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

The 'strong case' critically examined

Perhaps it was too unconventional setting out an argument (against independent central banks, ICBs) that I did not agree with, even though I made it abundantly clear that was what I was doing. It was too much for one blogger, who reacted by deciding that I did agree with the argument, and sent a series of tweets that are best forgotten. But my reason for doing it was also clear enough from the final paragraph. The problem it addresses is real enough, and the problem appears to be linked to the creation of ICBs.

The deficit obsession that governments have shown since 2010 has helped produce a recovery that has been far too slow, even in the US. It would be nice if we could treat that obsession as some kind of aberration, never to be repeated, but unfortunately that looks way too optimistic. The Zero Lower Bound (ZLB) raises an acute problem for what I call the consensus assignment (leaving macroeconomic stabilisation to an independent, inflation targeting central bank), but add in austerity and you get major macroeconomic costs. ICBs appear to rule out the one policy (money financed fiscal expansion) that could combat both the ZLB and deficit obsession. I wanted to put that point as strongly as I could. Miles Kimball does something similar here, although without the fiscal policy perspective

Of course many macroeconomists do see the problem, but the solutions they propose are often just workarounds. Things like Quantitative Easing, or NGDP targets, or a higher inflation target. [1] None completely remove the basic difficulty created by the ZLB. (One proposal that does is negative interest rates coupled with eliminating paper money, which I will come back to.) As a result, these workarounds mean that in response to a sharp enough recession, we would still regret no longer having the possibility of undertaking a money financed fiscal stimulus.

I also think there is a grain of truth in the argument that ICBs created an environment where deficit obsession became easier. Take the UK for example. In the 2000s the organisation that came to dominate budget analysis was the IFS. They are excellent on both the microeconomics of particular budget measures and their costing. Before the Great Recession that meant that all the IFS needed was a macro forecast (of which there are many) and they had all they required to provide excellent budget analysis. The IFS did not have strong macro policy expertise, and sometimes this shows, but as long as the consensus assignment worked that did not matter.

One of the those working at the IFS during this Labour government period was Rupert Harrison. In 2006 he became chief of staff to George Osborne. He helped introduce, perhaps reflecting his IFS experience, two important and positive policy innovations: setting up the OBR (with some minor assistance from a certain UK academic), and a form of fiscal rule (a five year deficit target) which allowed debt to be a shock absorber. But he also appeared to bring the received wisdom on the consensus assignment untroubled by the ZLB, which meant that Osborne could give a speech in 2009 outlining the macroeconomic basis of his strategy in which the ZLB was not mentioned.

This is an example of a more general point, which Robert in comments reminded me I could have made to strengthen the strong argument still further. With ICBs, macroeconomic expertise can move from finance ministries to central banks, leaving finance ministries unprepared for what they may need to do in a major recession.

But this grain of truth runs up against a real difficulty, which is the major flaw in the ‘strong argument’ I set out in the earlier post. To see the flaw ask the following question: in the absence of ICBs, would our deficit obsessed governments actually have undertaken a money financed fiscal stimulus? To answer that you have to ask why they are deficit obsessed. If it is out of ignorance (my Swabian syndrome), then another piece of macro nonsense that ranks alongside deficit obsession is the evil of printing money in any circumstances. I suspect a patient suffering Swabian syndrome would also be subject to this fallacy. If the reason is strategic (the desire for a smaller state) the answer is obviously no. We would simply be told it could not be done because it would open the inflation floodgates.

Following my grain of truth idea you might counter that without ICBs the knowledge within or outside government that these excuses were without foundation would be greater, and so governments could not get away with them so easily. But you would still have plenty of economists from the financial sector telling you that not only did you need to reduce debt rapidly to appease the markets, but also that any government printing money would scare the markets even more. Indeed, would governments alone have had the courage to undertake the scale of QE that we have seen ICBs undertake?

As for the argument that macroeconomic expertise gets concentrated in central banks, surely the answer here is to allow that expertise into the public domain by making central banks more open, and to directly combat the forces that make some central bank leaders routinely argue for austerity when they can no longer effectively combat deflation.

The basic flaw with my strong argument against ICBs is that the ultimate problem (in terms of not ending recessions quickly) lies with governments. There would be no problem if governments could only wait until the recession was over (and interest rates were safely above the ZLB) before tackling their deficit, but the recession was not over in 2010. Given this failure by governments, it seems odd to then suggest that the solution to this problem is to give governments back some of the power they have lost. Or to put the same point another way, imagine the Republican Congress in charge of US monetary policy.

But if abolishing ICBs is not the answer to the very real problem I set out, does that mean we have to be satisfied with the workarounds? One possibility that a few economists like Miles Kimball have argued for is to effectively abolish paper money as we know it, so central banks can set negative interest rates. Another possibility is that the government (in its saner moments) gives ICBs the power to undertake helicopter money. Both are complete solutions to the ZLB problem rather than workarounds. Both can be accused of endangering the value of money. But note also that both proposals gain strength from the existence of ICBs: governments are highly unlikely to ever have the courage to set negative rates, and ICBs stop the flight times of helicopters being linked to elections.

      

These are big (important and complex) issues. There should be no taboos that mean certain issues cannot be raised in polite company. I still think blog posts are the best medium we have to discuss these issues, hopefully free from distractions like partisan politics.  

   

[1] Please do not misunderstand what I mean by workarounds. The workaround may be still be useful in its own right (I have argued that monetary policy should be guided by the level of NGDP), but it does not completely remove the problem of the ZLB.

 

Why do central banks use New Keynesian models?

And more on whether price setting is microfounded in RBC models. For macroeconomists.

Why do central banks like using the New Keynesian (NK) model? Stephen Williamson says: “I work for one of these institutions, and I have a hard time answering that question, so it's not clear why Simon wants David [Levine] to answer it. Simon posed the question, so I think he should answer it.” The answer is very simple: the model helps these banks do their job of setting an appropriate interest rate. (I suspect because the answer is very simple this is really a setup for another post Stephen wants to write, but as I always find what Stephen writes interesting I have no problem with that.)

What is a NK model? It is a RBC model plus a microfounded model of price setting, and a nominal interest rate set by the central bank. Every NK model has its inner RBC model. You could reasonably say that these NK models were designed to help tell the central bank what interest rate to set. In the simplest case, this involves setting a nominal rate that achieves, or moves towards, the level of real interest rates that is assumed to occur in the inner RBC model: the natural real rate. These models do not tell us how and why the central bank can set the nominal short rate, and those are interesting questions which occasionally might be important. As Stephen points out, NK models tell us very little about money. Most of the time, however, I think interest rate setters can get by without worrying about these how and why questions.

Why not just use the restricted RBC version of the NK model? Because the central bank sets a nominal rate, so it needs an estimate of what expected inflation is. It could get that from surveys, but it also wants to know how expected inflation will change if it changes its nominal rate. I think a central banker might also add that they are supposed to be achieving an inflation target, so having a model that examines the response of inflation to the rest of the economy and nominal interest rate changes seems like an important thing to do.

The reason why I expect people like David Levine to at least acknowledge the question I have just answered is also simple. David Levine claimed that Keynesian economics is nonsense, and had been shown to be nonsense since the New Classical revolution. With views like that, I would at least expect some acknowledgement that central banks appear to think differently. For him, like Stephen, that must be a puzzle. He may not be able to answer that puzzle, but it is good practice to note the puzzles that your worldview throws up.

Stephen also seems to miss my point about the lack of any microfounded model of price setting in the RBC model. The key variable is the real interest rate, and as he points out the difference between perfect competition and monopolistic competition is not critical here. In a monetary economy the real interest rate is set by both price setters in the goods market and the central bank. The RBC model contains neither. To say that the RBC model assumes that agents set the appropriate market clearing prices describes an outcome, but not the mechanism by which it is achieved.

That may be fine - a perfectly acceptable simplification - if when we do think how price setters and the central bank interact, that is the outcome we generally converge towards. NK models suggest that most of the time that is true. This in turn means that the microfoundations of price setting in RBC models applied to a monetary economy rest on NK foundations. The RBC model assumes the real interest rate clears the goods market, and the NK model shows us why in a monetary economy that can happen (and occasionally why it does not). 

Is the Walrasian Auctioneer microfounded?

For macroeconomists

I found this broadside against Keynesian economics by David K. Levine interesting. It is clear at the end that he is child of the New Classical revolution. Before this revolution he was far from ignorant of Keynesian ideas. He adds: “Knowledge of Keynesianism and Keynesian models is even deeper for the great Nobel Prize winners who pioneered modern macroeconomics - a macroeconomics with people who buy and sell things, who save and invest - Robert Lucas, Edward Prescott, and Thomas Sargent among others. They also grew up with Keynesian theory as orthodoxy - more so than I. And we rejected Keynesianism because it doesn't work not because of some aesthetic sense that the theory is insufficiently elegant.”

The idea is familiar: New Classical economists do things properly, by founding their analysis in the microeconomics of individual production, savings and investment decisions. [2] It is no surprise therefore that many of today’s exponents of this tradition view their endeavour as a natural extension of the Walrasian General Equilibrium approach associated with Arrow, Debreu and McKenzie. But there is one agent in that tradition that is as far from microfoundations as you can get: the Walrasian auctioneer. It is this auctioneer, and not people, who typically sets prices.

Within this framework, the key price when it comes to Keynesian economics is the real interest rate. In Real Business Cycle models it is the real interest rate that moves, by assumption, to ensure that there are no problems of deficient or excess demand. So these models rule out Keynesian features by imagining an intertemporal auctioneer.

You might say what is wrong with imagining an auctioneer. Auctioneers are really just an ‘as if’ story that are meant to approximate how markets work. However any story of how the real interest rate gets determined should acknowledge the existence of two critical features of actual economies: the existence of money and central banks.

When we allow for the existence of money, it becomes quite clear how the ‘wrong’ real interest rate can lead to a demand deficient outcome. Brad DeLong takes Levine to task for trying to use a barter economy and Say’s Law to refute Keynesian ideas, and Nick Rowe turns the knife. What New Keynesian models do is attempt to remove the intertemporal auctioneer from RBC models. To adapt the Levine quote above, to replace the auctioneer with a more modern macroeconomics - a macroeconomics where firms set prices and central banks change interest rates to achieve a target. 

Now your basic New Keynesian model contains a huge number of things that remain unrealistic or are just absent. However I have always found it extraordinary that some New Classical economists declare such models as lacking firm microfoundations, when these models at least try to make up for one area where RBC models lack any microfoundations at all, which is price setting. A clear case of the pot calling the kettle black! I have never understood why New Keynesians can be so defensive about their modelling of price setting. Their response every time should be ‘well at least it’s better than assuming an intertemporal auctioneer’.[1]

Levine himself makes no explicit reference to New Keynesian models. If he had, he would have to acknowledge that in these models temporary cuts in government spending will indeed reduce output - particularly if monetary policy is unable to respond. All his stuff about perpetual motion machines would have to go out of the window. As to the last sentence in the quote from Levine above, I have talked before about the assertion that Keynesian economics did not work, and the implication that RBC models work better. He does not talk about central banks, or monetary policy. If he had, he would have to explain why most of the people working for them seem to believe that New Keynesian type models are helpful in their job of managing the economy. Perhaps these things are not mentioned because it is so much easier to stay living in the 1980s, in those glorious days (for some) when it appeared as if Keynesian economics had been defeated for good.

[1] What criticisms of Calvo contracts and the like should do is indicate the limitations of the microfoundations methodology, but another consequence of the New Classical revolution is that most macroeconomists mistakenly view microfoundations as the only ‘proper’ way to do macro. There is no epistemological basis for this view.

[2] As Stephen Williamson points out, these microfoundations would do a pretty poor job at explaining the behaviour of any particular individual, but instead model common tendencies that emerge within large groups of individuals.  

Helicopter money

Periodically articles appear advocating, or discussing, helicopter money. Here is a simple guide to this strange sounding concept. I go in descending order of importance, covering the essential ground in points 1-7, and dealing with more esoteric matters after that.

1. Helicopter money is a form of fiscal stimulus. The original Friedman thought experiment involved the central bank distributing money by helicopter, but the real world counterpart to that is a tax cut of some form.
   
2. What makes helicopter money different from a conventional tax cut is that helicopter money is paid for by the central bank printing money, rather than the government issuing debt.
   
3. The central bank printing money is nothing new: Quantitative Easing (QE) involves the central bank creating reserves and using them to buy financial assets - mainly government debt. As a result, helicopter money is actually the combination of two very familiar policies: QE coupled with a tax cut. Another way of thinking about it: instead of using money to buy assets (QE alone), the central bank gives it away to people. If you think intuitively that this would be a better use of the money as a means of stimulating the economy, I think you are right.
   
4. Is it exactly the same as a conventional tax cut plus QE? A conventional tax cut would involve the government creating more debt, which the central bank would then buy under QE. With helicopter money no additional government debt would be created. But is government debt held by the central bank, where the central bank pays back to the Treasury the interest it receives on this debt, really government debt in anything more than name only? The answer would appear to be yes, because the central bank could decide to sell the debt, in which case it would revert back to being normal government debt.
   
5. However at this point we have to ask what the aim of the central bank is. Suppose the central bank has an inflation target. It achieves that target by changing interest rates, which it can either control (at the short end) or influence (at the long end) by buying or selling assets of various kinds. So central bank decisions about buying and selling government debt are determined by the need to hit the inflation target. Given this, whether money is created by buying government debt (through QE) which finances the tax cut or by financing the tax cut directly seems immaterial, because decisions about how much money gets created in the long run are determined by the need to hit the inflation target.
   
6. There is a general principle here that should always be born in mind when thinking about helicopter money. The central bank cannot independently control inflation and control money creation - the two are linked in the long run (although the short run may be much more unpredictable). Now it could be that advocates of helicopter money really want higher inflation targets, but do not want to be explicit about this, just as they may not want to call helicopter money a fiscal stimulus. The problem with this is that central bankers do understand the macroeconomics, so there seems little point trying to be deceptive. If helicopter money does not mean higher inflation targets, then this policy is just fiscal stimulus plus QE. (I elaborate on this point here, and discuss but largely discount possible differences here. A less technical discussion is here.)
   
7. Saying that helicopter money is 'just' fiscal stimulus plus QE is not meant to be dismissive. Mark Blyth and Eric Lonergan make the quite legitimate point that our institutional separation between monetary and fiscal policy may not be appropriate to a world where the liquidity trap may be a frequent problem. Many years ago I suggested in a FT piece that the central bank might be given a limited ability to temporarily change a small number of fiscal instruments to enhance its control over the economy. The more recent proposal outlined by Jonathan Portes and myself has some similarities with this idea.
   
8. Turning to the tax cut, would this work in stimulating consumption? A familiar objection to a bond financed tax cut is Ricardian Equivalence: people just save the tax cut because they know taxes will increase in the future to pay the interest on the new debt. Now we know that for very good reasons Ricardian Equivalence does not hold in the real world, so we are entering the territory of angels and pins here, and as a result you may want to stop reading now. If not, the question is: if Ricardian Equivalence did hold, would a tax cut financed by printing money be subject to the same problem? Here we come to the issue of whether central bank money is 'irredeemable'. The next point explains.
   
9. Ricardian Equivalence works because, to avoid having to reduce future consumption when taxes rise to pay the interest on the government debt created by the original tax cut, consumers are forced to invest all of the tax cut. If a £100 tax cut implies taxes are higher by £5 each subsequent year to pay a 5% interest rate, then if the rate of interest consumers can receive is also 5%, to generate an extra £5 each year to pay those higher taxes they have to invest all £100 of the tax cut. Now suppose the tax cut is financed by printing money. There is now no interest to pay. So if the central bank never wanted to undo its money creation, there is no reason why private agents who hold this money should not regard it as wealth and at some point spend it. This is what is meant by money being irredeemable.
   
10. However we need to recall that the central bank may have an inflation target. For that reason, it may want to undo its money creation. If people expect that to happen, they will not regard their money holding as wealth. The logic of Ricardian Equivalence does apply. (The central bank may not be able to reduce money by raising taxes, but it can sell its government debt instead. Now the government has to pay interest on its debt, so taxes will rise.) This is why Willem Buiter stresses that it is expected future money, not current money, that is regarded as wealth.
    
11. Tony Yates has a recent post on this. He argues that if the central bank assumes money is irredeemable, and starts printing a lot of it, people may stop wanting to use it. If they do that, it will no longer be seen as wealth. This is real angels and pins stuff that can come from taking microfoundations too seriously. Just ask yourself what you would do if you received a cheque in the post from the central bank. As Nick Rowe points out in this post, we can cut through all this by noting the link between money creation and inflation targets. The money required to sustain an inflation target will not be redeemed, so it can be regarded as wealth.
    
12. Suppose central banks do stick to their inflation targets, but are having trouble achieving them because inflation is too low and we are in a liquidity trap. Without helicopter money, the inflation target will be undershot. That is the context of the current discussion. Might agents save the tax cut, because they will anticipate higher prices and recognise that they will need the additional money as a medium of exchange? As I discuss here, this is not a problem because the increase in prices will reduce real interest rates, which will stimulate the economy that way. As Willem Buiter says, "there always exists a combined monetary and fiscal policy action that boosts private demand".

The ECB and the Bundesbank

There can be no doubt that some of the responsibility for the current Eurozone recession has to be laid at the feet of the ECB. Some of that might in turn be due to the way the ECB was set up. Specifically

1) That the ECB sets its own definition of price stability

2) This definition is asymmetric (below, but close to, 2%)

3) No dual mandate, or even acknowledgement of the importance of the output gap

4) Minimal accountability, because of a concern about political interference

It is generally thought that the ECB was created in the Bundesbank’s image. Tony Yates goes even further back in this post. Yet the irony is that the ECB abandoned the defining feature of Bundesbank policy, which could be providing significant help in current circumstances.

The defining feature of Bundesbank policy was a money supply target. Whereas the UK and US experience with money supply targeting was disastrous and short lived, the Bundesbank maintained its policy of targeting money for many years. There is little doubt that this was partly because the Bundesbank was in practice quite flexible, and the money target was often missed. Nevertheless the Bundesbank felt that maintaining that money target played an important role in conditioning expectations, and there is some evidence that it was correct in believing this.

When the ECB was created, it adopted a ‘twin pillar’ approach. The first pillar was the inflation target, and the second pillar involved looking at money. It was generally thought that the second pillar was partly a gesture to Bundesbank practice, and subsequently most analysis has focused on the inflation target.

There are very good reasons for abandoning money supply targets: they frequently send the wrong signals, and are generally unreliable in theory and practice. However a monetary aggregate should be related to nominal GDP (NGDP), and you do not need to be a market monetarist to believe there are much better reasons for following a NGDP target. What a NGDP target does for sure is make you care about real GDP, which would go a long way to correcting points (2) and (3) above. What it can also do, if you target a path for the level of NGDP, is provide a partial antidote for a liquidity trap, as I discuss here. More generally, it can utilise most effectively the power of expectations, which is why perhaps the most preeminent monetary economist of our time has endorsed them.

So do not blame the Bundesbank for the flawed architecture of the ECB. The ECB abandoned the critical aspect of Bundesbank policy, which was to target an aggregate closely related to nominal GDP. ECB policy has suffered as a result.

How the ECB could be radical by being old fashioned

In a recent post I wondered whether, in 20 years time, we might look back on this period with the same bewilderment that we now look back on monetary policy in the early 1930s or 1970s. After the 1929 crash the Federal Reserve was relatively slow to cut interest rates, and Milton Friedman argued the Fed was largely to blame for the subsequent depression. In the 1970s central banks failed to raise interest rates in response to rising inflation. As my previous post was ‘for economists’, let me spell out what central banks may be missing this time.

As we all know, short term nominal interest rates in the US, UK, Eurozone and Japan are as low as they can go, so it appears as if there is nothing more central banks can do with conventional interest rate policy. However that is not the case. What they can do is promise to keep future interest rates lower than they would otherwise be. This policy, first suggested by Paul Krugman for Japan and championed by the highly influential Michael Woodford, I will call ‘forward commitment’. It is not the same as ‘forward guidance’, which central banks are implementing.

The form of forward guidance that the US and UK operate involves giving the public some information about when interest rates might begin to rise. For example, if unemployment falls below some figure, each central bank may think about raising rates, but there is no commitment to do so. I believe the best way to understand this policy is that it is entirely conventional, targeting a combination of expected inflation and the output gap, but that it gives the public a bit more information about the trade off between these two goals.

The forward commitment policy is radically different. It promises to allow both inflation and the output gap to be above target in the future, so as to increase demand today. How does this work? Perhaps the easiest way to think about this is by considering long term interest rates. Long term (say 5 year) interest rates are mainly a combination of expected short rates from now until 5 years ahead. If you promise to have above target inflation tomorrow, the central bank must allow future short term interest rates to be lower tomorrow, which reduces long term rates today. Lower long term interest rates encourage additional consumption and investment today.

I call this the forward commitment policy because the central bank has to make the private sector believe it will carry it out. The problem is that the policy has a built in temptation for the central bank to cheat. They increase demand today by making the promise to allow inflation to be above target tomorrow, but once tomorrow comes they can change their mind - because who likes above target inflation? Yet if the private sector believes they will change their mind, the policy will not work today. So the central bank has to commit to allow inflation to be above target in the future, and get the private sector to believe in that commitment.

There are various ways it could do this. One is to have a target path for the level of nominal income (nominal GDP). The recession reduces nominal income, so nominal income has to grow more rapidly to catch up with its target path. That may well involve inflation rising above 2% for a prolonged period.

You might wonder whether this policy just helps one problem (lack of demand in the recession) by creating another - above target inflation after the recession is over. That is true, but if the recession is deep enough the net result is still positive on balance. However what is also true is that the policy is best implemented at the beginning of the recession. Once the recovery is underway, and the period at which nominal interest rates would normally be stuck at zero decreases, the net benefits of implementing the forward commitment policy decline.

Some people have interpreted forward guidance as forward commitment, because forward guidance in the UK and US allows inflation to go slightly above target if unemployment remains high. I think that is a mistake. Traditional inflation targeting allows inflation to go above target if unemployment is high (as we have seen in the UK and US). The distinctive feature of forward commitment is a promise to allow inflation to be above target when unemployment is low (or equivalently the output gap is positive, rather than negative as it is at present). No central bank has made this promise.

So what we may ask in 20 years time is why central banks did not try this forward commitment policy. In simple toy models, as my previous post showed (where conventional policy is called ‘discretionary’), it can lead to much better outcomes. Is it too late? In the US, with the recovery well under way, I suspect it is. In the UK, where we seem to have got very excited by the economy actually growing again, the same is probably (if regretfully) true. However the story might be very different in the Eurozone.

The Eurozone experienced a real double dip recession. Although positive growth has recently resumed, the OECD still expect the output gap to be -3.5% in 2015: much higher than they forecast for the US or UK. Inflation is currently below 1%, and my colleague Andrea Ferrero argues that there is a real risk of deflation. So the case for a forward commitment policy in the Eurozone remains strong. Furthermore, the ECB feels it cannot implement a Quantitative Easing programme of the type followed by the UK and US, so it may be more inclined to try forward commitment.

But, you may rightly say, isn’t the ECB also notoriously conservative? In particular, German central bankers and their allies would never allow a promise of above target inflation. I suspect this is right, but let me offer a glimmer of hope. Forward commitment could be sold not as a radical new policy, but a return to a very old one: money targeting. The one major central bank that did maintain a money targeting policy for more than a few years was the Bundesbank.

Why is money targeting like a forward commitment policy? Because the level of the money stock is closely related to the level of nominal income. So having a target path for the stock of money is like having a target path for nominal income. And as I suggested above, having a target for nominal income is one way of implementing a forward commitment policy.

So if I was ever in the position of advising the ECB (!) I would sell forward commitment this way. I suspect it would not work, partly because the Bundesbank in practice never rigidly targeted the level of the money supply. However I could reasonably argue that the inflation performance of the German economy in the 1970s was better than in the UK or US partly because expectations were anchored through money supply targeting. It would be worth a try.      

Government debt, Inflation and Money

Do budget deficits cause inflation? Let me be a little more specific: does raising the level of debt and keeping it there when the economy is at full employment raise the price level? The conventional answer is: not if the central bank controls inflation. Sometimes economists say the same thing in a different way: not if the debt is not monetised. High debt may be problematic for other reasons (e.g. crowding out of private capital, default risk, increasing distortionary taxation), but not because it must cause inflation.

This post is about explaining this conventional view. The two ways of giving the answer reflect two different ways to describe the conventional view, and I think that tells us something interesting - although perhaps controversial - about the role of money.

In the textbooks, the conventional view starts by talking about the demand for the medium of exchange, money. The amount of money in the economy, it is assumed, is related to the amount of money created by the central bank, but not the amount of debt issued by the government. The demand for nominal money is proportional to the price level, which is what economists mean when they say people demand ‘real balances’. So, if the stock of nominal money does not change, neither can the price level. When economists talk about not monetising the debt, they mean that the central bank keeps nominal money fixed.

There are two elements in this argument. The first has to do with the relationship between the amount of money created by the central bank (‘base’ or ‘high powered’ money), and what the financial institutions that create money (private banks) can do. The second has to do with money demand, which is what I want to focus on first. To do so, imagine an economy where the only money is cash printed by the government.

It is trivial to show why there can be this tight and simple link between cash and the price level. The economic system is all about real variables: not just consumption and output, but also relative prices like real wages. Furthermore people want money to buy some real quantity of goods, so the demand function can be written as M/p = f(...) where (...) includes real output. So, if the price level only appears on the left hand side of this equation and nowhere else in the system of equations describing the economy, and the central bank controls the supply of cash M, then this will lock down the price level. This is the famous neutrality of money. Furthermore, the mechanism by which this lock down works is intuitive: if the central bank creates more cash, we have ‘too much money chasing too few goods’, so prices rise.

Once we allow private banks to create money, the story can get much more complicated. The textbooks try and short circuit this by teaching the money multiplier, which I think does a lot more harm than good. But we could just assume there is some mechanism by which the central bank can control the amount of money created by banks, and continue to tell our neutrality story.

So according to this conventional view there is no worry about government debt, as long as the central bank ignores debt when ‘fixing the money supply’. Whether it always will ignore debt, or whether it always can, is a separate issue for another post. The critical assumption I make here that allows me to avoid this issue is that the fiscal authority does adjust its taxes or spending to make the higher level of debt sustainable.

This story is missing a key ingredient, and to see why consider the following. Let all government debt be nominal (not indexed). Suppose that, just as there is a demand for real money, there is also a demand for a real quantity of government debt: B/p = g(....). The government, by cutting taxes for a period, raises the supply of nominal debt by a fixed amount. Suppose it keeps nominal debt at this level. In that case, using an argument analogous to the earlier one involving money, will the price level not increase, until the supply of real debt matches the demand for real debt? If so, higher government debt has raised the price level.

One argument here is to say that, as the government increases the nominal quantity of debt, the demand for debt also rises in step, so there is no need for prices to rise. This will happen if consumers are completely Ricardian, because they believe tax cuts today mean tax increases tomorrow, and they save to pay for those future tax increases by buying government debt. In this sense, the supply of government debt creates its own demand, so we do not need anything else, including the price level, to change.

Suppose, however, that this process is incomplete, perhaps because some consumers are credit constrained, and so spend rather than save their tax cut. Does that not mean prices will still have to rise a bit to match the increase in the supply of nominal bonds? However, if we still have a fixed nominal amount of money, then higher prices will raise the demand for money, giving us a contradiction. What squares this circle is that interest rates rise, which makes people economise on money, and also raises the demand for government debt without the need for prices to increase. So higher debt might raise interest rates, but it will not raise the price level if it is not monetised.

Now an interesting feature of this story is that we could cut out the stuff about money altogether. We could just talk about the supply and demand for nominal government debt, and how the demand for debt is positively related to interest rates and prices. If the government wants to borrow more, the demand for nominal bonds needs to rise, and this can happen either because interest rates rise or because the price level rises. If interest rates rise sufficiently there is no need for higher prices. Loanable funds vs liquidity preference and all that. [1]

It is a small additional step to just talk about the central bank controlling interest rates to fix the price level. Nowadays this is how many macroeconomists would explain why higher government debt does not raise prices: the central bank changes interest rates to make sure it does not. This explanation not only has the advantage of simplicity (we do not need to talk about the demand for money, or how the central bank controls its supply), but it also seems to match how central banks think.

Of course something about money is there in the background. When we talk about interest rates being varied to control inflation, and why therefore we can ignore the size of the stock of government debt as an influence on inflation, we are assuming that the central bank has the ability to control interest rates. This depends on the fact that the government can issue money, or more specifically that the central bank’s “liabilities happen to be used to define the unit of account”, to quote from the bible Michael Woodford’s Interest and Prices (p 37). So money is there, but like the impresario of a play, it does not need to appear on stage.

In terms of the question posed by the title, both ways of describing the conventional view (with or without money) end up with the same answer to the question about government debt and inflation, which is good. However I remain puzzled about one thing. Do those who still tell the story using money think that telling the story just with interest rates is equally valid, or in some way misleading? When, with Campbell Leith, I first started using ‘cashless’ models of the Woodford type, a frequent complaint was ‘where was money?’. To appease potential referees we occasionally put money in, even though this added nothing to the main points of the paper. Yet I think those asking the question thought we might be missing something more fundamental, but I never discovered what it was. I remain genuinely curious.     

[1] Recall that I am assuming full employment in all this. In a recession caused by people saving more, higher saving will raise the demand for bonds, so even if the supply of bonds also rises following budget deficits, interest rates or the price level could fall rather than rise.

Money as Credit

The relationship between money and macroeconomics is very strange. At one time money was thought to be central to the discipline - advanced courses in macroeconomics were often called monetary economics. We had monetarism. Then gradually money slowly faded away. We had real business cycle models that were just real, and if we wanted to make them nominal you just added money as a ‘medium of exchange’. Then even Keynesian models with sticky prices began to dispense with money altogether, becoming cashless. Money seemed both essential - for example to the concept of inflation and to why Says Law did not hold - but also dispensable.

These thoughts followed from reading a book called ‘Money: The Unauthorised Biography’ by Felix Martin. 

The first thing to say is that this book is a great read, and one that I think non-economists will find completely accessible. Much of the book, as you would expect from the title, involves a historical discussion of how money evolved, was developed and was understood in particular societies at different times. Some of this I was familiar with - like the stones of Yap - but a great deal was new to me. But this is a biography with a message. Money is not fundamentally a commodity medium of exchange that made exchange more efficient compared to barter, but a particular form of credit, a system of clearing accounts (transferable credit). Yet, Martin argues, the dominant view since Adam Smith has been of money as a commodity medium of exchange, and this has enabled macroeconomics to largely ignore financial crises, until they actually happen. Here is a passage:

“From the moneyless economics of the classical school there evolved modern, orthodox macroeconomics: the science of monetary society taught in universities and deployed in central banks. From the practitioners’ economics of Bagehot, meanwhile, there evolved the academic discipline of finance - the tools of the trade taught in business schools, used by bankers and bond traders. One was an intellectual framework for understanding the economy without money, banks and finance. The other was a framework for understanding money, banks, and finance, without the rest of the economy. The result of this intellectual apartheid was that when in 2008 a crisis in the financial sector caused the biggest macroeconomic crash in history, and when the economy failed to recover afterwards because the banking sector was broken, neither modern macroeconomics nor modern finance could make head or tail of it.”

Some of this will be familiar, although what was new for me (but perhaps not to followers of Minsky or MMT) - and quite challenging - was the idea that this could all be traced back historically to a misconceived view of money itself. (According to Martin, the 17th century philosopher John Locke has a lot to answer for.) The threads developed from the historical account of the origins of money are numerous. For example money as credit is inevitably social, and so its value is bound to be politically determined. In a financial crisis, when the size of debts begin to encumber the economy, it is therefore quite logical and natural to adjust the value of money to redistribute between creditors and debtors.

So this is a big ideas, big picture kind of book. Inevitably, therefore, some of the brushstrokes may be a little too broad or bold for some. The story of macroeconomics as essentially classical and real with only a brief incursion by Keynes is I think too simple and easy, and I would have liked to know his take on the explosion of macro work on financial frictions since the crisis. But the historical detail is fascinating, and the ideas they are used to illustrate are clear and thought provoking, so I’m very glad I read it.

Money and inflation

When I suggest that the ECB could, in principle, end the Euro crisis by printing money (and using that money to buy government debt), a question I am often asked by non-macroeconomists is ‘will this not increase inflation’? The idea that printing money will inevitably lead to inflation is of course the monetarist position.

                The appeal of this idea comes from a simple thought experiment. Imagine an economy without banks, where the only money was printed by the government. People hold money because they want to buy things (money as a ‘medium of exchange’), so the demand for money is proportional to the value of overall spending. The government then doubles the supply of this money, by giving everyone a Christmas gift of cash. (This is Freidman’s famous helicopter money.) People will spend this money, because they now have more than they need. If the quantity of goods produced in the economy (‘supply’) is unchanged, we have ‘too much money chasing too few goods’, and excess demand leads to rising prices. People go on spending (the money does not get destroyed) until they have the amount of money they need, which is the same proportion of the total value of spending. The process will only stop when everything costs twice as much. This is the famous ‘neutrality of money’.

                The neutrality of money is a very robust proposition. For those mathematically inclined, imagine a set of equations that describe the real economy (output, real wages etc). This real economy includes ‘real balances’: the purchasing power of money, or money divided by prices. Now suppose the government has control of one nominal quantity, money. If we start from an equilibrium where all the equations hold, and double money, then the set of equations will also hold for the same set of real quantities plus a doubled price level, because this gives us the same level of real balances.

                Now monetarists have always understood that the process from doubling money to doubling prices may take time. Furthermore, the assumption that supply remains unchanged may not be correct if we start with unemployed resources (i.e. a recession). Freidman was highly critical of the Federal Reserve in the Great Depression for not printing enough money.  However, if in time unemployed resources disappear, any additional money will lead to higher prices.

                The thought experiment above involved the government giving people money. But that combines monetary and fiscal policy: it is like a tax cut financed by printing money. A pure monetary policy operation would involve the central bank using its newly printed money to buy assets like government debt. This is what we now call quantitative easing. The neutrality of money idea should still work, because by buying assets the bank raises their price, which lowers interest rates, which encourages more people to borrow and spend. But suppose interest rates have hit a zero lower bound i.e. we are in a liquidity trap. The problem now is that the central bank is swapping money for assets that pay the same as money (because interest rates are zero), so nothing has really happened. There is a lot more to say about whether Quantitative Easing will work in stimulating the economy, but at best that is what it will initially do – output will rise because there are unemployed resources, and prices will not. This is why the Bank of England and the Federal Reserve have printed money like crazy over the last few years.

                But when the economy recovers, will not the chickens eventually come home to roost? Inflation must increase in the end, surely – that’s what neutrality implies. But our thought experiment assumed that the money would stay doubled in quantity. A sensible central bank, one the economy recovers, will begin to contract the money supply. Job done, so back to business as usual. If the central bank has bought lots of government debt, it can start selling it. The central bank can certainly start raising interest rates above zero, which will encourage people to switch out of money. So the money supply will shrink back down.

                This is just a rather elaborate way of saying that printing money need not be inflationary because it can be temporary. Those who argue that printing money must be inflationary are making an implicit assumption that the extra money is permanently with us, and this is an assumption that need not hold, particularly if monetary policy is in the hands of an inflation targeting independent central bank like the ECB.

                If this all sounds too abstract, here is what happened to money (in this case M1) in Japan in the early years of this century. 

In an effort to boost the economy the Japanese central bank tried a programme of Quantitative Easing, leading to rapid growth in narrow money. Japan was also in a liquidity trap, so broader definitions of money did not increase that much. However inflation did not increase: on average inflation has been zero between 2003 and today. How much it helped expand the economy is still unclear. Below is a graph of the level of the monetary base – the money the central bank actually prints. The expansion in 2003 is clear, but so is the contraction in 2006, when the experiment ended. The bottom line: printing money can be temporary, and will not be inflationary in a recession.

Monetary Base in Japan (source: Bank of Japan)