Options for Europe – Part 69

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).

Part III – Options for Europe

Chapter 17 Overt Monetary Financing?

[PRIOR SECTIONS HERE]

Why is Overt Monetary Financing taboo and should it be?

[PRIOR MATERIAL HERE]

[CONTINUING THIS SECTION WITH NEW MATERIAL TODAY]

This brings us to a further misconception that is related to the fear of inflation argument against OMF. The mainstream macroeconomic textbooks all have a chapter on fiscal policy, which introduce the so-called Government Budget Constraint (GBC). The claim is that governments face funding constraints in the same way as a household and thus have to raise income via taxation or borrow to finance their spending. It is acknowledged that governments are not quite like households because they can create money out of thin air, a capacity that no household possesses. But that option is eschewed and vilified for the reasons we have discussed. To further the case against money creation, the textbooks claim that the expansionary impact of a fiscal deficit in terms of total spending in the economy is lower if the government matches the deficit with debt-issuance to the private sector relative to if it just creates money. In other words, the inflation risk is much higher under OMF. The reason advanced is that when the government issues debt it not only drains the excess reserves in the banking sector created by deficit and, thus, takes private purchasing power out of the monetary system, but, further, by ‘competing’ for funds with other private borrowers it pushes the interest rate up, which chokes of some private spending. This is the so-called ‘crowding out’ effect of ‘debt finance’.

In presenting their case in support of OMF, Bossone and Wood (2013) seem to be operating within this mainstream paradigm. They advocate OMF because they concur with the concern that “in cases where public debt is already high and ‘conventional’ government bond sales are used to finance the budget deficits” interest rates will rise. In this regard, they conclude that:

Fiscal multipliers and marginal propensities to consume ordinary goods and services would be relatively larger under overt money financing than under quantitative easing/new bond financing of budget deficits. Overt money financing offers the most powerful combination of monetary and fiscal policies to combat the dual problems of recessions/depressions and high public debt.

There are several issues that need to be dealt with here. First, the ‘financial crowding out’ argument, which is a central plank in the mainstream economics attack on government fiscal intervention, is based on a totally false construction of the financial system. At the heart of this misconception is a flawed viewed of financial markets. The Classical economists advanced the so-called ‘loanable funds doctrine’ which claimed that the loanable funds market mediates saving and investment via interest rate variations. Thus, saving (supply of funds) responds positively to rising interest rates because savers can get a higher return and increase their future consumption possibilities. Investment (demand for funds) declines with the interest rate because the costs of funds to invest in (houses, factories, equipment etc) rises. In this theory, shortages of funds for lending push up interest rates and vice versa.

According to this theory, if the fiscal deficit rises and the government increases its borrowing then interest rates have to rise because there are now more borrowers in the market competing for the scarce savings. The higher interest rates then choke off some private investment spending – it is deemed to have been ‘crowded out’ by the government spending. But in the real world, a point that was made by John Maynard Keynes in the 1930s when he demolished the ‘crowding out’ hypothesis, total saving rises when national income rises. In other words, when the government increases its net spending (that is, the deficit rises) it not only increases national income but total saving also rises. In Chapter 18, we learned that deficit spending also creates new financial assets in the non-government sector, which show up as increased reserves in the banking system, once all the transactions (purchases and sales) are accounted for. These extra assets, held initially as bank account balances, are available to buy the newly issued government bonds. In this way, the sale of debt by the government is really ‘borrowing’ funds that the government has already spent into existence when it ran the deficit. The sale of bonds just alters the composition of the portfolio of assets that are held by the non-government sector (more interest-bearing bonds and less bank deposits). In that context, it makes no sense to say that government borrowing rations finite ‘savings’ which could alternatively finance private investment.

Ask yourself the question – what would happen if the government didn’t borrow and used OMF instead? Like all government spending, the treasury would spend by instructing the central bank to put money into the bank accounts of the recipients of the spending, which would involving ‘crediting’ 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 (reserves increase) and its liabilities also increase because a deposit would be made on behalf of the recipient of the government spending. The transactions are clear: the commercial bank’s assets and liabilities rise because a new deposit has been made by the government spending. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth. Taxation does the opposite and so a fiscal deficit (spending greater than taxation) means that bank reserves increase and private net worth increases.

This means that there are likely to be excess reserves in the banking system, which then raises issues for the central bank about its liquidity management. The aim of the central bank is to ‘hit’ its ‘target’ or policy interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target. For a commercial bank, excess reserves constitute dead-money unless the central bank pays a return on them. If there is no return on the excess reserves held overnight, the banks will scurry to seek interest-earning opportunities by loaning to other banks in the interbank market, which might have a shortage of reserves. The excess reserves put downward pressure on the overnight interest rate because banks will accept anything above a zero return, which is what they get if they cannot rid themselves of the surplus funds. Faced with this competitive situation, 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 interest rate it seeks to maintain as its expression of the monetary policy stance. Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation. The ‘penalty’ for the central bank that doesn’t pay interest on reserves would be a Japan-like zero interest rate. Should a default support rate be paid on excess reserves, the interest rate would converge on that support rate. Any economic ramifications (like inflation or currency depreciation) would be due to lower interest rates (stimulating excessive nominal growth rates relative to the real capacity of the economy) rather than any notion of OMF.

What would happen if the government borrowed to match its fiscal deficit? All that happens is that the banks reserves are reduced by the bond sales. But this does not reduce the level of bank deposits created by the net governmentspending. In other words, the net worth of the non-government sector 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 (as in OMF) and issuing debt to the private sector is that the central bank has to use different liquidity operations to maintain 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 are no differences in the impact that the fiscal deficits have on net worth in the non-government sector.

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend. That is clearly not the case in a modern monetary economy. As we have seen, the reality is that building bank reserves does not increase the ability of the banks to lend just as draining them does not reduce the capacity of banks to lend. The banks will lend to credit worthy customers, knowing they can access bank reserves after the fact from a number of sources, with a guarantee that they can source them from the central bank if all other options fail. The banks are able to create credit whenever they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending. Bank loans simultaneously create new deposits which borrowers can then use to invest in capital formation (building productive capacity). Even if the government borrowing drained the bank reserves that the initial government spending created, the central bank is always standing by to provide the desired reserves to the commercial banks to ensure the integrity of the payments system. There can be no shortage of reserves over any relevant period. There can be no squeeze on private investment arising from government borrowing.

Ultimately, private agents may refuse to hold any more cash or bonds. What would happen then? The private sector at the micro level can only dispense with unwanted cash balances in the absence of government bond sales by increasing their spending levels. Given the current tax structure, this reduced desire to net save would generate a private expansion and reduce the fiscal deficit, eventually restoring the portfolio balance at higher private employment levels with lower required budget deficits.

Bossone and Wood (2013) also claim that the concerns about “any potential inflation threat are misplaced” because the “new money can be withdrawn from the economy (sterilised), if liquidity is adequate”. This is again related to the claim that the inflation risk is higher with OMF than with borrowing. We should initially emphasise that fiscal deficits certainly carry inflation risk. To explain that point requires us to further expose the myths taught in macroeconomics. The approach taught to students fails to explicate and reinforce the fact that government spending is performed in the same way irrespective of these accompanying monetary operations (taxation, bond sales or money creation). What is even more telling is that the inflation risk of fiscal deficits is embedded in the spending function of government and issuing bonds to the private sector does not alter that risk. Governments spend by crediting bank accounts (issuing cheques which are then deposited is equivalent). All the accounting institutions that might be put in place whereby ‘tax’ funds go into a certain account which is then drawn down when governments spend are just a chimera of the underlying reality.

All components of total spending – consumption expenditure, private investment, exports and government spending – carry an inflation risk if they become excessive. Inflation is caused by total spending growing faster than the capacity of the economy to produce real goods and services in response. In that situation, firms have no flexibility to increase production and thus ‘ration’ off the spending growth by putting up prices. Significantly, the reserve position of the banks is not functionally related with that process. The central bank can ‘sterilise’ the liquidity impacts of the deficit spending by selling bonds to the private sector. But that doesn’t reduce the inflation risk at all. It just means the private sector have more bonds and less deposits. The government spending has already occurred. Whether this generates inflation depends on the ability of the economy to expand real output to meet rising nominal demand. The government would have no desire to expand the economy beyond its real limit given the political problems it would face should inflation rise sharply.

In many cases, the underlying motive for recommending OMF instead of bond sales is suspect. For example, in 2003 the then Chairman of the US Federal Reserve Bank, Ben Bernanke considered that Japan should expand its deficit through tax cuts using central bank money creation instead of matching the deficit increase with bond issuance. His recommendation was influenced by the observation that “Japan’s large national debt may dilute the effect of fiscal policies” because “people may be more inclined to save rather than spend tax cuts when they know that the cuts increase future government interest costs and thus raise future tax payments for themselves or their children”. His theoretical source for this claim are “economics textbooks” where “the idea that people will save rather than spend tax cuts because of the implied increase in future tax obligations is known as the principle of Ricardian equivalence” (Bernanke, 2003).

References to the term ‘Ricardian Equivalence’ have been common during the recent crisis. Economists and financial commentators regularly invoke it as an authority for their claims that fiscal stimulus measures will not be effective in increasing economic activity. They think the technical sounding term will boost the public’s acceptance of their ideologically-motivated arguments against government intervention, despite all the evidence to the contrary – where fiscal stimulus has been applied it has been very effective, as we discussed in Chapter 21. While the classical economist David Ricardo is implicated, he actually rejected the likelihood that taxpayers would act in this way and concluded the theoretical possibility had no practical value (Ricardo, 1951). The modern concept was revived by Robert Barro at Harvard in the 1970s as the Monetarist resurgence was gathering pace. To ‘prove’ his result, Barro made a number of assumptions. all of which had to ‘hold’ for the result to occur. Not surprisingly, in the world where mainstream economists engage in abstract mathematical modelling based on highly tenuous assumptions, whose object is to ‘count the number of angels on the top of a pinhead’, these assumptions could never be realised in the real world. Once the assumptions are relaxed to reflect reality, the ‘model’ fails to support the predictions produced by Barro and his colleagues. In that sense, we would not consider the Ricardian Equivalence framework to be very useful at all.

But, theory aside, do we ever observe these effects in practice? When Barro released his paper (late 1970s) there was a torrent of empirical work examining its predictive capacity. It was opportune that about that time the US Congress gave out large tax cuts (in August 1981) and this provided the first real world experiment possible of the Barro conjecture. The US was mired in recession and it was decided to introduce a stimulus. The tax cuts were legislated to be operational over 1982-84 to provide such a stimulus to aggregate demand. Barro’s adherents, consistent with the Ricardian Equivalence models, all predicted there would be no change in consumption and saving should have risen to pay for the so-called ‘future tax burden’ which was implied by the rise in public debt at the time. What happened? If you examine the US data you will see categorically that the personal saving rate fell between 1982-84 (from 7.5 per cent in 1981 to an average of 5.7 per cent in 1982-84). In other words, Ricardian Equivalence models got it exactly wrong.

In the recent policy debate, the concept has been used by austerity proponents to justify their so-called ‘fiscal contraction expansion’ claim, where the ‘Ricardian’ effects are alleged to be reversed such that once austerity is imposed and governments cut deficits, consumers and investors will realise that tax rates will not have to rise and, consequently, will increase their spending and more than offset the loss of government spending. Of-course, this denies basic psychology. Why would households go on a spending spree as unemployment skyrockets and pensions and wages are cut? Why would firms suddenly invest in new capacity when the existing capacity is more than enough to meet current demand and sales are falling fast? Basic psychology predicts exactly the opposite will happen, which is what the real world data has indicated.

[TO BE CONTINUED – CONCLUDING REMARKS FOR THIS OPTION WILL COME TOMORROW]

Additional references

This list will be progressively compiled.

Bank of England (2014) ‘Money creation in the modern economy’, Quarterly Bulletin, Quarter 1. www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf

Bernanke, B. (2002) ‘Deflation: Making Sure “It” Doesn’t Happen Here’, Speech to the National Economists Club, Washington, D.C., November 21, 2002. http://www.federalreserve.gov/boardDocs/speeches/2002/20021121/default.htm

Bernanke, B. (2003) ‘Some Thoughts on Monetary Policy in Japan’, Remarks before the Japan Society of Monetary Economics, Tokyo, Japan, May 31, 2003. http://www.federalreserve.gov/boarddocs/speeches/2003/20030531/default.htm

Bossone, B. (2013a) ‘Time for the Eurozone to shift gear: Issuing euros to finance new spending’, VoxEu, April 8, 2013, http://www.voxeu.org/article/time-eurozone-shift-gear-issuing-euros-finance-new-spending

Bossone, B. (2013b) ‘Italy, Europe: Please do something!’, EconoMonitor, April 19, 2013. (http://www.economonitor.com/blog/2013/04/italy-europe-please-do-something/

Bossone, B. and Wood, R. (2013) ‘Overt Money Financing of Fiscal Deficits: Navigating Article 123 of the Lisbon Treaty’, July 22, 2013. http://www.economonitor.com/blog/2013/07/overt-money-financing-of-fiscal-deficits-including-navigation-through-article-123-of-the-lisbon-treaty/

Committee on Economic and Monetary Affairs (2013a) ‘Draft Report on the European Central Bank Annual Report for 2012’, European Parliament, ECON/7/12316, June 11, 2013. http://www.europarl.europa.eu/meetdocs/2009_2014/documents/econ/pr/939/939362/939362en.pdf

Committee on Economic and Monetary Affairs (2013b) ‘Amendments 1-247 – Draft report – on the European Central Bank Annual report for 2012’, European Parliament, ECON/7/12316, July 12, 2013. http://www.europarl.europa.eu/sides/getDoc.do?pubRef=-%2f%2fEP%2f%2fNONSGML%2bCOMPARL%2bPE-516.605%2b01%2bDOC%2bPDF%2bV0%2f%2fEN

Committee on Economic and Monetary Affairs (2013c) ‘Report on the European Central Bank Annual report for 2012’, European Parliament, ECON/7/12316, November 13, 2013. http://www.europarl.europa.eu/document/activities/cont/201311/20131113ATT74398/20131113ATT74398EN.pdf

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ECB (2013) ‘Annual Report 2012’, European Central Bank. http://www.ecb.europa.eu/press/key/date/2013/html/sp130424.en.html

ECB (2014a) ‘Introductory statement to the press conference (with Q&A)’, Mario Draghi, President of the ECB, Frankfurt am Main, 3 April 2014. http://www.ecb.europa.eu/press/pressconf/2014/html/is140403.en.html

ECB (2014b) ‘ELA Procedures’, Accessed April 18, 2014. https://www.ecb.europa.eu/pub/pdf/other/201402_elaprocedures.en.pdf

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Eurostat (2014b) ‘Euro area unemployment rate at 11.9%’, February 2014, published April 1, 2014. http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-31032014-AP/EN/2-31032014-AP-EN.PDF

Eurostat (2014c) ‘Seasonally adjusted government deficit down to 3.1% of GDP in the euro area’, February 3, 2014. http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-03022014-AP/EN/2-03022014-AP-EN.PDF

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Friedman, M. (1969) The optimum quantity of money, and other essays, Chicago, Aldine Publishing Company.

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McCulley, P. and Pozsar, Z. (2013) ‘Helicopter money: or how I stopped worrying and love fiscal-monetary cooperation’, Global Society of Fellows, 7 January 7, 2013. http://www.interdependence.org/wp-content/uploads/2013/01/Helicopter_Money_Final1.pdf

MNI (2014) ‘Interview with Jens Weidmann’, March 21, 2014. http://www.bundesbank.de/Redaktion/EN/Interviews/2014_02_28_weidmann_mn.html

Ricardo, D. (1951) ‘Essay on the Funding System’, in P. Sraffa (ed) The Works and Correspondence of David Ricardo, Volume IV, Cambridge, Cambridge University Press.

Turner, A. (2013) ‘Debt, Money and Mephistopheles: How do we get out of this mess?’, Speech to Cass Business School, London, February 6, 2013. www.fsa.gov.uk/static/pubs/speeches/0206-at.pdf

von Goethe, J.W. (1888) ‘Faust: A Tragedy’, London, Ward Lock and Co.

Weidmann, J. (2012) ‘Money Creation and Responsibility’, Speech at the 18th colloquium of the Institute for Bank-Historical Research (IBF), Frankfurt, September 28, 2012. http://www.bundesbank.de/Redaktion/EN/Reden/2012/2012_09_20_weidmann_money_creaktion_and_responsibility.html

White, W. (2013) ‘Overt Monetary Financing (OMF) and Crisis Management’, Project-Syndicate, June 12, 2013. http://www.project-syndicate.org/blog/overt-monetary-financing–omf–and-crisis-management

Wood, R. (2012) ‘The economic crisis: How to stimulate economies without increasing public debt’, Policy Insight, No. 62, Centre for Economic Policy Research, August. http://www.cepr.org/sites/default/files/policy_insights/PolicyInsight62.pdf

Wood, R. (2013a) ‘Conventional and Unconventional Fiscal and Monetary Policy Options’, EconoMonitor, June 20, 2013. http://www.economonitor.com/blog/2013/06/conventional-and-unconventional-fiscal-and-monetary-policy-options/

Wood, R. (2013b) ‘Overt Money Financing and Public Debt’, September 3, 2013. http://www.economonitor.com/blog/2013/09/overt-money-financing-and-public-debt/

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.