The transitory view of the current inflation episode is getting more support from the evidence.…
OMF – paranoia for many but a solution for all
When the Committee on Economic and Monetary Affairs (ECON) of European Parliament considered the 2012 Report from the European Central Bank, the Rapporteur of the Committee and Deputy President of the EP, Gianni Pittela tendered the – Draft Report – on June 11, 2013. The ECB presented its – Annual Report 2012 to the Committee on April 24, 2013. The ECB is accountable to the EP and this Committee was exercising its political functions under that relationship. Under the heading Monetary Policy, the draft report contained two interesting items (9 and 10). By the time the amendments were finalised you learned a lot about politics in Europe and why the current system is unworkable.
As background, the data in the following graphs is taken from the ECB data warehouse.
The first graph shows the annual inflation rate (derived from monthly CPI data excluding administered prices) for the Eurozone from January 2002 to October 2013. The inflation rate is falling quite rapidly at present and if the current trend continues the Eurozone will have be back into deflation (negative inflation).
The second graph shows the annual real GDP growth and inflation rates (quarterly data) for the same period. It doesn’t take too much imagination to see the correspondence between the two series. The deflation during 2009 was accompanied by a major collapse in real GDP growth.
More recently, the drop in inflation followed (the annual rates of inflation lag real GDP growth) the double-dip recession that began in the March-quarter 2012.
So the environment is one of low and decelerating inflation, heading towards deflation.
The ECON presented its – Final Report – on November 13, 2013. It bore little relation to the Draft Report and appears as a largely innocuous document that will change nothing.
Items 9 and 10 in the Draft Report were thus:
9. Considers that the monetary policy tools that the ECB has used since the beginning of the crisis, while providing a welcome relief in distressed financial markets, have revealed their limits as regards stimulating growth and improving the situation on the labour market; considers, therefore, that the ECB could investigate the possibilities of implementing new unconventional measures aimed at participating in a large, EU-wide pro-growth programme, including the use of the Emergency Liquidity Assistance facility to undertake an ‘overt money financing’ of government debt in order to finance tax cuts targeted on low-income households and/or new spending programmes focused on the Europe 2020 objectives;
10. Considers it necessary to review the Treaties and the ECB’s statutes in order to establish price stability together with full employment as the two objectives, on an equal footing, of monetary policy in the eurozone;
These might be termed the Modern Monetary Theory (MMT) proposals to temporarily redress some of the damage that is being done across the member Eurozone states by the flawed design of the monetary union.
These proposals were then subjected to a lengthy process of amendments. You can track the deliberations in the – Amendments Document – (July 12, 20013), which considered 247 proposed amendments to the Draft Report.
The discussions about Items 9 and 10 begin with proposed Amendment 109 on page 49 and you then zig-zag from the left-hand column (Motion for a resolution) to the right-hand column (Amendment) and snake your way down through the pages as each amendment is subsequently altered and the final outcome bears no relation to the starting point as above.
German conservative member Werner Langen is a card. Amendment 116 says (in part):
Considers that the monetary policy tools that the ECB has used since the beginning of the crisis may have provided welcome relief in distressed financial markets in the short term, but the easy money policy has done nothing to bring about a lasting economic recovery; considers, therefore, that the only way to promote growth is through sustainable economic policy and purposeful structural reforms, that the ECB must concentrate primarily on the goal of price stability, and that ECB financing of government debt is unlawful and must be prevented at all costs;
So get that!
“Must be prevented at all costs” – which include youth unemployment above 60 per cent in some nations, almost permanenent stagnation across the monetary union, failing public services and increasing poverty rates.
No, we will not have any “ECB financing of government debt”! Not ever.
If the focus of the discussions was not so important you would read these deliberations as some sort of comedy script. The mincing of words to avoid the reality. At least Werner Langen has the directness to come right out and be up front about his paranoia.
By Amendment 120, he was sick of the to and fro and proposed a completely new version of Item 9:
Welcomes the Annual Report of the Bank for International Settlements and its finding that an accommodative monetary policy has caused reform efforts in the eurozone to slacken and the dependence between banks and sovereigns has increased;
I am not sure he was on the planet much that day given that the deliberations were about the ECB and not the Bank of International Settlements.
But we can forgive him for being a little off – he was nursing his paranoic fears about what might happen if the dreaded OMF – overt monetary financing – might be considered in public at all, much less become an operational reality as the ECB took of its ridiculous straitjacket and actually did something positive for European people for a change.
The discussion about Item 10 was similarly comical and I will leave it to you to trace it through. But just in case you think this is a blog that is attacking the German national illness (fear of inflation) think again.
There were stunning contributions from others. The Dutch born libertarian politician Derk Jan Eppink, who now stands as a Belgian member of the EP (affiliated with the right-wing List Dedecker party) provided some perspective.
In the last few days (November 22, 2013), this character wrote an Op Ed article – Ireland and Greece prove the naysayers wrong.
But in the Amendments debate he proposed this change to Item 10 (Amendment 136):
Underlines that the primary mandate of the ECB is to maintain price stability in the Euro area, and that the achievement of this mandate overrides subordinate objectives such as supporting economic growth and job creation;
Bow down to the god of inflation control and subjugate peoples’ jobs and income to it.
Werner was not to be silenced though, and by Amendment 137 he wanted the price stability objective canonised in the holy writ:
Endorses the objective of maintaining price stability, which the ECB is called upon to pursue as a matter of priority, as is laid down in the Treaties and in the ECB’s statutes, and stresses that monetary policy cannot be a substitute for necessary structural reforms and sustainable economic policy;
So staying on song.
On July 22, 2013, the Item 9 proposal was considered in the following Op Ed article by Biagio Bossone and Richard Wood – Overt Money Financing of Fiscal Deficits: Navigating Article 123 of the Lisbon Treaty.
They argued a very MMT-line that the “greater coordination between monetary and fiscal policy could provide substantial policy synergies needed to stimulate economic growth without increasing public debt”. Not that increasing public debt should weight any attention if the central bank is doing its job properly.
I don’t agree with all the claims made by these two authors. They clearly lapse into believing the issue is ineffectiveness of monetary policy in times of “historically low interest rates” (the so-called liquidity trap explanation that the softer New Keynesians like Paul Krugman entertain, wrongly).
But it is true that “Many economies are entrapped in austerity straitjackets” and that “austerity fails to achieve its own objectives” because:
… fiscal revenues contract, budget deficits increase, and public debts are pushed upward. Austerity aggravates recession or depression …
After (rightly) rejecting QE as a way forward, they propose a “practical pro-growth economic plan” – (I hope Werner is sleeping soundly as I write this) – Overt Monetary Financing (OMF).
OMF is proposed as “the means to resolve the problems of insufficient demand and high public debt simultaneously”.
Their article then outlines several gymnastic-type ways to get around what they term “institutional constraints” (Lisbon Treaty Article 123 (which prohibits the ECB from buying member-state debt); credit rating agencies responses, accounting standards etc) to allow the ECB to directly fund member state deficits (OMF).
I would rather just propose getting rid of Article 123 altogether, ignoring the credit rating agencies, and modifying the accounting standards to suit.
On the credit-rating agencies, their assessment of sovereign debt is irrelevant. Japan proved that categorically in the early 2000s. And if OMF eliminates the need to issue debt then they become irrelevant for the Eurozone as well.
The authors lapse themselves into thinking that OMF is okay because it avoids Ricardian equivalence issues. They say:
Since no debt service burden will arise from OMF, no future tax revenues will be required and no (Ricardian) offsetting savings would take place.
A sop to the mainstream. There has never been any credible empirical evidence produced by anyone to show that private households and firms deliberately stop spending and increase saving when deficits rise because they fear future tax increases and want to save up to pay for them.
Ricardian agents only exist in the rarified world of mainstream macroeconomic textbooks and have never been observed at large in the real world.
So when proposing a progressive solution why even acknowledge this mythical (non)-problem?
The authors acknowledge that the central bank can extend funds to the member-states at zero cost – “the cost of producing money is zero” and the central bank “cannot become illiquid, and can operate quite effectively with negative accounting net worth”.
That is, the ECB can never go broke. Please read my blog – The US Federal Reserve is on the brink of insolvency (not!) and The ECB cannot go broke – get over it – for more discussion on this point.
So the proposal is simple even if some of the gymnastics to get around the stifling European rules are not.
1. It amounts to the ECB telling member states that they will provide the Euros to permit sufficient deficit spending aimed at increasing employment and production.
2. No public debt is issued.
3. No taxes are raised.
4. Interest rates would not rise.
5. A Job Guarantee could be introduced immediately.
6. The Troika can retire – no more bailouts.
7. As growth returns, structural changes – better public services, better schools, better health care etc can be implemented. Growth allows structural changes to occur more quickly because people are happy to move between jobs if there are jobs to move between.
Ah, but this is money printing gone wild (echoing Werner!).
Alas, no new money would need to be printed! Governments spend by crediting bank accounts in the main. They do not spend by printing money.
None of the proposal is new however.
In 1943, Abba Lerner produced one of the best 14 pages ever written by an economist. The article – Functional Finance and the Federal Debt – appeared in the journal Social Research, Vol 10, pages 38-51.
In his second paragraph, Lerner writes:
In recent years the principle by which appropriate government action can maintain prosperity have been adequately developed, but the proponents of the new principles have either not seen their full logical implications or shown an over-solicitousness which caused them to try to save the public from the necessary mental exercise. This has worked like a boomerang. Many of our publicly minded men who have come to see that deficit spending actually works still oppose the permanent maintenance of prosperity because in their failure to see how it all works they are easily frightened by fairy tales of terrible consequences.
So if you think all the deficit terrorism is new think again. The amplifiers that propagate it are more powerful now (blogs, E-mail, cable TV etc) but the same worn out fear mongering was there in the 1940s as Lerner was writing as it is in 2013.
For non-economists, he was writing at a time where the ideas of Keynes and others were commanding sway. The Second World War was still in progress but the military spending associated with it proved categorically that deficit spending could eliminate the worst recession.
The Great Depression really didn’t end until the War started and the governments spent millions on armaments etc.
In this article, Lerner was seeking to elucidate the idea of the “new fiscal theory” (of Keynes etc) – “to pose the theorems in the purest form” so as to tease out “all the unorthodox implications”.
He was writing at a time when there was scepticism in the academy about the new ideas, which he suggested were “extremely simple” but which “learned professors who find it hard to abandon ingrained habits of thought” had tried to make more complicated by “dressing it up to make it more complicated and accompanying the presentation with impressive but irrelevant statistics”.
The article then said:
The central idea is that government fiscal policy, its spending and taxes, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound or unsound.
It was this principle he terms Functional Finance.
He also said that the:
… first financial responsibility of the government (since nobody else can undertake that responsibility) is to keep the total rate of spending in the country on goods and services neither greater nor less than that rate which at the current prices would buy all the goods that it is possible to produce … the government can increase total spending by spending more itself or by reducing taxes so that taxpayers have more money left to spend.
And the same in reverse.
He says that sometimes the government might run a surplus and at other times a deficit and in “neither case should the government feel that there is anything especially good or bad about this result; it should merely concentrate on keeping the total rate of spending neither too small nor too great, in this way preventing both unemployment and inflation”.
On taxes and bond-issuance we read:
1. Taxation is not undertaken “merely because the government needs to make money payments” and the government can get more money to spend more easily by “printing money”.
2. The only purpose of bond issuance is if it is deemed “desirable that the public should have less money and more government bonds, for these are the effects of government borrowing. This might be the situation if those who are holding cash decide to “lend it out … and induce too much investment”.
He notes the “almost instinctive revulsion … to the idea of printing money, and the tendency to identify it with inflation” but that:
… we calm ourselves and take note that this printing does not affect the amount of money spent. That is regulated by the first law of Functional Finance, which refers to inflation and unemployment.
In other words, it is spending that creates the inflation risk. And as long as total spending is at the appropriate level specified above, then “printing money” will be an appropriate accompaniment to total government spending.
And the implications of all that are that:
… Functional Finance rejects completely the traditional doctrines of “sound finance” and the principle of trying to balance the budget over a solar year or any other arbitrary period.
The point to note is that the inflation risk lies in the spending not the monetary operations (debt-issuance etc) that might or might not accompany the spending.
All spending (private or public) is inflationary if it drives nominal aggregate demand faster than the real capacity of the economy to absorb it.
Increased government spending is not inflationary if there are idle real resources that can be brought back into productive use (for example, unemployment).
Related propositions include the claims that issuing bonds to the central bank, the so-called ‘printing money’ option, devalues the currency whereas issuing bonds to the private sector reduces the inflation risk of deficits. Neither claim is true.
First, there is no difference in the inflation risk attached to a particular level of net public spending when the government matches its deficit with bond issuance relative to a situation where it issues no debt, that is, invests directly.
Bond purchases reflect portfolio decisions regarding how private wealth is held. If the funds that we used for bond purchases were spent on goods and services as an alternative, then the budget deficit would be lower as a result.
Second, the provision of credit by the central bank (in return for treasury bonds) will only be inflationary if there is no fiscal space.
Fiscal space is not defined in terms of some given financial ratios (such as a public debt ratio).
Rather, it refers to the extent of the available real resources that the government is able to utilise in pursuit of its socio-economic program.
Further, hyperinflation examples such as 1920s Germany and modern-day Zimbabwe do not support the claim that deficits cause inflation. In both cases, there were major reductions in the supply capacity of the economy prior to the inflation episode.
As Lerner said we should “calm ourselves and take note that this printing does not affect the amount of money spent.
I would not use the term “printing” but the principle is clear. Spending creates inflation risk not how that spending is facilitated.
OMF is the most effective solution to the Eurozone crisis without tearing down the monetary union.
That is enough for today!
(c) Copyright 2013 Bill Mitchell. All Rights Reserved.
This Post Has 7 Comments
“So the environment is one of low and decelerating inflation, heading towards deflation. Deflation is damaging because it undermines nominal income growth and …”
Hi Bill, what’s the end of that sentence? Must’ve been in a hurry today 🙂
Thanks Apj (at 2013/11/28 at 17:56)
Not so much hurry but the hour I was writing (jet lag issues).
Not to forget a technicality.
The ecb would need to pay interest on the euro balances it creates when spending/lending, in order to support their policy rate (if positive).
They call it sterilization and note they necessarily spend/lend first, then sterilize/borrow
sorry to be off topic but I want to pick the good brains on this blog
why in the UK do banks borrow from the central banks funding for lending scheme
when they could just create the money without the small level of interest attached
Neil Wilson has a nice post on that subject:
Today I read a very interesting piece from Jason Bond (Why the Fed Won’t Taper) where he introduces a graph from the Saint Louis Federal Reserve that shows the ratio of the “M1 Money Multiplier” having dropped continually over the period from 1987 to today (from over 3.0 to below 1.0) and it really fell off a cliff as the GFC began in 2008. This graph was prefaced with the statement that it “must scare the Fed the most” and hence is the primary reason QE will continue at its current rate for the foreseeable future (along with continuing declines in the US Labor Participation rate). I realize the general opinion here with regard to QE and also the concept of a money multiplier, but I also saw where the author introduced this equation:
GDP = C+I+G+(X-M)
which looked awfully familiar (in this case I believe that “G” stood for net government spending). He notes that if C (consumption) and I (gross investment) are weak, only G could pick up the slack. Now, he also goes on to state that the Fed must pick up the bond buying if China and Japan are cutting back, which we understand to be a misrepresentation of the dynamics in a fiat economy, but still I thought this was progress of a sort. In this installment of Billy Blog, we are seeing the (albeit slow) change in the ECB toward a more accommodative stance in policy, which of course drives the Germans bonkers.
Given the above, I think there may be some small cause for celebration?
Here are the links to the piece and the graph I reference herein:
The government is not fiscal constrained to service the debt, it is however extra spending which could be inflationary. Any increase in the government’s deficit can result in greater aggregate spending on existing productive capacity, so if the government is sending more interest to bond holders, ceteris paribus, this is creating the potential for inflation.So therefore the primary benefit of stopping bond issuance and debt service is freeing up fiscal space for useful primary deficit spending.