The Governor gets confused

A few weeks ago in this blog – So who is going to answer for their culpability? – I wrote about the IMFs latest “discovery” that their policy advice, which has caused millions to become unemployed and nations to shed income and wealth in great proportions and all the rest of the austerity detritus, was based on errors in estimating the value of the multiplier. They now admit the expenditure multipliers may be up to around 1.7, which means that for every dollar of government spending, the economy produces $1.70 of national income. Under their previous estimates of the multiplier, a dollar of government spending would translate into only 50 cents national income (a bad outcome). The renewed awareness from the arch-austerity merchants that they were wrong and that fiscal policy is, in fact, highly effective, has to be seen in the light of the continued obsession not only with fiscal austerity but also with discussions surrounding monetary policy. There have been many articles over the last few years expressing surprise that the vast monetary policy changes have had little effect. But as soon as the writers note this they launch into the standard arguments about inflation risk and the rest of the narratives that accompany discussions about central banks. Soon we will have to accept the fact that monetary policy is not a suitable tool to stabilise aggregate demand at appropriate levels. We will also have to acknowledge that the only way out of the crisis is via renewed fiscal stimulus.

There was an recent article (October 23, 2012)- Gauging the multiplier: Lessons from history – by Barry Eichengreen and Kevin O’Rourke, which considered the evidence relating to the size of the multiplier.

The full reference that the Voxeu OP Ed summarises is Almunia, M., Benetrix, A., Eichengreen, B., O’Rourke, K. and Rua, G. (2010) ‘From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons’, Economic Policy, 25.

The Voxeu article notes that the admission by the IMF means that:

… Europe’s policies of austerity are in fact directly responsible for the fact that the continent’s recessions have been even deeper than initially forecast.

A conclusion that was obvious from the time the neo-liberal regained control of the policy debate and embarked on the austerity push. Now, even some of the main architects of that austerity – the IMF – are acknowledging that, although I have been waiting for Madame Le Garde to resign, given the damage her organisation has inflicted on the world.

The Voxeu authors summarise evidence of historical studies based on 27 countries during a period (1930s) when monetary policy settings were similar to today (low interest rates) and the world was beset by a balance sheet recession.

For an explanation of a balance sheet recession, please read my blog – Balance sheet recessions and democracy.

The multiplier estimates they produce vary between 2.5 in the first year to 1.2 after that – in the case of defence spending. It is clear that the Great Depression ended when the nations scaled up their military spending to prosecute the Second World War effort. It was a classic budget deficit stimulus although clearly the world would have been better served had the spending gone into education, hospitals, and other non-military outcomes. But it was the times and the despot had to be stopped.

In terms of non-defence government spending their “estimate of the multiplier is 1.6 when evaluated at the median values of the independent variables”, which means that “the IMF’s new estimates are, if anything, on the conservative side”. That is, fiscal austerity is likely to cause even more damage than the IMF’s estimates are now showing.

Consider that information in the light of the following. The Governor of the Bank of England, Mervyn King gave a – Speech – on October 23, 2012 to the South Wales Chamber of Commerce at The Millennium Centre, Cardiff.

It was an exercise in contradiction but has some illuminating moments.

In the context of a slowing world economy collapsing under the yoke of self-imposed austerity (by the elites who personally do not bear the burden – having high salaries and largely secure jobs and pensions) and, recognising that the UK has “its own currency and control of monetary policy”, the Governor admits that:

… this unprecedented degree of monetary loosening has prevented a depression, it has caused pain to those dependent on interest income. And we have not been able to avoid a sharp rise in youth unemployment.

Which tells you that, in fact, the monetary policy bias at present has not delivered. Part of the bias towards monetary policy as the principle stabilisation policy tool and the downgrading of fiscal policy was due to the flaky estimates of fiscal multipliers that keep being pumped out by the mainstream of my profession who sought to bolster their ideological distaste for government spending and taxation.

They stood defiant when challenged and quoted one IMF study after another (or other studies), all of which claimed multipliers were low if not negative.

It is now clear – and it is something that Modern Monetary Theory (MMT) proponents have known for a long time – that fiscal policy is very effective while the impact of monetary policy is relatively unknown but clearly not very stimulatory.

The Governor then asserted that:

In the long run, we will need to rebalance our economy away from domestic spending and towards exports, to reduce our trade deficit, to repay our debts, and to raise the rate of national saving and investment.

Which demonstrates his biases. Modern Monetary Theory (MMT) does not prioritise income growth driven by export growth over domestically-sourced spending growth. Indeed, given exports are a “cost” to the nation (they deprive the local population of the use of the resources shipped abroad) the only reason a nation would want to export would be to get more imports back in return – in real terms.

An external deficit is not something that should be targetted by policy for reduction. It represents a positive real terms of trade because it means that foreigners are willing to ship more real goods and services to a nation in return for receiving less back in return.

The Governor then gave a short lesson to the audience about how he considered monetary policy works. There was truth amongst the fiction.

He said:

When banks extend loans to their customers, they create money by crediting their customers’ accounts. The usual role of a central bank is to limit this rate of money creation, so that an excessive expansion of money spending does not lead to inflation. But a damaged banking system means that today banks aren’t creating enough money. We have to do it for them. And as private sector balance sheets contract, public sector (government and central bank) balance sheets have to take the strain. The way in which the Bank of England expands the money supply is to purchase government gilts from the non-bank private sector and credit the bank accounts of people from whom the gilts are purchased.

A fundamental precept of MMT is that loans create deposits not the other way around. This is more than a catchy phrase, even though it is a catchy slogan.

Loans creates deposits means that the mainstream textbook treatment of monetary policy and the constraints which are claimed to prevent government spending from being effective (so-called crowding out effects) is wrong.

The mainstream theory alleges that the money multiplier m transmits changes in the so-called monetary base (MB) (the sum of bank reserves and currency at issue) into changes in the money supply (M).

The formula for the determination of the money supply is: M = m x MB. So if a $1 is newly deposited in a bank, the money supply will rise (be multiplied) by $10 (if the required reserve ratio = 0.10).

Please read my blog – Money multiplier and other myths – for more discussion on this point.

The way this multiplier is alleged to work is explained as follows (assuming the bank is required to hold 10 per cent of all deposits as reserves):

• A person deposits say $100 in a bank.
• To make money, the bank then loans the remaining $90 to a customer.
• They spend the money and the recipient of the funds deposits it with their bank.
• That bank then lends 0.9 times $90 = $81 (keeping 0.10 in reserve as required).
• And so on until the loans become so small that they dissolve to zero.

So you should expect a fairly constant relationship between the monetary base and the measures of the money supply. Indeed, mainstream theory claims that the central bank uses this relationship to control the money supply.

In his Principles of Economics (I have the first edition), Mankiw’s Chapter 27 is about “the monetary system”. In the latest edition it is Chapter 29.

In the section of the Federal Reserve (the US central bank), Mankiw claims it has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system”. So I suppose on that front he would be calling for the sacking of all the senior Federal Reserve officials given the massive collapse that occurred under their watch.

The second “and more important job”:

… is to control the quantity of money that is made available to the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy (emphasis in original).

And in case you haven’t guessed he then describes how the central bank goes about fulfilling this most important role. He says that the:

Fed’s primary tool is open-market operations – the purchase and sale of U.S government bonds … If the FOMC decides to increase the money supply, the Fed creates dollars and uses them buy government bonds from the public in the nation’s bond markets. After the purchase, these dollars are in the hands of the public. Thus an open market purchase of bonds by the Fed increases the money supply. Conversely, if the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars it receives for the bonds are out of the hands of the public. Thus an open market sale of bonds by the Fed decreases the money supply.

This September 2008, Federal Reserve Bank of New York Economic Policy Review artcle – Divorcing Money from Monetary Policy – demonstrated why the account of monetary policy in mainstream macroeconomics textbooks (such as Mankiw and in the Governor’s Speech etc) is flawed.

The FRBNY article states clearly that:

In recent decades, however, central banks have moved away from a direct focus on measures of the money supply. The primary focus of monetary policy has instead become the value of a short-term interest rate. In the United States, for example, the Federal Reserve’s Federal Open Market Committee (FOMC) announces a rate that it wishes to prevail in the federal funds market, where overnight loans are made among commercial banks. The tools of monetary policy are then used to guide the market interest rate toward the chosen target.

This is practice is not confined to the US. All central banks operate in this way and I have shown in other blogs that central banks cannot control the “money supply”.

There is no unique relationship of the sort characterised by the erroneous money multiplier model in mainstream economics textbooks between bank reserves and the “stock of money”.

MMT shares the Post Keynesian view that the “money supply” is endogenously generated (that is, cannot be controlled by the central bank) – and, as such, attaches very little meaning to the aggregate.

The idea that the central banks controls the money supply is a residual from the commodity money systems where the central bank could clearly control the stock of gold, for example. But in a credit money system, this ability to control the stock of “money” is undermined by the demand for credit.

The theory of endogenous money is central to the horizontal analysis in MMT. When we talk about endogenous money we are referring to the outcomes that are arrived at after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).

The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 is just an arbitrary reflection of the credit circuit. Please read my blog – Understanding central bank operations – for more discussion on this point.

So the supply of money is determined endogenously by the level of GDP, which means it is a dynamic (rather than a static) concept. Central banks clearly do not determine the volume of deposits held each day. These arise from decisions by commercial banks to make loans. The central bank can determine the price of “money” by setting the interest rate on bank reserves.

Further expanding the monetary base (bank reserves) as I argued in these blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit.

While the central bank cannot control the broad money supply aggregate, the total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not affected by private banks’ lending decisions.

The liquidity facilities introduced by the Federal Reserve in response to the crisis have created a large quantity of reserves. While changes in bank lending behavior may lead to small changes in the level of required reserves, the vast majority of the newly-created reserves will end up being held as excess reserves almost no matter how banks react. In other words, the quantity of excess reserves reflects the size of the Federal Reserve’s policy initiatives, but says little or nothing about their effects on bank lending or on the economy more broadly.

This conclusion may seem strange, at first glance, to readers familiar with textbook presentations of the money multiplier. The reality is that the central bank does not have the capacity to control the money supply.

In the world we live in, bank loans create deposits – as the Governor acknowledges – and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank.

The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.

The mainstream view is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves.

The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.

But banks do not operate like this. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.

The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.

When discussing the impacts on quantitative easing activities conducted by the central bank – in terms of the way they alter bond prices and change yields, the Governor admits that:

The size of these effects is of course uncertain. But there can be no doubt that our economy would have followed an even more painful path over the past few years in the absence of asset purchases.

This is an important point. Central bankers do not demonstrate in any coherent way that they understand the magnitudes of the impacts of their policy activities.

That conclusion applies to both the standard measures they employ – altering the overnight cash rate – or the non-standard balance sheet activities (for example, quantitative easing). They assert – as Governor King has done here – that the policy changes make a difference – but there is little hard evidence and analysis to substantiate those assertions.

We cannot even be sure whether cutting rates is expansionary. As the Governor admitted above – it certainly hurts those on fixed incomes. It hurts creditors, while aiding debtors. These distributional effects are not clearly defined.

There is every reason to believe that they will, at least offset each other.

Further, monetary policy works in an indirect manner. Inasmuch as it might stimulate spending it does so indirectly by people altering their consumption and investment patterns as the cost of borrowing falls. But consumers will not spend more as a result of credit being cheaper if they fear for their jobs.

Firms will not invest in new capacity if they can meet current and expected demand with the capacity they already have in place.

So there are unknown time lags between the cost of credit falling and borrowers deciding to increase their access to credit.

In the current climate, it is clear that monetary policy changes have not led to the anticipated rise in private borrowing. That is a good thing given that private debt levels are largely the reason the crisis unfolded in the first place.

We have been beguiled by the neo-liberal press into believing the crisis is about sovereign debt levels. That narrative suits their anti-government agenda. But the reality is that the crisis is sourced and being prolonged by a private debt binge and fiscal austerity is exacerbating it.

Further, it is also likely, especially given the new evidence about fiscal multipliers, that the rising budget deficits (an act of fiscal policy) saved the world (or most of it) from depression.

The nations that are now in or close to depression (Greece is in depression, other nations are heading that way) is because of fiscal austerity.

The credit being claimed by the Governor for the role played by monetary policy in saving the world from depression is not warranted. The early monetary policy changes stabilised the financial system. But the interventions from the ECB, for example, via the SMP are more fiscal policy actions.

The Governor also supports the contention that a path out of the crisis requires:

A downward correction of expectations about future incomes and wealth has rendered unprofitable some of the investments made before the crisis.

He uses the over-investement “in shopping centres” as an example.

The crucial point is that:

Households, businesses and, especially, banks are all deleveraging.

Nowhere is the overhang of debt more obvious than in the banking sector where deleveraging is holding back the flow of new lending.

The question he doesn’t address adequately is how policy can support this process. In a balance sheet recession, this realignment in asset values and balance sheet compositions can take many years.

While the adjustment process in on-going, non-government demand (spending) is likely to be muted. The only way that growth can continue – which itself provides the income support for the private sector to run down their debt levels into safer territory – is if fiscal policy takes up the slack.

Monetary policy – which alters interest rates – will not be effective because no-one wants to – nor should they – increase their borrowing. The recession has to be resolved with a combination of balance sheet adjustments and fiscal stimulus – and those elements must persist for years – maybe 10-15 years.

The Governor failed to tell his audience about the crucial role of fiscal policy in this adjustment process.

Sure enough, central bank policy changes can reduce the cost of borrow and make the balance sheet adjustments “cheaper”. But that doesn’t increase spending.

The stimulus to spending to keep income growth positive and avoid private insolvencies has to come from fiscal policy and the associated spending multipliers that are triggered by increases in government budget deficits.

The Governor then gave a problematic account of the difference between what he termed “good” and “bad” money creation in the context of quantitative easing.

He said:

Over the past three years, the Bank of England has bought £375 billion of government bonds – gilts – from the private sector to create a lot of new money. Many – perhaps some of you – are understandably concerned about the use of such an unusual and unfamiliar policy. Some people talk about the dangers of money creation. I want to explain why it is important to distinguish between “good” and “bad” money creation. In essence, the argument is very simple. “Good” money creation is where an independent central bank creates enough money in the economy to achieve price stability. “Bad” money creation is where the government chooses the amount of money that is created in order to finance its expenditure. Insufficient money creation can lead to a contraction of the money supply and a depression. We saw that in the United States during the Great Depression and we see it today in Greece. Excessive money creation leads to accelerating inflation and ultimately the collapse of the currency.

Quantitative easing creates bank reserves. The expansion of bank reserves carries no inflation risk. Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.

What determines the inflation risk that an economy faces is the relationship between nominal aggregate demand growth and real output capacity. There is no unique, monotonic relationship between the expansion of bank reserves (something the central bank can engineer) and the inflation risk a nation faces.

He further considers whether:

… money created by the Bank could be used directly to finance additional government spending, or even that money could be given away … such operations would combine monetary and fiscal policies.

There is no need to combine them because, as now, once the Bank has decided how much money should be created to meet the inflation target, the case for the Government to increase spending or cut taxes to counter a downturn stands or falls on its own merits. What determines the interest rate at which the government can borrow, however, is the path for the amount of government debt held by the private sector, rather than the total amount of gilts in issue. That is true when the Bank purchases gilts and will be true later when the Bank comes to sell the gilts.

The central bank doesn’t determine “how much monetary should be created”. Commercial bank loans create deposits. Please re-read the earlier parts of this blogs and the related links if you are unsure about this.

The interest rate at which the government can borrow can be solely determined by the central bank should it wish to do so. By offering to buy an unlimited amount of government debt (at some maturity range – for example, 10 years) at a given interest rate, including zero – the central bank rules the private bond markets impotent.

It is just a charade the governments and central banks play, which allows the private bond markets to determine yields via the competitive tendering process.

But the Governor’s real message is that:

Not only is combining monetary and fiscal policies unnecessary, it is also dangerous. Either the government controls the process – which is “bad” money creation – or the Bank controls it and enters the forbidden territory of fiscal policy.

This is in relation to the falsehood that the Governor spreads along with the overwhelming majority of my profession – that government spending backed by central bank reserves is inflationary – and that issuing bonds to cover public deficits reduces the inflation risk.

The mainstream macroeconomic textbooks all have a chapter on fiscal policy (and it is often written in the context of the so-called IS-LM model but not always).

The chapters always introduces the so-called Government Budget Constraint that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. The writer fails to understand that government spending is performed in the same way irrespective of the accompanying monetary operations.

The textbook argument claims that money creation (borrowing from central bank) is inflationary while the latter (private bond sales) is less so. These conclusions are based on their erroneous claim that “money creation” adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.

All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.

So what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt? This would be “dangerous” behaviour in the Governor’s view.

Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.

The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made.

Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet).

Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.

This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target.

Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.

There is no sense that these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance.

So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.

What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.

The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).

There is no difference to the impact of the deficits on net worth in the non-government sector.

This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.

It is totally fallacious to think that private placement of debt reduces the inflation risk.

Conclusion

I have to rush now to catch a flight. I am off again to work in Melbourne for a few days. As usual on Friday’s blog space – we will be textbook writing.

That is enough for today!

(c) Copyright 2012 Bill Mitchell. All Rights Reserved.