Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 21 October 2015

Central bankers and their irrational fear

Mervyn King said

“Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.”

As an academic turned central banker, King knew of what he spoke. The fear is sometimes called fiscal dominance: that they will be forced to monetise government debt in such a way that means inflation rises out of control.

I believe this fear is a key factor behind central banks’ reluctance to think seriously about helicopter money. Creating money is no longer a taboo: with Quantitative Easing huge amounts of money have been created. But this money has bought financial assets, which can subsequently be sold to mop up the money that has been created. Under helicopter money the central bank creates money to give it away. If that money needs to be mopped up after a recession is over in order to control inflation, the central bank might run out of assets to do so. A good name for this is ‘policy insolvency’. [1]

There is a simple way to deal with this problem. [2] The government commits to always providing the central bank with the assets they need to control inflation. If, after some doses of helicopter money, the central bank needs and gets refinanced in this way, then helicopter money becomes like a form of bond financed fiscal stimulus, but where the bond finance is delayed. In my view that delay may be crucial in overcoming the deficit fetishism that has proved so politically successful over the last five years, as well as giving central banks a much more effective unconventional monetary instrument than QE. [3] But central banks do not want to go there, partly because they worry about the possibility of a government that would renege on that commitment.

The fear is irrational for two reasons. First, central banks already face the possibility that they may make sufficient losses on QE that they may require refinancing by the government. The Bank of England has requested and been given a commitment to cover those losses. There is no conceptual difference between this and underwriting a helicopter drop except probabilities.

The second reason is more basic. In today’s world, where in the major economies it is now well understood that interest rates need to rise in a boom to control inflation, it is hard to imagine a government that would make its central bank impotent by refusing to provide it with assets. If such a government ever existed, it would have long before ended central bank independence because it wanted to stop it increasing interest rates with the assets it already had. Under the government of central bank nightmares, the central bank would lose its independence before it could complain that the government was reneging on an earlier commitment to underwrite helicopter money.

The fear of fiscal dominance is itself not irrational, although it seems increasingly unlikely it would happen in a modern democracy. What is irrational is thinking that allowing helicopter money in a recession would make fiscal dominance more likely to happen. [4]

I have also argued that this irrational fear has already been costly. I have described how the widespread adoption of austerity at the beginning of the recovery represents the failure to politicians to follow basic macro. Here central banks become a policy intermediary between academia and politicians: they have the knowledge of how costly austerity can be when rates are zero. But what politicians heard from senior central bankers was not these costs, but encouragement to pursue austerity. An irrational fear of budget deficits may be one explanation for central banks being economical with the truth.

Central banks overcame one big psychological barrier when they undertook Quantitative Easing. That was the first, and perhaps the more important, stage in ending their primitive fear of fiscal dominance. They now need to complete the process, so we can start having rational discussions about alternatives to QE.

[1] A central bank cannot actually become insolvent, as this post explains.

[2] No one to my knowledge has ever proposed giving the central bank the legal power to collect a poll tax.

[3] A key feature of deficit fetishism is a concern about deficits in the short term. Politicians seem happy to take measures that cut deficits in the short term even if debt becomes higher in the longer term. Indeed the analysis presented by DeLong and Summers argues that hysteresis forces would not have to be that large before austerity would raise long run debt to GDP levels. We also know that deficit fetishism is specific to increases in debt caused by recessions: over the longer run if anything deficit bias implies rising rather than falling levels of government debt. So any form of fiscal stimulus that avoided an increase in debt in the short run but not in the long run would avoid deficit fetishism. That is what a money financed fiscal stimulus aka helicopter money aka People’s QE could do.

[4] Why am I confident that a government could not be so obsessed with its debt that it might renege on an underwriting pledge? It is because deficit fetishism is only politically attractive in a recession when individuals are themselves cutting back on their borrowing, and therefore feel the government should do the same. This will not apply when the recovery has taken place and inflation is in danger of exceeding its target.






31 comments:

  1. "[2] No one to my knowledge has ever proposed giving the central bank the legal power to collect a poll tax."

    Gesell's stamped money is like a poll tax, *provided* the central bank always burns the currency it collects as a tax on currency. It does have substitution effects too, but the substitution and quantity effects would exactly cancel out in their one-time effects on the price level, leaving only a steadily falling stock of currency, and a lower inflation rate.

    Exactly the same thing would happen with (negative) interest rates paid on currency (or reserves), if the interest payments were burned.

    (This is a case where the Neo-Fisherians would be right, albeit for the wrong reasons.)

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    1. (I confess my above comment was a little pedantic.)

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  2. It would be hard to envision a circumstance where expansions of money under helis would later need to be reversed. People would have to hoard the money received so that the central bank needs to expand by a large amount. This seems very unlikely because people that are on low incomes or unemployed will spend a large proportion of their money.

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    1. It's difficult to envision it within the current political climate where central bankers across the globe are deathly afraid of inflation.

      But I could imagine a central bank overshooting in combination with unique external shocks. Maybe the central bank let the helicopter drop go for too long.

      We saw inflation in the 1970s if not fiscal dominance. In the U.S. unions were powerful enough to negotiate future price hikes into contracts. That's no longer the case so I seriously doubt we'll see an outbreak of inflation anytime soon.

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  3. I don’t get the bit about government needing to provide the CB with assets to sell in order to mop up excess money in private sector hands. Surely all we need do is let the CB (even where it has no assets) just wade into the market and announce it is willing to borrow at above the going rate of interest.

    As to where the money comes from to pay that interest, it would be best for that to come from tax rather than the CB just printing the relevant money. The objective of “wading into the market” is to impose a deflationary effect, and the effect of tax is deflationary, while printing is stimulatory – not the object of the exercise.

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    1. Have you not answered your own question. Bonds issued by the government are backed by its ability to raise taxes. Without underwriting, bonds issued by the central bank are not.

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  4. "The fear is sometimes called fiscal dominance: that they will be forced to monetise government debt in such a way that means inflation rises out of control.

    I believe this fear is a key factor behind central banks’ reluctance to think seriously about helicopter money. Creating money is no longer a taboo:"

    Why is there an obsession with helicopter money?

    The government can expand fiscal policy without 'monetization'.

    And just in case the central bank purchases of government debt in large quantities, the effect of this is far less compared to the fiscal expansion itself.

    Big deal.

    Surprised you fail to understand such basic stuff.

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    1. Try reading the post more carefully - the bits where I talk about deficit fetishism.

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    2. "The government can expand fiscal policy without 'monetization'. "

      Have you been following the news? Austerity has been the rule since 2010.

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    3. Well SWL, I understand your post about deficit fetishism ... my point was obviously not against your critique of this fetishism. My point was about the so called monetization. There's no taboo or anything. It's simply about relaxing fiscal policy. That monetization thing is a sideshow.

      Peter ... Yes austerity is there and my point was not arguing that there's no austerity. My point was simply arguing about relaxing fiscal policy such as by higher government expenditure. 'Monetization' is irrelevant.

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  5. Even with a non-cooperating Central Bank, a government can issue and assign Tax Credit Certificates to the public, so to achieve similar goals. Here is how to do it for a Eurozone country http://bastaconleurocrisi.blogspot.it/2015/05/tax-credit-certificates-fixing.html

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  6. The BoE can't make Helicopter drops of money, because it operates with a Balance Sheet. To create a "deposit" in the back gardens of the populace, from the Helicopter, someone would have to throw a signed loan agreement, back into the Helicopter. The BoE would then have an "asset" (the loan) to balance its "liability" (bucket loads of paper money thrown out of the whirlybird).

    Throwing currency out of a Helicopter is a fiscal operation that can only be done by the currency issuer, the Treasury, because its assets and liabilities of account, don't have to balance. (The difference between the two, over time, we call the national debt.) Treasury Helicopters would just be adding a bit more to the deficit / debt. The BoE loan agreement would then be replaced by Treasury taxation to get its money back.

    If you think this is silly, you should read how the "Funding for Lending Scheme" works. Pages of smoke and mirrors, to make what is Treasury fiscal stimulus, disguised for purely political reasons, as a BoE monetary stimulus operation. You could make a "Helicopter Drop", look like a BoE operation, using the same FLS smoke and mirrors. Have a look at Appendix A in http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb120401.pdf . The DMO creates Treasury Bills and keeps them in the desk drawer. The BoE borrows them with a uncollateralised stock lending agreement with the DMO; lends those Bills it has never had its hands on and, keeps them "off balance sheet" because they are designated again as stock lending transactions by the BoE.

    Paul Daniels the TV magician is an amateur compared with this lot.

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    1. "Throwing currency out of a Helicopter is a fiscal operation that can only be done by the currency issuer,"

      Bankers QE is a fiscal operation technically speaking. In the U.S. they bought Treasury debt from banks and GSE-backed mortgage-backed securities. They gave the banks a bunch of money.

      Did they have to get permission from the Treasury to helicopter money on to the banks? Yes they have these new assets on their balance sheet, but it doesn't really matter. They can keep them there forever. It's a technical detail.

      Why do the banks get money, but it can't be done in better more efficient and productive ways?

      You sound like a pedantic lawyer trying to prevent the government from bringing about a swift recovery. SWL laid out a good blog post and you offer up this !@#$ in response?

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    2. The Central Bank can't increase the fiscal assets in the economy, it can only swap them for other fiscal assets, cash; reserves, short and long etc. When it lends like a commercial bank it creates a deposit (a liability) in exchange for a loan agreement (an asset). Like all "credit" operations, in all the commercial banks, the financial assets, not "real" assets, and the liabilities sum to zero.

      If you study Section D in Bankstats, http://www.bankofengland.co.uk/statistics/Pages/bankstats/current/default.aspx ,you will see that the BoE creates, that is it re-creates, the original reserves created by Treasury spending; that bought the Gilts in the first instance.

      In the case of Corporate Bonds the BoE gets Treasury to create new "reserves" (increase budget deficit) to buy a private sector asset. The BoE bought about £1.5 billion of Corporate Bonds for the APF; financed by the capital asset it had in the office tea fund. The other £375 billion in the APF is financed by re created reserves.

      If you study the "Gilt repo and stock lending" sheet D3.1, you will see that the BoE runs one of the biggest financial Pawn Broking operations around.

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  7. "The Bank of England has requested and been given a commitment to cover those losses. There is no conceptual difference between this and underwriting a helicopter drop except probabilities."

    Is it possible that the BoE has already asked the government to underwrite helicopter drops and has been rejected?

    If the BoE needs permission from the government of the day for the particular forms of easing (Bankers' QE, People's QE, helicopter money), then surely independence is already gone?

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    1. Is it possible? - I doubt it very much. Independence need not include choosing the instruments of policy, and in the UK does not include the goals. But any government is very unlikely to make helicopter money possible if central banks remain antagonistic.

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  8. "that they will be forced to monetise government debt in such a way that means inflation rises out of control."
    But as QE and Japan for three decades have shown this is BS.

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  9. I will add their fear of "fiscal dominance" is not irrational, they will be out of a job and good riddance!

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  10. " If that money needs to be mopped up after a recession is over in order to control inflation, the central bank might run out of assets to do so."

    Why can't the central bank simply raise rates to control inflation? In the U.S. we now have interest on excess reserves as well.

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  11. I would just add too, even if a central bank (CB) did helicopter money, and then had no ammunition to pull it back in if inflation got above the optimal level, and the fiscal part of government would not raise taxes and/or cut spending to re-arm the CB:

    Then, the CB could just not add any more money for a while; then the surge in inflation should be just a onetime thing, and prices would stabilize at that level. Or, go down if the economy grows, as more goods chase the same amount of money.

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    1. I just don't see why it would have to be that bad if the CB had no securities to pull any excess money back in. As long as the CB establishes a reputation of printing no more until inflation comes back down again to target, then I'd think any inflation from an overshoot of printing would be only pretty onetime and short-term.

      It might be better to have securities to sell, to act faster, but having none doesn't seem like it would be that much a problem, especially with a CB with credibility to say no more printing until our inflation goals are achieved.

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  12. OPEN TO ANYONE:

    What happens if the Central Bank does not recieve money from the government like it has promised? The Central Bank is responsible for a lot of spending and finances that.

    If the government does not complete its end of the deal by printing money and causing inflation, what happens to the government? Can the government print money for itself?

    If the government prints money for the Central Bank, do they have the power to control inflation and not let money into the country?

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    1. The Bank of England is a subsidiary of HM Treasury. The shares are owned by HM Treasury's Solicitor? (I think?)
      Anyhow, that is rather like saying you have power over your boss and can choose not to follow his orders. You get fired. So you don't.

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    2. The Central Bank always gets "money" from the government (Treasury), every time the government spends its own money. It is not real money, it is a "unit of account". When the government pays your pension into your bank current account, it effectively sends an identical amount to your bank's current account at the BoE. BUT they are just numbers; "units of account" in a FIAT currency system. The only "spending" the central bank is responsible for is staff wages.

      If you send electronically your pension to another account at another commercial bank, the same amount has to move from your bank's current account at the BoE to the other banks current account at the BoE; as part of the daily settlement system for balancing, balance sheets.

      The government does not "print money" it just spends it into existence and taxes it out of existence. (It does mint coins.) Try and forget you ever heard the phrase, it is meaningless. If the Treasury writes a cheque in payment or transfer of funds, nobody has the power to bounce that cheque, not even the central bank. The Treasury has a bottomless pit full of its "units of account". But the government can't spend faster; OR, allow private sector credit banks to loan faster than the economy has the capacity to supply; inflation being the outcome of that.

      Anyway, economies worked fine without central banks for centuries. The US is now on its third central bank system. After it shut-down the second one, it was 75 years before they started this third one. Personally, I would make the central bank part of the Treasury Debt Management Office. There are far to many unelected people running our major institutions these days, because our Mickey Mouse politicians, are too scared of getting blamed by the voters, if thinks go mammaries up.

      BTW. If you have studied the Whole of Government Accounts (WGA); prepared under IFRS accounting standards, you will have realised that the Treasury and the Central Bank have been consolidated into one entity. They are one and the same in a fiat currency economy, but don't tell the politicians.

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  13. I don't see the Government ever approving helicopter drops. It would be very hard for the government to explain to the man on the street, given the fairy tale that this govt and the coalition before it has successfully sold about spendthrift Labour and responsible Conservatives, hardworking Chinese and lazy Brits.

    An awful lot of people have actually bought into this nonsense, so I think the public would be very confused, and regard the idea of free money as some kind of heresy.

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    1. This. It would destroy the rhetorical position that underpins the narrative.

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  14. Small point: Central banks can become financially insolvent - on this point, see Buiter (Can central banks go broke?; Del Negro and Sims (When Does a Central Bank’s Balance Sheet Require Fiscal Support?); Reis (Different types of central bank insolvency and the central role of seignorage); Benigno & Nistico (Non-neutrality of open-market operations). That is, the present value of liabilities can exceed the present value of assets, something that need not happen at the same time as accounting net worth goes negative - the latter event being mostly irrelevant since central banks are almost always immune from bankruptcy proceedings.

    Still, practically speaking, policy insolvency may be a more relevant concept than financial insolvency, since policy insolvency will arrive first. That's at least true when the policy task is to keep inflation down. I wonder whether it is also true for helicopter money, when the objective is to get inflation up?

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    1. Policy solvency amounts to confidence that the value of money is supported by fundamentals.

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    2. The fundamentals being that you have to pay taxes on Sterling.
      Also, only way to get a passport bus pass etc.

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