Money and Debt

For economists

As regular readers will know, my advocacy of helicopter money (HM) does not depend on it being different from, or better (at stimulating demand) than, fiscal policy. [1] So, for example, when Fergus Cumming from the Bank of England said that if after HM the government recapitalised a central bank this “reduces the initial stimulus to a vanilla, bond-financed fiscal transfer”, then that sounds just fine to me. Except, of course, to note that HM is not just like fiscal policy because (a) HM may be quicker to implement than conventional fiscal policy, and speed matters (b) HM can bypasses both genuine debt fears and deficit deceit (c) with HM there is no chance of monetary offset.

Much the same is true for this Vox article by Claudio Borio et al. They argue that if interest is paid on all bank reserves, then HM is “is equivalent to debt-financing from the perspective of the consolidated public sector balance sheet”. Maybe, but why should that be a problem? It is only a problem if you set up a straw man which is that HM has to be more effective than a bond financed helicopter drop.

The reason some people think it is not a straw man is that, if you set up a model where Ricardian Equivalence holds and you have an inflation targeting central bank, a bond financed lump sum tax cut would have no impact. Then you would indeed want HM to do something more. And perhaps it could, if it led agents to change their views about monetary policy. While such academic discussions may be fun, I also agree with Eric Lonergan that “theoretical games being played by some economists, which masquerade as policy insights, are confusing at best.” A good (enough) proportion of agents will spend HM - at least as many as spend a tax cut - for perfectly sound theoretical reasons. [2]

The Bario et al article does raise an interesting question. When the central bank pays interest on all reserves, what is the difference between money and bond financing? Reserves would seem to be equivalent to a form of variable interest debt that can be redeemed for cash at any time. It is exactly the same question raised in a paper by Corsetti and Dedola, an early version of which I discussed here. The answer their model uses is that the central bank would never default on reserves, whereas debt default is always an option.

I think this all kind of misses the point. Base or high powered money (cash or reserves) is not the same as government debt, no matter however many times MMT followers claim the opposite. (For a simple account of why the tax argument is nonsense, see Eric Lonergan here.) Civil servants can frighten the life out of finance ministers by saying that they may no longer be able to finance the deficit or roll over debt because the market might stop buying, but they cannot do the same by saying no one will accept the money their central bank creates. [3] Money is not the government’s or central bank’s liability. (For a clear exposition, see another piece by Eric, or this by Buiter.) Money is not an obligation to make future payments. Money is valuable because, as Eric describes here, it is an established network.

Bario et al seem to want to claim that because central banks nowadays control interest rates by using the interest they pay on reserves, this somehow creates an obligation. Reserves are like variable rate, instant access debt that banks get for nothing.

I think we can see the problem with this line of argument by asking what happens if obligations are broken. If the government breaks its obligation to service or repay its debt we have default, which has extremely serious consequences. If the central bank decides on a different method to control short term interest rates because paying interest on reserves is too much like a transfer to banks, no one but the banks will notice.

So reducing the macroeconomics of helicopter money to fiscal policy is not an argument against it. Furthermore money created by the central bank is not the same as government debt, even if interest is paid on reserves.

[1] They would also know - unlike Jörg Bibow - that I do not think there is any kind of contest between fiscal policy and HM, because the fiscal authority moves first.

[2] The two main reasons some people will spend a tax cut is if they are borrowing constrained, or if they think there is a non-zero probability that the tax cut will be paid for by reducing government spending. An additional reason for spending HM is that it might be permanent if it avoids the central bank undershooting its inflation target.

[3] If the finance minister knows some macroeconomics they would of course realise that not being frightened by the second means you should not be frightened by the first. But that does not negate the conceptual difference.           

Postscript (8/6/16): This by Biagio Bossone provides a very good complement to my analysis, looking a why HM is not 'permanent' and discussing interest on reserves

Confidence as a political device

Some technical references but the key point does not need them

This is a contribution to the discussion about models started by Krugman, DeLong and Summers, and in particular to the use of confidence. (Martin Sandbu has an excellent summary, although as you will see I think he is missing something.) The idea that confidence can on occasion be important, and that it can be modelled, is not (in my view) in dispute. For example the very existence of banks depends on confidence (that depositors can withdraw their money when they wish), and when that confidence disappears you get a bank run.

But the leap from the statement that ‘in some circumstances confidence matters’ to ‘we should worry about bond market confidence in an economy with its own central bank in the middle of a depression’ is a huge one, and I think Tony Yates and others are in danger of making that leap without justification. Yes, there are circumstances when it may be optimal for a country with its own central bank to default, and Corsetti and Dedola (in a paper I discussed here) show how that can lead to multiple equilibria.

But just as Krugman wanted to emulate Woody Allen, I want to as well but this time pull Dani Rodrik from behind the sign. In his excellent new book (which I have almost finished reading) Rodrik talks about the fact that in economics there are usually many models, and the key question is their applicability. So you have to ask, for the US and UK in 2009, was there the slightest chance that either government wanted to default? The question is not would they be forced to default, because with their own central bank they would not be, but would they choose to default. And the answer has to be a categorical no. Why would they, with interest rates so low and debt easy to sell.

The argument goes that if the market suddenly gets spooked and stops buying debt, printing money will cause inflation, and in those circumstances the government might choose to default. But we were in the midst of the biggest recession since the 1930s. Any money creation would have had no immediate impact on inflation. Of course their central banks had just begun printing lots of money as part of Quantitative Easing, and even 5 years later where is the inflation! So once again there would be no chance that the government would choose to default: the Corsetti and Dedola paper is not applicable. (Robert makes a similar point about the Blanchard paper. I will not deal with the exchange rate collapse idea because Paul already has. A technical aside: Martin raises a point about UK banks overseas currency activity, which I will try to get back to in a later post.)

Ah, but what if the market remains spooked for so long that eventually inflation rises. The markets stop buying US or UK debt because they think that the government will choose to default, and even after 5 or 10 years and still no default the markets continue to think that, even though they are desperate for safe assets!? In Corsetti and Dedola agents are rational, so we have left that paper way behind. We have entered, I’m afraid, the land of pure make believe.

So there is no applicable model that could justify the confidence effects that might have made us cautious in 2009 about issuing more debt. There are models about an acute shortage of safe assets on the other hand, which seem to be ignored by those arguing against fiscal stimulus. Nor is there the slightest bit of evidence that the markets were ever even thinking about being spooked in this way.

Martin makes the point that just because something has not yet been formally modelled does not mean it does not happen. Of course, and indeed if he means by model a fully microfounded DSGE model I have made this point many times myself. But you can also use the term model in a much more general sense, as a set of mutually consistent arguments. It is in that sense that I mean no applicable model.

Now to the additional point I really wanted to make. When people invoke the idea of confidence, other people (particularly economists) should be automatically suspicious. The reason is that it frequently allows those who represent the group whose confidence is being invoked to further their own self interest. The financial markets are represented by City or Wall Street economists, and you invariably see market confidence being invoked to support a policy position they have some economic or political interest in. Bond market economists never saw a fiscal consolidation they did not like, so the saying goes, so of course market confidence is used to argue against fiscal expansion. Employers drum up the importance of maintaining their confidence whenever taxes on profits (or high incomes) are involved. As I argue in this paper, there is a generic reason why financial market economists play up the importance of market confidence, so they can act as high priests. (Did these same economists go on about the dangers of rising leverage when confidence really mattered, before the global financial crisis?)

The general lesson I would draw is this. If the economics point towards a conclusion, and people argue against it based on ‘confidence’, you should be very, very suspicious. You should ask where is the model (or at least a mutually consistent set of arguments), and where is the evidence that this model or set of arguments is applicable to this case? Policy makers who go with confidence based arguments that fail these tests because it accords with their instincts are, perhaps knowingly, following the political agenda of someone else.     

Government default, reserves and QE

For macroeconomists. Paul Krugman needed more coffee to get his head round the latest paper by Corsetti and Dedola. I had a similar feeling, and I have written this post to try and get my thoughts in order. So this comes with a health warning, which is that I may have failed.

This post is all about the distinction between central banks and governments, but to make those distinctions clear, its helpful to consolidate their budget constraints. Initially assume that this consolidated entity can finance its deficit by either issuing bonds or printing cash. It is therefore true that this entity need never default: if no one buys its bonds, it just issues cash. However that does not mean that it will never default. Suppose, as Corsetti and Dedola do, there is a direct and simple link between cash and inflation, while issuing debt has no impact on inflation. Avoiding default by printing cash therefore creates inflation, which is costly. It may be so costly that the government/central bank entity chooses to default, rather than bear those costs.

I do not think this idea is controversial, but failure to distinguish between ‘need’ and ‘choose’ can cause confusion. What may be controversial in the above is the simple quantity theory link between cash and inflation, but in fact we do not need anything so sharp. As long as printing cash is more likely to raise inflation than issuing debt, the proposition still holds. What the exact nature of the inflation link will influence, of course, is the likelihood the government will choose to default rather than create higher inflation.

This choice may also be influenced by the existence of independent central banks. If governments give control over printing money and inflation to a conservative central banker in the Rogoff sense, then this could decrease the likelihood of using inflation to avoid default, and therefore makes default more likely for a given fiscal position. This may also, of course, influence fiscal policy. Whether independent central banks have that much independence is of course debatable.

Now let’s add the possibility of multiple equilibria. The ‘good’ equilibria is the one where the interest paid on government debt reflects the ‘true’ probability of default i.e. it reflects the circumstances in which the consolidated government chooses to default. The ‘bad’ equilibrium is one where the rate of interest reflects a much higher probability of default. As De Grauwe has recently emphasised, because the market can in effect force default by not buying debt, this bad equilibrium is possible.

However as our consolidated government/central bank can print cash, does this rule out the bad equilibrium? The answer, according to Corsetti and Dedola, is not necessarily. The reason is straightforward. Printing cash is still costly, because it raises inflation. The bad equilibrium could still exist, because to prevent it would require creating an undesirable amount of inflation, which the consolidated government will not at the end of the day do, whatever it may say it will do.

However Corsetti and Dedola note that in practice, central banks are buying government debt not by printing cash, but by creating reserves. So they extend their model to include a third asset, bank reserves. In terms of the consolidated government, what are these reserves? In Corsetti and Dedola I think reserves are default free debt. They pay a risk free interest rate, but there is no chance of default, because (by some means) the central bank always promises to pay back the interest and capital with money. However, like government debt and unlike money, there is no link between the quantity of reserves and inflation.

Now I find it intuitive that with this additional asset, it is now possible to remove the bad equilibrium, as the authors show. The government/central bank can simply choose to swap any normal debt that the market will not buy with reserves, which the market will buy, because reserves are default free. The government/central bank is essentially ruling out its option to default. Why does the government/central bank ever issue bonds?  In the absence of the possibility of a bad equilibrium, it might prefer issuing bonds because it wants to keep the default option.

I have traditionally thought about Quantitative Easing as being equivalent to swapping debt for cash. For exactly the reasons Corsetti and Dedola outline in a world without reserves, to do this permanently would raise the price level, so as a result QE is strictly temporary. But now add reserves of the Corsetti and Dedola type. QE then involves a swap between two types of debt: one default free and one not. The consolidated government/central bank is reducing its option to default on debt, in order either to remove a bad equilibria, change the term structure, increase the supply of completely safe assets, reduce its interest bill, or something else.

Now what is crucial in this analysis is that issuing reserves, unlike issuing cash, has no implications for inflation. You might object that while that clearly seems realistic at the moment, this reflects the peculiar circumstances of the zero lower bound (ZLB), and in the longer term additional reserves would be inflationary because they would allow private banks to create more loans and deposits etc etc. However in this context a recent post from Paul De Grauwe and Yuemei Ji is interesting.

De Grauwe and Ji, among many other things, consider the situation in a which the central bank buys government debt with reserves, and the government defaults. It is then often suggested that the central bank loses the ability to control interest rates and inflation. De Grauwe and Ji argue that this “does not hold water” for two reasons: the central bank can reduce the money stock by either raising reserve requirements, or by issuing interest bearing bonds. So would a permanently higher stock of reserves necessarily imply higher inflation once the ZLB was over? Following De Grauwe and Ji the answer is no, because either private banks can be forced to hold more reserves and not create more deposits, or the central bank could exchange reserves for some other kind of central bank asset that was still default free but which had no knock on implications for the banking sector.

So to the extent that reserves are just default free debt, or can be turned into default free debt, QE does not need to be temporary even with unchanging inflation targets. Whether this is of any consequence I’m not sure, particularly as central banks do not want to make QE permanent, as recent events illustrate. Seeing reserves as default free debt may also not be terribly interesting for the UK or US right now as the perceived default risk of each country’s debt is pretty low anyway, and so the chances of a bad equilibrium emerging are equally low. But the implications for the Eurozone are clearly much more interesting.