Saturday Quiz – January 23, 2010

This Post Has 9 Comments

1. Hi Bill,

   I still really want to hear your thoughts on the mechanics of unfunded government spending. By this I mean deficit spending not financed through the creation of bonds. I see you mention QE a lot and say how it doesn’t do much and definitely doesn’t get the banks lending. But isn’t the simply act of removing interest bearing debt from the economy a big deal? Would Britain have been able to finance a £200bn deficit without it?

   And if we acknowledge that the only limit to unfunded deficit spending is excess capacity and how you spend it, how would you stop it from becoming inflationary? I think it is quite clear that in Britain you could fund building houses out of newly created money and this would be a boon to the economy. If there’s one thing we lack it is housing. Lots of une
   ployed people could be put to work.

   The problem is that as people came around to the idea that govt spending can be unfunded I believe it would become very difficult to ‘put a lid on it’. Public sector workers would want their pay rises, departments would want to employ more people, and you would end up with lots of newly created money going towards nothing productive in the economy. And *that* would be inflationary.

   I love your simple business card model but when you try to expand it and re-orientate the economy around government spending instead of bank created credit I fail to see the mechanics of how it could work.

   Let me give you an example. If I went to a bank and said I want to build a bridge to an empty island off of the coast of Britain, they’d laugh at me. My proposed invesment offers no potential return. A return indicates further beneficial economic activity being generated. However, a govt with the ability to spend what it wishes could decide it’s a good idea for a whole host of political reasons. All that money gets spent but no new economic activity is then generated. That spending would be inflationary.

   I find that so far no one has suggested the political changes that would need to be made to facilitate re-orientating the economy around government spending instead of bank created credit. Or even how you after the thorough brainwashing of everybody to think that ‘printing money is inflationary’ you could do it without it being inflationary. After all, isn’t inflation largely about expectation?

   I’d really appreciate your thoughts here. How would *you* run an economy, politically and economically?

   All the best,

   Alex

2. “As a consequence, unless it was prepared to pay the same rate on overnight reserves held with it by the commercial banks, then any government net spending has to be offset with debt-issuance.”

   Saying debt-issuance is confusing terminology. Central banks in this case would want to drain reserves from the commercial banks, they do this by selling government debt (CD’s or Tresuries etc). They could also raise reserve requirements. Well you know this. I just think I deserve credit on this question teacher.

3. Dear Tschäff

   Give yourself 6 out of 5 this week!

   I use debt-issuance to overcome the mainstream notion that a sovereign government borrows to finance its spending.

   Further, I use it to make it clear that the central bank and the treasury are the one unit from an operational perspective when dealing (vertically) with the non-government sector.

   best wishes
   bill

4. Yes Bill this is a point you make well and often but where does it end? How can the govt decide a suitable amount of unfunded (no debt issuance) deficit spending? Up to full employment? To the amount necessary to provide the job guarantee? To fund economically stimulating infrastructure projects?

   If I recall you have an article about the way Australia used to fund it’s deficit by the ‘tap’ system or something like that? The central bank offered to sell bonds of the amount needed for deficit spending and if there wasn’t enough demand at the interest rate the central bank just created the rest. Would that at least be an improvment on the current system? And isn’t this what QE is really anyway? Funding deficit spending? The UK Govt wants a zero interest rate and to fund it’s deficit so the central bank buys £200bn of govt bonds whilst the govt is selling that amount. There might be a time difference to your tap system but the net result is the same surely?

   Am I missing something???

   Thanks,

   Alex

5. Alex,

   The tap system and QE are different. Depends on how you look at it. In the tap system, the price (and hence the yield) is fixed but in QE, the amount of purchases by the US Federal Reserve was fixed.

   The Tap system philosophy is different. I am speculating a bit, since I am not from Australia but the idea is that the government offers households/investors an alternative to holding bank deposits.

   The system has changed and there is no tap system anywhere. In normal times, there is no QE and bonds are auctioned and sold. If the government runs a deficit of $x, then they require that $x worth of bonds be sold. It is based on the neoliberal myths like the market will find the right price and yields and that the governments need to be disciplined etc etc etc.

   Central banks all around the world have a “paradigm” that interest rates are good for controlling the macroeconomical situation. They increase rates in order to control inflation and aggregate demand. They think they do a good job but that is such a lie! One reason they think it works is that increasing rates reduces bond prices since prices and yields move in the opposite direction and investors suffer a capital loss. On the other hand, if they want to increase aggregate demand and have inflation, they reduce interest rates. Usually they target the overnight rate and this indirectly has an effect on the whole yield curve. Enter Bernanke and his research work at Princeton. He wrote many papers on QE and thought that the central bank buying government bonds increases prices and since investors achieve capital gains, this will lead to an increase in aggregate demand. Now, he is correct about the fact that QE indeed increases bond prices because of reduction of supply of government bonds in the market, this in no way proves that the strategy will lead to an increase in aggregate demand.

   Bernanke has written on this at many places that this is different from the Japanese style QE and calls it “credit easing” but the effect on the economy is the same – nothing great! It is more useful to the financial markets who will have better balance sheets.

6. Ramanan I understand what you’re saying but what I’m trying to point out is that QE is in effect funding the govt deficit without sale of bonds to private investors. The bank of England is not buying the bonds from the govt but the net result is the same: govt sells bonds to the public (private investors). BofE buys bonds from public with new money. The net result is the same as the BofE giving the govt interest free money.

   Yes it then boosts bank reserves. Yes it drives down bond yields. But it also finances deficit spending interest free!

   Unless/until they sell the bonds back onto the Market.

   Why doesn’t Bill and others recognise this side to QE? That it can also be seem as a fiscal tool for filling the gap in demand for bonds at the targeted interest rate)?

   Thanks,

   Alex

7. Alex,

   Agreed. You can check some posts on QE here. The argument is that one way or the other, the central bank controls the yield curve. A stronger statement is that the whole yield curve can be pegged. Now, the question is if that is the case, what should be the correct value and you can check many posts where it has been argued that the natural rate is zero!

   The idea here is that the government is the issuer of the currency and doesn’t need to “borrow”. So the government can just spend and reserves created with remain as excess in the banking system.

8. So Ramanan the question is: are chancellors and finance ministers blissfully unaware of this? Why would any self-respecting finance minister take their currency into a monetary union (e.g. The Euro, the proposed Amero) if it means losing sovereignty over your currency? Would you say there is a wider political agenda at play?

   What can we do to change views on this? What did you think of my questions to Bill about the practicality of implementing changes?

   The problem with economic change is you need political will and change with it otherwise it is a non-starter!

   How much energy do you devote to economic change? Do you think it’s a worthy and possible
   pursuit? Or do you think the forces of power are too entrenched?

   I can’t help feeling that they are.

   All the best

9. Aah .. you have to be patient and millions of words in Billy Blog are there for you to read.

   The short answer to your question is people do not understand all this. “People” includes finance ministers, central bank officials, and the whole academic discipline … I understand that sounds funny. In spite of The Scourge Of Monetarism (title of a book as well), it (monetarism) is do deeply ingrained in everyone’s mind that it is difficult to get it out.