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Tuesday's Top 10 with NZ Mint: A debate about 'Helicopter money'; Why money printing is not the work of the devil; Milton Friedman was a money printer; OMF is better than QE; Dilbert
Here's my Top 10 links from around the Internet at midday in association with NZ Mint.
As always, we welcome your additions in the comments below or via email to email@example.com.
My must read today is #1-10. I've done something a bit different. I have linked to a speech and that speech only. That's one speech and 10 links about it. It's that good. I recommend everyone read the speech in full. It's 46 pages long. Those in the government who use slogans such as 'funny money' or 'wacky economics' or just utter the words 'Zimbabwe' or 'Weimar Republic' in response to talk about 'money printing' should definitely read it.
1. Helicopter money - The head of Britain's Financial Services Authority, Adair Turner, has thrown a huge cat amongst the monetary policy and banking policy pigeons with this February 6 speech titled: 'Debt, money and Mephistopheles: How do we get out of this mess?'. HT to Anatole Kaletsky and David (in yesterday's Top 10) for pointing me to this.
This is my must read for today.
Turner's speeches often are.
He has to be the most established and connected member of the economic establishment in the Western World who is seriously questioning the orthodoxy of monetary and banking policy. His argument is detailed, considered and backed up with all sorts of academic research and data. It's about as far from 'funny money' as you could get.
Just a reminder. This guy is in charge of regulating banks in Britain. He is no fringe party nutter or blogger.... ;)
It is five and a half years since the financial crisis began in summer 2007 and four and a half years since its dramatic intensification in autumn 2008. It was clear from autumn 2008 that the economic impact would be large. But only slowly have we realised just how large: all official forecasts in spring 2009 suggested a far faster economic recovery than was actually achieved in the four major developed economies – the US, Japan, the Eurozone and the UK. UK GDP is now around 12% below where it would have been if we had continued the pre-2007 trend growth rate: and latest forecasts suggest that the UK will not return to 2007 levels of GDP per capita until 2016 or 2017.
In terms of the growth of prosperity this is truly a lost decade. This huge harm reflects the scale of pre-crisis financial folly – above all the growth of excessive leverage - and the severe difficulties created by post-crisis deleveraging. And failure to foresee either the crisis or the length of the subsequent recession reflected an intellectual failure within mainstream economics – an inadequate focus on the links between financial stability and macroeconomic stability, and on the crucial role which leverage levels and cycles play in macroeconomic developments. We are still crawling only very slowly out of a very bad mess.
And still only slowly gaining better understanding of the factors which got us there and which constrain our recovery. We must think fundamentally about what went wrong and be adequately radical in the redesign of financial regulation and of macro-prudential policy to ensure that it doesn’t happen again. But we must also think creatively about the combination of macroeconomic (monetary and fiscal) and macro-prudential policies needed to navigate against the deflationary headwinds created by post-crisis deleveraging.
At the extreme end of this spectrum of possible tools lies the overt money finance (OMF) of fiscal deficits – “helicopter money”, permanent monetisation of government debt. And I will argue in this lecture that this extreme option should not be excluded from consideration for three reasons:
(i) Because analysis of the full range of options (including overt money finance) can help clarify basic theory and identify the potential disadvantages and risks of other less extreme and currently deployed policy tools;
(ii) Because there can be extreme circumstances in which it is an appropriate policy; and
iii) and because if we do not debate in advance how we might deploy OMF in extreme circumstances, while maintaining the tight disciplines of rules and independent authorities that are required to guard against inflationary risks, we will increase the danger that we eventually use this option in an undisciplined and dangerously inflationary fashion.
Even to mention the possibility of overt monetary finance is however close to breaking a taboo. When some comments of mine last autumn were interpreted as suggesting that OMF should be considered, some press articles argued that this would inevitably lead to hyper inflation. And in the Eurozone, the need utterly to eschew monetary finance of public debt is the absolute core of inherited Bundesbank philosophy. To print money to finance deficits indeed has the status of a moral sin – a work of the devil – as much as a technical error.
In a speech last September, Jens Weidmann, President of the Bundesbank, cited the story of Part 2 of Goethe’s Faust, in which Mephistopheles, agent of the devil, tempts the Emperor to distribute paper money, increasing spending power, writing off state debts, and fuelling an upswing which however “degenerates into inflation, destroying the monetary system”(Weidmann 2012).
Before you decide from that that we should always exclude the use of money financed deficits, consider the following paradox from the history of economic thought. Milton Friedman is rightly seen as a central figure in the development of free market economics and in the definition of policies required to guard against the dangers of inflation. But Friedman argued in an article in 1948 not only that government deficits should sometimes be financed with fiat money but that they should always be financed in that fashion with, he argued, no useful role for debt finance.
Under his proposal, “government expenditures would be financed entirely by tax revenues or the creation of money, that is, the use of non-interest bearing securities” (EXHIBIT 1) (Friedman, 1948). And he believed that such a system of money financed deficits could provide a surer foundation for a low inflation regime than the complex procedures of debt finance and central bank open market operations which had by that time developed.
When economists of the calibre of Simons, Fisher, Friedman, Keynes and Bernanke have all explicitly argued for a potential role for overt money financed deficits, and done so while believing that the effective control of inflation is central to a well run market economy – we would be unwise to dismiss this policy option out of hand.
His (Friedman's) conclusion was that the government should allow automatic fiscal stabilisers to operate so as “to use automatic adjustments to the current income stream to offset at least in part, changes in other segments of aggregate demand”, and that it should finance any resulting government deficits entirely with pure fiat money, conversely withdrawing such money from circulation when fiscal surpluses were required to constrain over buoyant demand. Thus he argued that, “the chief function of the monetary authority [would be] the creation of money to meet government deficits and the retirement of money when the government has a surplus”. Friedman argued that such an arrangement – i.e. public deficits 100% financed by money whenever they arose – would be a better basis for stability than arrangements that combined the issuance of interest bearing debt by governments to fund fiscal deficits and open market operations by central banks to influence the price of money.
His conclusion was that the government should allow automatic fiscal stabilisers to operate so as “to use automatic adjustments to the current income stream to offset at least in part, changes in other segments of aggregate demand”, and that it should finance any resulting government deficits entirely with pure fiat money, conversely withdrawing such money from circulation when fiscal surpluses were required to constrain over buoyant demand. Thus he argued that, “the chief function of the monetary authority [would be] the creation of money to meet government deficits and the retirement of money when the government has a surplus”. Friedman argued that such an arrangement – i.e. public deficits 100% financed by money whenever they arose – would be a better basis for stability than arrangements that combined the issuance of interest bearing debt by governments to fund fiscal deficits and open market operations by central banks to influence the price of money.
6. How money is really created - Turner talks about Friedman and post-Depression economist Henry Simons here too. Those who saw Seven Sharp's banking piece last week and wrote it off as crackpot should read this in particular.
Friedman thus saw in 1948 an essential link between the optimal approach to macroeconomic policy (fiscal and monetary) and issues of financial structure and financial stability. In doing so he was drawing on the work of economists such as Henry Simons and Irving Fisher who, writing in the mid-1930s, had reflected on the causes of the 1929 financial crash and subsequent Great Depression, and concluded that the central problem lay in the excessive growth of private credit in the run up to 1929 and its collapse thereafter.
This excessive growth of credit, they noted, was made possible by the ability of fractional reserve banks simultaneously to create private credit and private money. And their conclusion was that fractional reserve banking was inherently unstable. As Simons put it “in the very nature of the system, banks will flood the economy with money substitutes during booms and precipitate futile efforts at general liquidation afterwards”. He therefore argued that “private institutions have been allowed too much freedom in determining the character of our financial structure and in directing changes in the quantity of money and money substitutes”.
As a result Simons reached a conclusion which gives us a second paradox from the history of economic thought. That the rigorously freemarket Henry Simons, one of the father figures of the Chicago School, believed that financial markets in general and fractional reserve banks in particular were such special cases that fractional reserve banking should not only be tightly regulated but effectively abolished.
7. Turner goes on to say it's time to wind back the leverage of banks - Remember, he's the regulator of banks in Britain...
By the way, here's David Chaston's excellent table of the leverage of New Zealand's banks. They're not as bad as those in America and Europe. But still too high, in my view.
Even if we reject the radical policy prescriptions of Simons, Fisher and early Friedman, their reflections on the causes of the Great Depression should prompt us to consider whether our own analysis of the 2008 financial crisis and subsequent great recession has been sufficiently fundamental and our policy redesign sufficiently radical. Three implications in particular may follow.
First, that while there is a good case in principle for the existence of fractional reserve banks, social optimality does not require the fraction (whether expressed in capital or reserve ratio terms) to be anything like as high as we allowed in the pre-crisis period, and still allow today6. As David Miles and Martin Hellwig amongst others have shown, there are strong theoretical and empirical arguments for believing that if we were able to set capital ratios for a greenfield economy (abstracting from the problems of transition), the optimal ratios would likely be significantly higher even than those which we are establishing through the Basel III standard.
Second, that issues of optimal macroeconomic policy and of optimal financial structure and regulation, are closely and necessarily linked. A fact obvious to Simons, Fisher and Friedman, but largely ignored by the pre-crisis economic orthodoxy. As Mervyn King put it in a recent lecture, the dominant new Keynesian model of monetary economics “lacks an account of financial intermediation, so that money, credit and banking play no meaningful role”. Or, as Olivier Blanchard has put it, “we assumed we could ignore the details of the financial system”. That was a fatal mistake.
And third, that in our design of both future financial regulation and of macroeconomic policy, it is vital that we understand the fundamental importance of leverage to financial stability risks, and of deleveraging to post- crisis macro-dynamics.
8. Turner then goes on to say the unsayable again by suggesting pure inflation targeting be reconsidered. New Zealand is the purest (and first) of the inflation targeters.
The increasingly dominant assumption of the last 30 years has been that central banks should have independent mandates to pursue inflation rate targets. The specifics vary by country, but orthodoxy and practice has tended to set price stability as the objective and to define price stability as low but positive inflation, for instance around 2%. Central banks typically pursue that objective looking forward over medium-term timeframes e.g. over two to three years. That orthodoxy is now extensively challenged, and a plethora of alternative possible rules have either been already applied or are now proposed.
Blanchard et al questioned in 2010 whether a period of somewhat higher inflation might be required to cope with the challenges of high debt levels and attempted deleveraging (Blanchard et al., 2010). The Federal Reserve has adopted a policy of state contingent future commitment, with a clearly stated intent to keep interest rates close to the zero bound and to continue quantitative easing until and unless employment falls below 6.5% or inflation goes above 2.5%.
Mark Carney has suggested that a range of possible options, including a focus on nominal GDP, should at least be considered. And Michael Woodford, author of a canonical statement of pre-crisis monetary theory (Woodford, 2003) has proposed that central banks should conduct policy so as to deliver a return to the trend level of nominal GDP, which would have resulted from the continuation of pre-crisis NGDP growth.
So why is our own central bank and our new central bank governor stonewalling this debate in the face of a massive reassessment overseas? Are we somehow immune or not involved in the global economy? Are our heads in the sand?
That's when Overt Monetary Finance (OMT) is needed.
He points out, for example, that the existing form of QE may turn out to be more like pure deficit financing because it may not be reversed. Ie. The bonds could be cancelled. So there's not much difference.
All QE operations therefore carry within them the contingent possibility that they will turn out post facto to have been (in part or whole) permanent monetisation: and that this may be an appropriate policy. The gross debts of the government of Japan, after netting out holdings by the Japanese government amount to 200% of GDP: of this 200%, around a sixth (i.e. 31% of GDP) is held by the Bank of Japan (EXHIBIT 32). Whether this debt exists in any meaningful economic sense, or whether an element of Japan’s past fiscal deficits has been de facto money financed, is a moot point.
There is, moreover, no inherent technical reason (as against political economy reason) to believe that OMF will be more inflationary than any other policy stimulus, or that it will produce hyperinflation It is no more inflationary than other policy levers provided the “independence” hypothesis holds. If spare capacity exists and if price and wage formation process are flexible, the impetus to nominal demand induced by OMF will have a real output as well as a price effect, and in the same proportion as if nominal demand were stimulated by other policy levers.
Conversely if these conditions do not apply, the additional nominal stimulus will produce solely a price effect whether it is stimulated by OMF or by any other policy lever. And the impacts on nominal demand and thus potentially on inflation will depend on the scale of the operation: a “helicopter drop” of £1bn would have a trivial effect on nominal GDP: a drop of £100bn a very significant effect and as a result create greater danger of inflation. And if the stimulative effect of OMF subsequently proved greater than anticipated or desired, it could be offset by future policy tightening, whether in the extreme form of Friedman’s “money withdrawing fiscal surpluses” or through the tightening of bank capital or reserve requirements.
The idea that OMF is inherently any more inflationary than the other policy levers by which we might attempt to stimulate demand is therefore without any technical foundation.