted the overdrafts also buy the bonds. This is an asset swap for the banks: it replaces loan assets (drawn overdraft facilities) with bonds. There is no change in the banks' liabilities. So M3 rose* when government drew on its overdrafts, as explained in the previous post, but it did not fall when the banks replaced loan assets with bonds. The government's deficit spending is NOT sterilised.

Bond issuance precedes spending: banks buy bonds from government instead of granting overdraft facilities. The proceeds from the bond sale go into the government's deposit accounts (which therefore have POSITIVE balances). Government then draws on that funding to meet spending commitments. This is exactly the same as lending to government and the accounting is identical. Banks create new deposits to the value of the bonds, which raises M3. When the government spends the money created, the liabilities move from bank to bank but there is no change in the aggregate liabilities of the banking sector. So M3 is created as a consequence of bank lending to government (bond purchases), not government spending.

In summary, a primary auction bought entirely by broker-dealers does not sterilise government deficit spending. It is simply an alternative version of bank lending to government, which raises M3.

However, there is a complication. In some versions of primary issuance via banks, banks pay the central bank for their purchases from their reserves, and the central bank reimburses the fiscal authority via its account at the central bank. This is a drain of M0 (the monetary base), not M3**: the commercial banks exchange reserves for government bonds, leaving their liabilities unchanged, and the transfer of reserves to the government's account takes them out of circulation. However, because private sector agents to whom government makes payment don't have central bank reserve accounts, government must still make those payments via commercial banks. In this mechanism it does so via the central bank, which credits the reserve accounts of the payees' banks: the banks then create deposits on behalf of the payees to the amount of the transferred reserves. Both M0 (reserves) and M3 (deposits) therefore rise. The combination of reserve-funded bond purchases and reserve-funded government spending leaves M0 unchanged, but banks still have to sell government bonds to non-banks to sterilise M3.

Primary issue: bonds bought entirely by non-banks: Again, we have two versions - bond issuance after spending, and bond issuance prior to spending.

But there is an additional complication. Non-bank asset purchases are always intermediated through banks, and non-banks may borrow from banks either to finance the purchase itself (unlikely, admittely) or to fund other spending as a consequence of bond purchases. So let's look at how this works.

Spending precedes bond issuance: Government has drawn overdrafts at banks. When non-banks buy the bonds, they pay from their own deposit accounts into government accounts, extinguishing the drawn overdrafts. If non-banks make these payments from existing funds (i.e. balances on their deposit accounts were positive prior to payment and either positive or zero afterwards), then the extinguishing of government overdrafts reduces M3 in exactly the same way as paying off any other bank loan does.

But if non-banks themselves borrow from banks, then the reduction in M3 from the extinguishing of government overdrafts is offset by the rise in M3 due to new lending to non-banks and there is no change in the broad money supply.

As M3 rises initially when the government draws its overdrafts (because banks create money), this means that debt-financed (leveraged) purchases of government bonds by non-banks do not sterilise government spending, but purchases from existing funds, say by cash-rich pensioners (Government pensioner bonds, for example) do.

Bond issuance precedes spending. As before, when non-banks buy the bonds, they pay from their own deposit accounts into government accounts, increasing the balances in those accounts. Government then has positive balances in its bank accounts and subsequent spending has no effect on M3. But whether M3 is raised by the non-bank bond purchases depends on how they are financed. If non-banks borrow from banks (including temporary overdraft facilities) to fund the purchases, then M3 rises due to new bank lending and government spending is not immediately sterilised, though it would be when the non-banks extinguish the loans or overdrafts. If non-banks fund the purchases from existing funds, it is simply an asset swap for the private sector, payment is intermediated through the banking sector without affecting the size of its aggregate balance sheet and there is no change in M3.

For government spending to be fully sterilised by bond issuance, therefore, bonds must be issued to NON-banks and paid for with existing funds. In practice, primary issuance is primarily bought by banks, so does not sterilise spending.

Central bank monetisation of deficit spending: If the government borrows directly from the central bank to fund deficit spending with no bond issuance, then both M0 and M3 rise ***. The central bank creates new reserves (M0), which initially go into the government's account at the central bank but are then disbursed to reserve accounts at payees' banks as the government spends. Alternatively, the central bank simply creates the reserves as the government spends, placing them in the appropriate reserve accounts and creating an equivalent loan asset (overdraft) for the government. The loan asset is simple balance sheet accounting between two parts of the government, which disappears in consolidated accounting, but the monetary base increase is real. As before, when the new reserves are distributed to bank reserve accounts by the central bank on behalf of government, the banks create deposits in payees' accounts, which increases M3.

Now let's look at the effect on broad money of trading in the secondary market. 

Secondary market effects
Trading in the secondary market does not change the quantity of bonds issued, unlike a primary auction. But it does affect the broad money supply. This is because actors in the secondary markets include both non-banks and banks, and bank trading activity changes the money supply: banks create money when they purchase assets and destroy it when they sell them. 

The chief benefit to a bank of buying bonds from government rather than lending directly is that the bonds are liquid. They can be sold, to other banks or to the general public. When banks do this, the broad money supply changes, as I explain in the following examples. To keep things simple I'm going to pretend that all trades are OTC and bilateral.

Bank buys government bonds from another bank: This is simply an exchange within the banking sector and there is no net change in assets & liabilities. The buying bank increases M3 when it makes the purchase, because it creates money to do so, but the selling bank decreases M3 because a loan obligation (the bond) has been extinguished. The balance sheet of the buying bank increases, that of the selling bank shrinks. There is no net change to the aggregate balance sheet of the banking sector and therefore no change in M3.

Non-bank buys government bonds from a bank (and pays for them from existing funds): The size of the selling bank's balance sheet is unchanged, since the government bond is replaced with an equal cash asset (an asset swap). The size of the non-bank's balance sheet is also unchanged, since a bond purchase from existing funds is also an asset swap. However, the liabilities of the bank from which the non-bank makes the payment reduce, as do its reserves. Overall, therefore, the balance sheet of the banking sector shrinks and M3 falls.

Non-bank buys government bonds from another non-bank: This trade is intermediated through banks. As far as the non-banks are concerned this is simply an asset swap on both sides and there is no change in the aggregate non-bank balance sheet. Importantly, if the purchase is made from existing funds (no leverage) there is no change to the aggregate balance sheet of the banking sector and therefore no change to M3. But if the purchaser borrows from the bank to fund the purchase, even temporarily, M3 rises and remains elevated until the temporary loan is extinguished.

Summary and conclusion
When banks purchase primary bond issues from government, government spending is not sterilised. Sterilisation of the monetary effects of government spending happens when banks sell on government bonds to non-banks, unless non-banks borrow from banks to fund the purchases or cover consequent shortfalls.

In practice, government spending does increase the broad money supply even if it is fully covered by bond issuance. Bond issuance cannot wholly sterilise it, because banks don't sell their entire holdings of government bonds - they retain a substantial proportion as collateral for repo funding. Opportunity costs for non-banks, too, may lead to incomplete sterilisation due to higher bank lending to non-banks. So it is probably fair to say that bond issuance is not a very effective way of sterilising the monetary effects of government deficit spending. Taxation is the only fully effective means, and even then only if it is efficient, which most tax systems are not. Over time, therefore, we would expect persistent government deficit spending to increase the broad money supply. 

Whether or not the increase in broad money arising from incomplete sterilisation of government deficit spending - or even outright monetisation of government deficit spending by the central bank - is inflationary in my view depends on how the money is distributed and the purpose for which it is used. I think it is fallacious to assume that increasing the quantity of broad money, whether through central bank money creation, government deficit spending or simply through higher bank lending, necessarily raises consumer price inflation.  Looking at the quantity theory of money equation:


with M defined in this case as M3, we can see that an increase in P (inflation) is only one of the possible consequences of a rise in M. There could be an increase in output (Y) with no effect on inflation, or there could be no effect at all because people just sit on the money (V falls). Or, not shown in this equation, asset prices could rise.

I don't propose to discuss this any further here. Better folk than me have had endless debates about it. At JP Koning's suggestion, I refer those who are interested to Tobin's theory of reflux, Yeager's refutation of it, and more recently the extended argument between David Glasner, Nick Rowe and many others. The causes of inflation are endlessly puzzling and supply-of-money theories are hopelessly inadequate. As ever, in monetary economics, it just isn't that simple.

Related reading:

The fiscal theory of monetary expansion
Printing clever weird stuff - aka money - Principles & Interest
When wonks get things wrong - Pieria
Inflation is always and everywhere a political phenomenon - Pieria
Money creation in the modern economy - Bank of England (pdf)

* Throughout this post I've used M3 to mean broad money. US readers should mentally change this to M2 as the Fed no longer produces M3 figures. All the money creation I discuss in this post would form part of M2 as well as M3 - indeed much of it would be M1.

** The use of reserves to buy government bonds in a primary issue was omitted from my previous post. Thanks to all those who alerted me to this alternative.

*** I got this wrong in my last post:

"An alternative to bond issuance for draining M3 is borrowing from the central bank. Yes, I mean it. If a government borrows from the central bank to pay down a commercial bank overdraft, M3 falls. The monetary base M0 rises as a consequence of this borrowing, but this does not affect the economy unless commercial banks increase their lending to households & businesses or the central bank prints more physical currency."

This is not correct and I have removed it from that post. Thanks to Tim Young for explaining it. 

Oh, what have you done?

My latest Forbes post discusses the reasons for the Swiss National Bank's sudden removal of exchange controls and imposition of record negative rates. Here's a taster:
This action has without question been very costly. So why did the SNB do it?
Frankly, I don’t buy the SNB’s “cap is no longer needed” story. If the currency peg was really redundant, market reaction would have been far less extreme. Nor do I agree with Markus Brunnermeier and Harold James that this was due to domestic political worries about SNB solvency. In my view this is all about ECB QE – and about the power dynamics between central banks.
To read the whole post, click here.

The title to the Forbes post has confused lots of people, so let me explain. It's a reference to David Bowie's song  Love is Lost:

It's the darkest hour, you're 22
The voice of youth, the hour of dread
It's the darkest hour, and your voice is new
Love is lost, and lost is love

Your country's new, your friends are new
Your house, and even your eyes are new
Your maid is new, and your accent, too
But your fear is as old as the world

Say goodbye to the thrills of life
When love was good, when love was bad
Wave goodbye to the life without pain
Say hello, your beautiful girl

Say hello to the greater men
Tell them your secrets they're like the grave
Oh what you have done, oh what you have done
Love is lost, lost is love

You know so much, it's making me cry
You refuse to talk, but you think like mad
You've cut out your zone and the things have fold
Oh what have you done, oh what have you done
Oh what have you done, oh what have you done

The last verse seemed particularly appropriate. And the title of the song, of course.

Every economic blogger in the world seems to have things to say about the SNB action, most of which I disagree with. Here's a selection of the best posts.

The SNB and the Russia/oil connection - Izabella Kaminska
Switzerland's problem isn't an expensive currency but anaemic consumption - Matt Klein
What does the end of the Swiss peg tell us about central banks? - Simon Wren-Lewis
Central banks don't need financial capital but do need political capital - Cullen Roche
Making sense of the Swiss shock - Brunnermeier and James
Did the SNB score an own goal? - Willem Buiter (pdf)
Was the SNB's decision a deal with the ECB? - Juha Huopainen
Shocked by the Swiss franc? Blame Europe - Bloomberg View (editorial)
What unpegging the Swiss franc from the Euro means for the US dollar - Miles Kimball
Lessons from Switzerland doffing its cap - John Authers (paywall)
The SNB and the Berne Whale - Brad DeLong
Making Swiss Cheese of the Euro - Steve Keen
The cuckoo clock chimes for the Swiss franc - Paul Mason
A Lesson From The Swiss: Leverage and Online FX are a Dangerous Mix - Mike Casey, WSJ (paywall)

And here's a useful background post from 2013 by George Dorgan, which explains some of the drivers behind the decision:

IMF sees considerable risks on SNB balance sheet

Tuesday, 6 January 2015

The fiscal theory of monetary expansion

I am tired of theories of monetary expansion that ignore the considerable role of both commercial banks and fiscal authorities in the creation of money. To hear some people talk, you would think that all that is needed is for the central bank to increase base money (M0), and the total amount of money (M3) circulating in the economy will magically increase. So when the economy is on the floor, monetary conditions are tight and commercial banks not lending, inflate M0 by any means available and wait for life to return. This amounts to believing, in the face of considerable evidence to the contrary, that the earth is flat.

In a credit money system, the vast majority of money in circulation is created not by the central bank but by commercial banks. Furthermore, government deficit spending increases the total amount of money circulating in the economy (unless this money expansion is actively neutralised). Therefore the combination of fiscal authorities and commercial banks can create all the money required by the economy. Indeed it can create far too much, potentially triggering inflation. The job of the central bank is not to create money, but firstly to facilitate payments and secondly to limit the creation of money.

To those of you who are firm believers in the supremacy of central banks, this will seem like heresy. So let me explain how this works with the help of a simple example.

Imagine a sovereign country which issues its own fiat currency. The currency floats freely against other currencies. There is an extensive commercial banking system and a central bank which acts as lender of last resort for the private banks. The reserve requirement is zero and reserves are provided on demand to settle payments made by commercial banks. Most people in the country have bank accounts and the majority of transactions take place through banks. At the start of this example, reserves are zero and there is little physical cash, and consequently the central bank's balance sheet is very small. And (incredibly) the fiscal budget is exactly balanced in every period so that legacy debt doesn’t complicate the example. At the start of this example, therefore, the government's fiscal position is zero. It has no money. What little money is in circulation comes mainly from commercial bank lending to the private sector.

So our government puts together its budget for the year. It takes a while for tax receipts to arrive, and in the meantime it needs to pay wages to employees, benefits to recipients, payments to suppliers. We are used to governments funding their deficits by issuing bonds in advance of spending (more on this shortly), but let us assume for a moment that this government chooses not to pre-fund its deficit spending. How would it make these payments?

It would make them through a commercial bank, of course. Whether or not its transaction account at that bank actually contains any money is irrelevant. The government is the most creditworthy borrower in the country and the sole issuer of banking licences (which confer the right to create sovereign money). In the absence of pre-funding, therefore, the commercial bank would allow the government to make these payments by running an overdraft.

As the Bank of England explains, money is created when banks lend:
Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.
An overdraft is simply a bank loan of indeterminate duration. Overdraft financing of government spending therefore results in M3 expanding by the amount of the government's deficit.

This is, of course, monetary financing of the government deficit. It could be inflationary. So having forced a commercial bank to create money to fund its deficit, the government then drains the newly created money, leaving M3 at its original level.

The principal mechanism used to drain money created by government spending is bond issuance. Payments to government by purchasers of new bond issues are intermediated through the government’s commercial bank account, funding its deposit account and eliminating any overdraft. When a loan or overdraft is paid down, money is destroyed (eliminating the money created when the loan was made). Issuing new bonds ex post therefore reduces M3, while ex ante issuance prevents M3 expanding. Term deposits directly with the government (for example through NS&I) have the same effect.

And so do tax revenues. Bonds are redeemed as tax revenues are received. When the government’s spending (including bond interest payments) is entirely “financed” by bonds which are subsequently redeemed from tax revenues, the increase in M3 from government spending is wholly offset by the reduction in M3 from private sector purchases of new bonds, and their redemption from tax revenues is a wash. Regardless of how much the government spends, if it is wholly offset by bond issuance subsequently redeemed by taxation there is no net new money in the economy.

Of course, government spending may be expansionary for other reasons. Government expenditure mostly goes to people on low to middle incomes, who are likely to spend much of it, so increased government spending may raise the velocity of money even if M3 is unaffected. And investment expenditure can generate returns well in excess of the amount invested.

Government borrowing from central banks is inflationary when the absence of an external borrowing constraint enables the government to spend extravagantly and increased velocity arising from this pushes up prices and wages. This effect can be significant, but it would equally apply if government was borrowing from a captive commercial bank backed by unlimited central bank liquidity support. Prohibiting central bank financing but not commercial bank financing of government deficits is therefore absurd. Admittedly, if commercial banks are unwilling to fund the government deficit, the government can force the central bank to print physical currency and deliver it by a variety of mechanisms: helicopter drops, jars in the ground, brown envelopes, wheelbarrows…..But frankly, with a modern banking system, any government that had to resort to physical cash would already be in very deep trouble. After all, if it is so untrustworthy that domestic banks won’t lend to it, its days are numbered anyway.

Commercial bank lending to government is not really subject to central bank control. Central banks limit commercial bank lending to the private sector by controlling both the price of lending and its availability.  But as long as central banks are willing to supply reserves, and governments are willing to pay interest on their overdrafts, commercial banks will always create money for their governments. Central banks can discourage or prevent commercial banks lending to the private sector - but they can't stop commercial banks supporting their own government.After all, the central bank itself is beholden to its own government. The independence of central banks is entirely fictional.

But what about QE? If government bond issuance drains money, then surely a central bank purchasing bonds must create it.

Indeed it does. If a central bank - or a commercial bank, for that matter - buys all the bonds issued by a government in a budgetary cycle, M3 increases by the amount of the government's deficit exactly as if bonds had not been issued. So QE should be inflationary - and not because of magical multiplier effects arising from increased bank reserves, as flat-earthers monetarists think. Unless the central bank issues more physical cash, inflation comes from rising M3, not M0.

But there is little evidence that QE has much effect on consumer prices, although it does have a significant positive effect on asset prices. This seems to be because the distribution of the M3 increase arising from QE is very different from that arising from the original government spending. 

QE returns money to those who bought bonds, increasing bank reserves (M0) in the process. But increasing bank reserves does not force banks to lend. Returning money to the rich does not encourage them to distribute it more widely in the economy. Swapping one safe asset for another does not encourage the fearful to stop hoarding and spend money. And although QE might reduce yields on government bonds, this wouldn’t make any difference to monetary conditions: making it cheaper for governments to neutralise money growth doesn’t enhance money growth. Weakening the currency might help exporters but it wouldn’t improve domestic demand - indeed it might depress it still further by raising the price of imports.

It seems likely that because of its unfortunate distributional effects, QE simply cannot adequately replicate the velocity effects of direct government spending. Where the money goes matters even more than how much is created.The opportunity cost of relying on QE instead of fiscal stimulus after a severe negative demand shock, when fiscal multipliers are very large, is therefore considerable. And so is the harm done by premature fiscal consolidation undertaken in the belief that monetary policy will offset the negative effects. As I have shown here, it is painfully evident that QE does not fully offset the contractionary effects of fiscal consolidation.

So far, we have been talking about a currency-issuing sovereign with its own central bank. The Eurozone is more complex. But essentially, the same mechanism works there too. Spending in Euros by member state governments via Eurozone banks increases M3. Bond issuance by member state governments drains that increase, as does taxation. Central bank funding of government deficits is outlawed by Article 123 of the Lisbon Treaty, but commercial bank funding is not, so in theory there is nothing to prevent a Eurozone government forcing its banks to lend to it.

In fact they already do. But it's not a happy arrangement - and that is because rather than bank loans or overdrafts, governments have forced banks to buy bonds, exposing those banks to the risk of heavy losses if the market price of those bonds collapses. Since M3 rises when commercial banks buy bonds, these purchases have increased Eurozone M3. I hate to think what it would be without them. But this unfortunate arrangement is known as the sovereign-bank "doom loop", and so far no solution to it has been found. 

So why not replace those bonds with bank loans? Indeed why not end bond issuance completely, and fund government borrowing requirements entirely from bank lending, as Richard Werner of Southampton University has suggested? Hallelujah, we have a solution to the Eurozone crisis. Let all governments borrow directly from their banks to reflate their economies.

If only it were that simple. Eurozone member states have tied themselves into a treaty which requires them to balance their budgets over the business cycle and limit variation to 3% of GDP. To enforce compliance with these rules, the ECB has several times threatened to withdraw liquidity support from banks. Banks denied liquidity support cannot facilitate government spending. So even if Eurozone governments ended bond issuance tomorrow and funded their borrowing requirements entirely from bank lending, there would still be significant restriction of money growth due to ECB-enforced fiscal consolidation. And because the ECB, like all central banks, lacks the power to force commercial banks to lend, it cannot adequately offset this fiscal consolidation.

The only institutions that can create the money used for economic transactions in the real economy are commercial banks, and the only authority that can compel commercial banks to lend is the fiscal authority. Faux monetary expansion by central banks is no substitute for the real expansion caused by government deficit spending via commercial banks. So when the economy is on the floor, monetary conditions are tight and banks not lending to the private sector, unchain the fiscal authority - and stop worrying about deficits.

Related reading:

Printing clever weird stuff - Principles & Interest

Saturday, 3 January 2015

A Latin American tragedy

In my recent Forbes post about Venezuela, I said that neither the exchange rate policy nor the government's fiscal policy were sustainable, and the Maduro regime would eventually be forced to devalue and enact painful fiscal reforms. In the comments, Alexander Guerrero observed that it is already too late for this, because the economic mismanagement of the last few years has all but destroyed the supply-side of the economy: devaluation now would be likely to result in hyperinflation and default. 

The tragedy is that what is playing out now in Venezuela has happened many times before. Those who do not learn from history are doomed to repeat it.....and nowhere is that more true than in Latin America. In this paper from 1989, Dornbusch & Edwards examine the reasons for the parlous state of Peru's economy at that time in the light of the economic collapse of Chile in the early 1970s. These comments set the scene (my emphasis):
Our purpose in setting out these experiences, those of Chile under Allende and of Peru under Garcia, is not a righteous assertion of conservative economics, but rather a warning that populist policies do ultimately fail; and when they fail it is always at a frightening cost to the very groups who were supposed to be favored......
We are struck by the strong similarities in Chile, Peru,and in other episodes not developed in detail here of the way policy makers viewed the objective conditions of their economy, how they proposed that strongly expansionary policies should and could be carried out, and how they rationalized that constraints could be dealt with. And, of course, we are impressed by the fact that in the end, foreign exchange constraints and extreme inflation forced a program of violent real wage cuts that ended in massive political instability, coups and violence.
 But how does everything go so badly wrong?

Dornbusch & Edwards explain that the problem is a combination of factors:
The combination of external influences (debt crises,economic blockades etc.), domestic policies (socialization of firms, bank nationalization, etc.) and macroeconomic policies bring about an unsustainable economy where inflation is out of control, and the foreign exchange constraints force realism on policy makers.
 And they go on to list the four stages of the unfolding disaster.
Phase I: In the first phase, the policy makers are fully vindicated in their diagnosis and prescription: growth of output, real wages and employment are high, and the macroeconomic policies are nothing short of successful. Controls assure that inflation is not a problem, and shortages are alleviated by imports. The run-down of inventories and the availability of imports (financed by reserve decumulation or suspension of external payments) accommodates the demand expansion with little impact on inflation.

Phase II: The economy runs into bottlenecks, partly as a result of a strong expansion in demand for domestic goods, and partly because of a growing lack of foreign exchange. Whereas inventory decumulation was an essential feature of the first phase, the low levels of inventories and inventory building are now a source of problems. Price realignments and devaluation, exchange control, or protection become necessary. Inflation increases significantly, but wages keep up. The budget deficit worsens tremendously as a result of pervasive subsidies on wage goods and foreign exchange.

Phase III: Pervasive shortages, extreme acceleration of inflation, and an obvious foreign exchange gap lead to capital flight and demonetization of the economy. The budget deficit deteriorates violently because of a steep decline in tax collection and increasing subsidy costs.The government attempts to stabilize by cutting subsidies and by a real depreciation. Real wages fall massively, and politics become unstable. It becomes clear that the government has lost.

Phase IV: Orthodox stabilization takes over under a new government. An IMF program will be enacted; and, when everything is said and done, the real wage will have declined massively, to a level significantly lower than when the whole episode began! Moreover, that decline will be very persistent, because the politics and economics of the experience will have depressed investment and promoted capital flight. The extremity of real wage declines is due to a simple fact: capital is mobile across borders, but labor is not.
 To make their point, Dornbusch & Edwards provide the following charts of real wages for, respectively, Chile under Allende and Peru under Garcia.

Remember that at the time they wrote, Peru's collapse was in progress. The pattern is clear. When the economy collapses under the triple burden of supply-side dysfunction, unsustainable fiscal finances and capital flight, the real wage falls to below its previous level. The inevitable IMF program restores stability, but at the price of stagnation, inequality and poverty for much of the population. And as Dornbusch & Edwards explain, therein lie the seeds of the next crisis:
Initial conditions: The country has experienced slow growth, stagnation or outright depression as a result of previous stabilization attempts. The experience, typically under an IMF program, has reduced growth and living standards. Serious economic inequality provides economic and political appeal for a radically different economic program.The receding stabilization will have improved the budget and the external balance sufficiently to provide the room for, though perhaps not the wisdom of, a highly expansionary program.
Policymakers explicitly reject conservative economic policies and implement highly expansionary policies designed to reduce inequality and eliminate poverty quickly, usually by means of large real wage rises.  I was struck by the beliefs that justify such dramatic reversal in policy, in particular the rejection of conventional economics: Chavez, Allende and their kind simply don't think that the rules of economics apply to them. And when it all goes horribly wrong, they blame external factors while exonerating the domestic policies that have enabled external factors to exert such a destabilising influence on the country. It is hardly surprising if investors do not wish to invest in countries where their investments are at risk of expropriation, or where their profits could be wiped out by large government-mandated wage rises or sudden tax increases, or where rising inflation erodes not only their returns but their capital. The loss of capital investment arising from these policies is probably the most damaging aspect, since it erodes supply-side capacity and directly causes precipitous real wage falls when the collapse eventually comes.

Having said that, it is not reasonable to blame expansionary "populist" policies for economic collapses without taking account of the role of the preceding harshness in setting them up. IMF programmes may stabilise the economy, but too often at the cost of real suffering among the population: the desire to improve their lot is entirely understandable. Austerity breeds profligacy, which in its turn is forced to give way to even more austerity. Rinse, repeat. This has been the story of Latin America for a very long time.

Venezuela is currently in Phase III. There are pervasive shortages, inflation is over 65% and rising, and foreign reserves are declining sharply despite Venezuela's trade surplus. The budget deficit is currently at 17% and rising. The economy is demonetizing rapidly as more and more transactions are done on the black market. To make matters worse, the US government has imposed sanctions on Venezuela for suppressing dissent. So far, the government has resisted devaluation and subsidy cuts, but it cannot do so for much longer. Maduro - never as popular as his predecessor - is resorting to bribing the population with unsustainable fiscal expenditures, but this will only hasten the economic collapse that now appears inevitable. Venezuela is headed for default, hyperinflation, disorderly regime change and a wrenching fiscal adjustment. And the people who will suffer - indeed are already suffering - are the poor that Chavez and Maduro set out to help, just as the poor in Chile and Peru suffered.

Alexander Guerrero's warning about Venezuela seems all too prescient:
To put it in few words, our fiscal situation is similar with the Russian one in 1989 at the fall of communism in Europe. It means we have to go for a unlimited privatization process, I know that politically there is no way to get it, but we are driving to that point, I just beg God, that everything happens in peace, I doubt it any way!.
Poor Venezuela.

But this is not wholly a Latin American story. Much of what is described here also applies to Greece. The only difference is that Greece is in the Euro, so hyperinflation is impossible and all the adjustment must come from brutal fiscal retrenchment and sharp falls in real incomes. But if it were to leave the Euro, or worse, be thrown out for non-compliance with Troika demands.....

Be careful what you ask for, Mr. Tsipras.

Related reading:

Who pulled the switch?

Image from the Wall St. Journal