Did the UK really almost go bankrupt?

I normally publish posts in the first half of the week, but two separate attempts were overtaken by events, and they will have to wait for another day. I finally wrote something for the Guardian on the Governor’s interview that led to nonsense headlines about the UK almost going bankrupt. The piece explains why they are nonsense, but I should note here that the headlines are classic mediamacro, appealing to the idea that governments are like households.

Frances Coppola makes the same point a different way. You could describe what happened in March this year as a short term liquidity problem. There is no suggestion the UK is insolvent. And the thing about countries with their own currencies is that they never have a liquidity problem because they create money. She also notes that no headlines talked about the fragility of our commercial banks around the same time. You would think, after the GFC, that would be the big news. Here is a quote from Frances’s blog:

“I found the interviewers' constant focus on government financing a serious distraction from what was an important story about the Bank's vital responsibility for ensuring the smooth operation of financial markets. When financial markets melt down as they did in 2008, the whole world suffers. Central banks saw the same thing happening again in March 2020, and acted to stop it. And their action was extremely effective. It seemed to me that this was the story Bailey really wanted to tell, but the interviewers were intent on pushing him towards the issue of monetary financing and the Bank's independence.”

This episode was not, as some have suggested, an example of fiscal dominance. To make that clear, I give an example of what fiscal dominance would be in the article, where the Bank is forced to monetise borrowing against its better judgement. Dealing with market disorder in a pandemic is not that. But, rather more controversially, I do suggest that fear of fiscal dominance may make central bank governors not that objective when discussing fiscal policy.

So why does the media hype up some short run disorder in markets to be something it isn’t? Perhaps it all goes back to mediamacro’s view that government deficits are bad, whatever the causes. (I stress here that not every journalist thinks like mediamacro.) We have seen huge increases in these deficits as a result of the pandemic, which some in the media have written up with horror rather than as only to be expected. So maybe the media is looking for the markets to validate their view. I would be interested in what media folk think about why his interview was written up the way it was.

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.

Austerity as a Knowledge Transmission Mechanism failure

In this post I talked about the Knowledge Transmission Mechanism: the process by which academic ideas do or do not get translated into economic policy. I pointed to the importance of what I called ‘policy intermediaries’ in this process: civil servants, think tanks, policy entrepreneurs, the media, and occasionally financial sector economists and central banks. Here I want to ask whether thinking about these intermediaries could help explain the continuing popularity amongst policy makers of austerity during a liquidity trap, even though there is an academic consensus behind the idea that austerity now would harm output.

In this post I looked at various reasons for thinking there was such a consensus, and one of them was that the framework generally used to analyse business cycles was the (New) Keynesian model. In this Keynesian framework cuts in government spending when interest rates are stuck at their lower bound clearly reduce output, with multipliers around one or more.

Where are these models used in anger? Among academics studying business cycles of course, but also within central banks. As far as I know, pretty well all the core models used by central banks to do forecasting and policy analysis are (New) Keynesian. (This includes the ECB.) An important point about the delegation of stabilisation policy to independent central banks is that expertise on business cycles has tended to shift from civil servants working in finance ministries to economists working in central banks.

Suppose you are a policy maker, who is genuinely concerned about what impact cuts in government spending might have in the period after the Great Recession. Where would you, or your civil servants, go to find expertise on this issue? Given the above, one obvious source, and perhaps the main source, would be independent central banks. One big advantage that independent central banks have over academics as a source for the received wisdom on this issue is that they are a single point of reference. No need to ask the many economists working in the central bank - just ask the central bank governor, who you would expect to distil the wisdom of their own economists.

Following this logic, you might expect to find central banks shouting the loudest about the dangers of austerity. After all, they get the rap for deflation, so anything that makes their job more difficult and uncertain when interest rates have hit their lower bound they should perceive as especially unwelcome. In front of committees of congress/select committees and the like, they should be banging on about how they cannot be expected to do their job if politicians continue to make life difficult by deflating demand. If they did this, some politicians (particularly on the centre left) would have had ammunition with which to counter homilies about Swabian housewives and maxed out credit cards. 

Of course this does not happen. The extent to which it does not happen varies among the major banks. In the US Bernanke did very occasionally (and somewhat discretely) say things along these lines, but he seemed reluctant to do so in any way that might prove influential. In the UK Mervyn King is believed to have actively pushed for greater austerity, and the Bank of England has never to my knowledge suggested that austerity might compromise its control of inflation. The ECB, of course, always argues for austerity. It is one of the great paradoxes of our time how the ECB can continue to encourage governments to take fiscal or other actions that their own models tell them will reduce output and inflation at a time when the ECB is failing so miserably to control both.

So what is going on here? I think there are two classes of explanation, related to the distinction between the roles of interests and ideas in political economy (see Campbell here, for example). The first class talks about why the interests of the elite might favour austerity, and how these interests could be easily mediated through senior central bankers. It could also explore the interests of finance, and their close connections to central banks.

The second class might focus on ideas involving perceived threats to central bank independence. In the US, this might be nothing more than a desired quid pro quo whereby central bankers avoided mentioning fiscal policy so that politicians steer clear of comments on monetary policy. More seriously, amongst other central bankers it may represent a primal (and in the current context quite unjustified) fear of fiscal dominance: being forced to monetise debt and as a result losing both independence and control of inflation. In this context I often quote Mervyn King, who 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.”

These ideas are in conflict with the message on fiscal policy coming from the central bank’s own models. In the UK and US, this contradiction is partly resolved by an excessive optimism about unconventional monetary policy. But it can also be resolved through overoptimistic forecasts, given that inflation targeting is in reality targeting future inflation. Although both these mechanisms come with a limited shelf life, they only need to operate for as long as austerity and the liquidity trap last.

The story I like to use about the Great Recession is that it exposed an Achilles’ heel with the consensus assignment that helped give us the Great Moderation. Yes, it was best to leave monetary policy to independent central banks, but the Achilles’ heel is that this would not work if interest rates hit their lower bound. In that situation fiscal policy had to come in as a backup for monetary policy. But if the analysis above is right the creation of independent central banks may have helped make that backup process much more difficult to achieve. By concentrating macroeconomic received wisdom in institutions that were predisposed to worry far too much about budget deficits, a huge spanner was thrown into the (socially efficient) working of the knowledge transmission mechanism.

  

Can we have our instrument back?

This is a rather long post about how one of the instruments of macroeconomic policy has been taken away, and replaced by a fetish about government deficits. It is not technical.

The latest Bank of England forecast has inflation returning to the 2% target by the end of 2017, which is in three years time. That is an unusually long time to be away from target. So what is the MPC proposing to do about this long lapse from target? Absolutely nothing. Tony Yates goes through all the detail, but remains mildly shocked. Much the same thing is happening in the US. In both countries the main discussion point is not what to do about this prolonged target undershoot, but instead when interest rates will rise. Two members of the MPC are voting to raise rates now! [1]

Cue endless discussion about whether the Bank or Fed think Quantitative Easing does not work anymore, or has become too dangerous to use, or whether the target is really asymmetric - 1% is not as bad as 3%. [2] All this is watched by a huge elephant in the room. We have a tried and tested alternative means of getting output and inflation up besides monetary policy, and that is called fiscal policy. We teach students of economics all about it - at length. But in public it has become like the family’s guilty secret that no one wants to talk about.

Once upon a time (in the 1950s, 60s and 70s) governments in the US, UK and elsewhere routinely used both monetary and fiscal policy to manage the economy. Governments did not stop using fiscal policy for this end because it did not work. Instead they found, and economists generally agreed, that when exchange rates were not fixed monetary policy was a rather more practical (and probably more efficient) instrument to use. They certainly did not stop using it because it caused the rise in inflation in the 1970s. That rise in inflation was the result of oil price shocks, combined with in many countries real wage resistance by powerful trade unions, and policy misjudgements involving both monetary and fiscal policy.

When, in the previous paragraph, I wrote ‘economists generally agreed’, I am talking about what could be described as the academic mainstream. However there were also two important minority groups. One, and the less influential, argued that the mainstream was wrong, and fiscal policy was better than monetary policy at stabilising demand. The other, often among those labelled monetarist, not only took the opposite view, but had a deep dislike of using fiscal policy. For example, many believed its use would be abused by politicians to increase the size of the state (and almost all in this group wanted a smaller state). For some there was the ultimate fear that politicians would run amok with their spending, which would force central banks to print money, leading to hyperinflation - we can call this fear of fiscal dominance. However, as I noted above, the rise in global inflation in the 1970s was not an example of fiscal dominance. I shall use the label ultra-monetarist for this second group: ultra, because it is not clear Friedman himself would be among this group.

These minorities aside, the mainstream consensus was that monetary policy was the instrument of choice for managing demand and inflation, but that fiscal policy was always there as a backstop. So, when Japan suffered a major financial crisis and entered a liquidity trap (interest rates fell to their Zero Lower Bound (ZLB)), the government used expansionary fiscal policy as a means of moderating the recession’s impact. At the time the results seemed disappointing, but following the experience of the Great Recession Japan’s performance in the 1990s does not look so bad.

The key event that would eventually change things was the creation of the Euro. For countries within the Eurozone, monetary policy was set at the union level, so to control demand within each country fiscal policy was the only instrument left. Unfortunately the influence of ultra-monetarists within Germany had always been very strong, and for various reasons the architecture of the Eurozone was heavily influenced by Germany. This architecture essentially ignored the potential use of the fiscal instrument. Instead the influence of monetarism led to what can best be described as deficit fetishism - an insistence that budget deficits should be constrained whatever the circumstances.

Within the Eurozone individual governments no longer had their own central banks who could in extremis print money. The worry among the ultra-monetarists who helped design the Eurozone architecture was that some rogue union members would force fiscal dominance on the union as a whole, so they put together fiscal rules that limited the size of budget deficits. This was both unnecessary, and a mistake. It was unnecessary because the Eurozone set up a completely independent central bank, and made fiscal dominance of that Bank illegal. It was a mistake because it completely ignored the issue of demand stabilisation for countries within the Eurozone - in practice it either took away the fiscal instrument (in a recession) or discouraged its use (in a boom [3]).

While the design of the Eurozone reflected the obsessions of ultra-monetarists within Germany, in the rest of the world the academic mainstream prevailed. So when the financial crisis hit, and interest rates fell to the ZLB across the globe, governments in the UK and US again used fiscal stimulus as a backup instrument to moderate the recession. The IMF, normally advocates of fiscal rectitude, concurred. The policy worked. But two groups were not happy. The ultra-monetarists of course, but also many politicians on the right, whose main aim was to see a smaller state, and who saw deficit reduction as a means to achieve that goal. Both groups began to warn of the dangers of rising government debt, which was rising mainly because of the recession, but also because of fiscal stimulus where that had been enacted.

What happened next was that the Eurozone struck back, although not in a calculated way. It turned out that it did contain just the kind of rogue state the architects had worried about: Greece. The fiscal rules failed to prevent excessive Greek government borrowing. Did this lead to fiscal dominance and hyperinflation in the Eurozone? - of course not, for reasons I have already given. But it did lead governments in the Eurozone to make a fatal mistake. What should have happened, and always does happen to governments that borrow too much in a currency they cannot print, is that Greece should have immediately defaulted on its debt. But instead Greece was initially encouraged to borrow from other Eurozone governments, perhaps because some countries worried that default might lead to contagion (the market would turn on other countries), but perhaps also because default would have hit commercial banks in the larger Eurozone countries who owned this Greek debt.

Eventually contagion happened anyway, and Greece was forced into partial default, although not until it had taken the poison of loans from other Eurozone countries which were conditional on crippling austerity. Equally important was the impact that Greece had on the use of fiscal policy in the rest of the world. Those ultra-monetarists and right wing politicians that had been warning of a government debt crisis used the example of the Eurozone to say that this proved them right. Many (but not all) economists in the mainstream began to believe it was time to reverse the fiscal stimulus, as did the IMF. 

From that point on, the idea that you could - and when monetary policy became ineffective should - use fiscal policy to stimulate the economy became lost. Even in 2009 it had been a difficult policy to sell publicly: why should government be increasing debt at a time that consumers and firms had to reduce their own debt? For those who had not done an undergraduate economics course (which included most political journalists), politicians of the right who said that governments should act like prudent housewives appeared to be talking sense. Greece and the subsequent Eurozone crisis just seemed to confirm this view. Deficit fetishism became pervasive.

Of course this about turn was just what both ultra-monetarists and politicians on the right wanted. The focus on government debt had an additional advantage in certain influential quarters. What had started out as a crisis caused by inadequate regulation of the financial sector began to appear as a crisis of the government’s making, which if you worked in the financial sector which had just benefited from a massive public subsidy was a bit of a relief. You could be really cynical, and say that austerity made room for another big financial bailout when the next financial crisis hit. 

But those with a more objective perspective watched the years after 2010 unfold with growing concern. There were no government debt crises in the major economies outside the Eurozone - instead interest rates on government debt fell to record lows. The market appeared desperate to lend governments money. The debt crisis was confined to the Eurozone. However austerity within the Eurozone, undertaken across the board and not just in the crisis economies, did nothing to end the crisis. The crisis only ended when the ECB offered to back the debt of the crisis countries. The offer alone was enough to halt the crisis, and interest rates on periphery country debt started to fall substantially. But austerity’s damage had been done, creating a second Eurozone recession. The fiscal policy instrument works, even when you use it in the wrong direction! Austerity delayed the UK’s recovery, and while growth was solid in the US, austerity there too meant that the ground lost as a result of the recession was not regained.

So those with a more objective perspective, including many in the IMF, began to realise the fiscal policy reversal in 2010 had been a big mistake. The world had been unduly influenced by the rather special circumstances of the Eurozone. Furthermore within the Eurozone the crisis that austerity had meant to solve had actually been solved by the actions of the ECB. It began to look as if austerity - in perhaps a milder form - had only been required in a few periphery Eurozone countries.

All this should have meant another policy switch, at least to end fiscal austerity and perhaps to return to fiscal stimulus. But deficit fetishism had taken hold. This was partly because it suited powerful political interests, but it was also because it had become the pervasive view within the media, a media that liked a simple story that ‘made sense’ to ordinary people. Politicians who appeared to deviate from the new ‘mediamacro consensus’ of deficit fetishism suffered as a consequence.

So as 2014 ends, we have at best an incomplete recovery and inflation below targets, yet central banks are either not doing enough, or have given up doing anything at all. A huge amount of ink is spilt about this. But if central banks really do believe there is nothing much they can do, with a very few exceptions they fail to say the obvious, which is that it is time to use that other instrument, or at least to stop using it in the wrong direction. Perhaps they think to say this would be ‘too political’. The media in the UK and US continue to obsess about government deficits, even though it is now clear to almost everyone with any expertise that there is no chance of a government funding crisis, so the obsession is completely misplaced. Within the Eurozone deficit fetishism has achieved the status of law!

There are some who say we cannot use the fiscal instrument to help the recovery, and get inflation on target, because debt will become a problem in 30 years time. It is as if a runner, who normally gets their fuel from eating carbohydrates but has run out of energy in mid-race, is denied a food with sugar (HT Peter Dorman) because a high sugar diet is bad for you in the long term. Others in the Eurozone say we must stick to the rules, because rules must be kept. But rules that create recessions with no compensating benefits are bad rules, and should be changed. Rule makers can make mistakes, and should learn from these mistakes. [4] It is perfectly possible to design rules that both ensure long term fiscal discipline, but which do not throw away the fiscal instrument when it is needed.

So every time someone writes something about what monetary policy could or should do to get inflation back to target, they should say at the outset that this goal could be achieved - in a more assured way - by a more expansionary fiscal policy. Political journalists who presume that more borrowing must be bad should get a severe telling off from their economist colleagues. For one thing that should now be clear is that rising debt since the recession has done no harm, but austerity policies that tried to tackle rising debt have done considerable damage. The 2010 Eurozone crisis was a false alarm. Macroeconomics needs to get its fiscal instrument back, and deficit fetishism has to end, but this is being prevented by an alliance between the political right, the ultra-monetarists, and I’m afraid the media itself.

[1] In the UK there is a certain irony here. When inflation was above target in 2010-13, most of the MPC was brave enough to avoid raising rates. Although they forecast that inflation would come back to 2% within two years, this forecast was met with considerable skepticism. Three members of the MPC in 2011 voted to follow their ECB colleagues and raise rates. Perhaps as a result, the Treasury wrote a paper in 2013 which said that on occasions like that (when inflation was above target in a recession) the MPC could be a little more relaxed about the speed at which inflation returned to target. The irony is that this latitude is being used (abused?) now, when inflation is below target and we are still recovering from a recession.

[2] Maybe in the US the target is asymmetrical - but shouldn’t be - but in the UK it is symmetric by law.

[3] In a boom, when fiscal policy should have been contractionary, budget deficits were low as a result of the boom, so the rules suggested no action was required.

[4] Equally those that lent money when they should not have lent money have to accept that they made a mistake.

Fighting the last war

It is often said that generals fight the last war that they have won, even when those tactics are no longer appropriate to the war they are fighting today. The same point has been made about macroeconomic policy: policymakers cannot avoid thinking about the dangers of rising inflation, and in doing so they handicap efforts to fully recover from the Great Recession.

Another military idea is the benefit of using overwhelming force. In the case of inflation we have two legacies of the last war that are designed to prevent inflation reaching the heights of the late 1970s: inflation targets and in many countries independent central banks. Do we need both, or is just one sufficient? I think this question is relevant to the debate over helicopter money (financing deficits by printing money rather than selling debt).

Why are helicopter drops taboo in policy circles? Why is it illegal in the Eurozone? The answer is a fear that if you allow governments access to the printing presses, high inflation will surely follow at some point. Many of those who worry about helicopter money are fairly relaxed about Quantitative Easing (QE), which involves much more money creation than would be involved in a helicopter drop. (Of course some are not relaxed, and (still) think that QE is about to produce rapid inflation - I will ignore that group here.) The key reason they are more relaxed is that central banks are in control of QE, whereas governments would initiate money financing of deficits. [1]

Take the recent interchange between Tony Yates and myself on helicopter money (TY, SWL, TY), and consider the following hypothetical. The economy needs a fiscal stimulus, but for some irrational reason the government will not allow debt to rise. It therefore instructs the central bank to create money to fund a fiscal stimulus (i.e. a helicopter drop). However it also tells the central bank that this action should not compromise its inflation target (which is currently being undershot), and the central bank agrees that the helicopter drop will not compromise its ability to stop inflation exceeding the target, but instead it will help inflation rise to meet that target.

Tony’s problem with this is in the instruction. In these particular circumstances the actions are not a problem, and will do some good (given the government’s irrational fear of debt). However we have crossed a barrier - the government is telling the central bank what to so. The fact that in my hypothetical example the inflation target remains is not enough: he writes “the inflation target in the UK is a very fragile thing”. He goes on: “So I don’t view the inflation target as a cast iron protection against helicopter drops undermining monetary and fiscal policy.  There’s a good reason why monetary financing is outlawed by the Treaty of Rome.  Allowing yourself tightly regulated helicopter drops is not time-consistent.  Once government gets a taste for it, how could it resist not helping itself to more?”

I think it is possible to take two quite different views to Tony on this. The first is that, in most OECD economies today where macroeconomic understanding is better and information more available, inflation targets are more than sufficient to prevent us experiencing the inflation rates of the 1970s again. The hypothetical to think about here is a government that has direct control over the inflation target, but asks the central bank to vary interest rates to achieve that target. Of course we do need to imagine this - it is the UK set-up. Would such a government happily raise the inflation target in order to finance a bit more spending? Such a move would be highly unpopular, because most people think higher inflation means lower real wages. In the UK no political party has even hinted that raising the inflation target might be a good idea, despite obvious fiscal incentives to do so. Suppose a government pretended repeated money creation would not breach the inflation target, even when the central bank advised otherwise. Would that government survive when inflation took off?

A second view is that we have the story of the 1960s and 1970s all wrong. We did not get high inflation in advanced economies because governments wanted to monetise their own profligacy. There were, after all, independent central banks in the US and Germany. Inflation occurred because of the combination of a number of specific factors: trade union pressure in the face of shocks that tended to reduce real wages, underestimation of the natural rate (and a poor understanding of how monetary policy should work), and placing too great a priority on achieving full employment. The latter might have been a legacy of the 1930s: policymakers were also fighting the last war, except in the 1970s the last war was about unemployment, not inflation.

I think both views are probably correct. As a result, I’m much more relaxed about money financing of deficits in the current situation. However in one crucial respect I do agree with those who say we have no need for helicopter money today, because there is no reason for governments to have a fear of rising debt if their central bank can undertake QE. However irrational fear of rising debt in a recession has similar characteristics to fighting the last war: deficit bias is a problem, but a recession is not the time to worry about it. I think this is why I am not persuaded by this article by Ken Rogoff: yes, in the grand scheme of things we should worry about inflation and debt, but right now we are worrying about them too much and therefore failing to deal with more pressing concerns.

[1] Some people imagine the central bank could itself initiate a helicopter drop, independently of government. That is simply not possible given current institutional arrangements, but as I noted in my earlier post (point 7) I think it is interesting to explore institutional changes that give the central bank some role in countercyclical fiscal policy. A simpler confusion is that helicopter money involves giving money to everyone, while tax cuts just go to taxpayers. Helicopter money is really about financing a fiscal stimulus of any kind using money: the form of that fiscal stimulus is a separate matter.

Article 123.1 and the ECB

123.1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.

This post will not be about the the legal interpretation of this article of the European Union Treaty. Ashok Mody does a much better job of that than I ever could, and he comes to the conclusion that the European Court of Justice (ECJ) could well decide that this Article, combined with other parts of the Treaty, makes OMT illegal. As OMT is widely credited with ending the debt funding crisis in the Eurozone, this would represent an existential threat.

The same treaty article may be crucial in deciding whether the ECB institutes a programme of Quantitative Easing (QE) to help revive the Eurozone economy. As Willem Buiter reminds us (in a paper which I discussed an earlier version of before in a different context) a combination of fiscal expansion and QE is a certain way to boost demand and raise inflation. He writes: “there always exists a combined monetary and fiscal policy action that boosts private demand—in principle without limit. Deflation, 'lowflation' and secular stagnation are therefore unnecessary.” He goes on to say that if the Eurozone Treaty prevents this policy, yet the Eurozone wants to avoid the kind of deflationary trap it is currently in, then the Treaty should be changed.

Ashok Mody’s view is nicely summarised in these two paragraphs.

“In highlighting the tensions between the TFEU and the OMT, the German Court is basically concerned that the OMT is a fiscal union by the backdoor. The ECJ could validate the current design of the OMT— locating the fiscal union in the central bank—in which case the nature of the eurozone will be fundamentally altered and the ECB will become a more political institution. Alternatively, if the ECJ were to determine that the German Court’s concerns need to be addressed by changes to the OMT—by imposing serious limits on purchases of sovereign bonds and requiring the ECB to claim seniority to private creditors—the OMT will be rendered ineffective. 

There is a third option. And that would be to agree that the OMT is needed as temporary support because an incomplete monetary union creates intolerable risks. The ECJ would ask the political actors to meet their responsibility by providing a transparent and legitimate mandate for a permanent OMT. They would do so by jointly guaranteeing the ECB against losses incurred if a particular transaction ends in a default. That guarantee may never be needed. But it would focus the minds and clarify who bears the cost. Then Europe would have taken a real step forward.”

I have a lot of sympathy for that view. I have argued that for the Eurozone to survive in something like its current form (and not to have to become a fiscal and political union), the decision about whether to implement OMT must never be automatic (default must be possible), and should be based on transparent and informed advice. However it also seems sensible that the ultimate responsibility for such a momentous decision should lie with member states and their elected representatives.

The issue I want to highlight here is the position of the ECB. At present, as I understand it, the ECB would have the right not to implement OMT, even if governments were happy with it. It also has complete authority about whether to introduce QE - member states get no say. The reasoning behind this is that the ECB’s control over inflation is absolute. As OMT could in theory compromise this control, it must be allowed a say in whether it goes ahead. Article 123 is designed to protect that control, and ensure that the ECB cannot be subject to fiscal dominance. The same mentality can explain why the ECB feels so free to tell member states what they should be doing with fiscal policy. Fiscal policy has a bearing on inflation, so the ECB has a right - indeed a duty - to speak out.

Discussion about the ECB often focuses on the difficulties it faces because its decisions may or may not lead to redistribution among member states. These difficulties would disappear, of course, if the Eurozone became a political union. However, as Ashok Mody points out, the ECJ seems content with this kind of redistribution if it is sanctioned by the democratic representatives of the member states involved. This could happen with OMT, or QE. But this cannot happen if the ECB is designed to be independent of any democratic control. If the ECB can take decisions independently of member states, and those decisions can redistribute income among member states, then the ECJ may say those decisions are illegal and cannot be made. We have a problem, because the ECB is beyond democratic control.

When economists extolled the virtues of central bank independence, did they really have this in mind? Should governments really have no say in what monetary policy’s targets should be, and what mechanisms it should or should not use to achieve them? If the monetary policy institution is completely autonomous, how do we guard against incompetence? Perhaps the perceived need to outlaw inflation using the constitution or by treaty is an attempt to solve a problem of the past, which is stopping us dealing with the problems of today.

Crossing the line at the ECB

Just how much should central bankers express views about fiscal policy? One reasonable response is not at all. Yet fiscal actions can have implications for monetary policy, so vows of silence are both difficult to sustain, and potentially withhold important information from the public.

For example, I have recently suggested that it is almost undeniable that fiscal austerity when interest rates are at the Zero Lower Bound (ZLB) makes it more difficult for monetary policy to do its job. If I was a monetary policy maker, I would want to make that clear to the public, if only to avoid getting all the blame when things go wrong. I have praised Ben Bernanke’s recent comments to that effect, which he reaffirmed more recently. Of course, outside the Eurozone, it would be seen as wrong for central bankers to condemn these policies, but it must be right for them to point out that it causes them difficulties.

So there should not be a taboo on central bankers talking about fiscal policy, when it influences their ability to do their job. Policy makers at the European Central Bank (ECB) are particularly fond of talking about fiscal policy and structural reform. Here is just one recent example, but the ECB’s own research confirms that “the ECB communicates intensively on fiscal policies in both positive as well as normative terms. Other central banks more typically refer to fiscal policy when describing foreign developments relevant to domestic macroeconomic developments, when using fiscal policy as input to forecasts, or when referring to the use of government debt instruments in monetary policy operations.”

So why does the ECB stand out here? One hypothesis that appears not to work is that the ECB has been dragged into commenting on fiscal issues by the Eurozone crisis. We could question, as Carl Whelan does (pdf), why the ECB is part of the Trioka? Was it dragged, or did it invite itself? However, as the ECB research cited above shows, the ECB’s unusual interest in making normative statements on fiscal policy predate this crisis period.

One strong clue is the nature of these interventions. Bernanke warns that excessive fiscal tightness could slow down the US recovery, and because of the ZLB the Fed’s ability to counteract this is at least uncertain. The ECB always urges European governments to make fiscal policy more restrictive. That suggests that it either has a completely different view about the macroeconomic conjuncture in the Eurozone compared to the US (unlikely), or that it believes in expansionary austerity (see below), or that it is concerned about something else (much more likely). The something else which many economists would point to is fiscal dominance.

The ECB and many other European policymakers seem obsessed by the fear that monetary policy will not be able to do its job because of excessive budget deficits in individual Euro member states. So how reasonable is this fear, and is the Eurozone special in this respect, so as to explain the ECB’s unusually vocal behaviour compared to other central banks? The answer is I believe quite clear - the ECB has less to fear from fiscal dominance than any other central bank!

It was partly to show this that I wrote two recent posts on budget deficits and inflation. In the first, I made the widely accepted point that monetary policy can always neutralise the impact of higher debt on inflation by raising interest rates, if fiscal policy makers raise taxes or cut spending sufficiently to stabilise debt. Once you eliminate market panics through OMT, then it is absolutely clear that all Eurozone countries are doing that. So there is no present threat of fiscal dominance.

But imagine there was. In a second post I looked at the possibility that a fiscal policy maker might not even attempt to stabilise debt. In that case, a conflict between fiscal and monetary policy could emerge. Yet I argued that in any resulting game of chicken, if the central bank was able and prepared to allow governments to default and not monetise the deficit, it could retain control of inflation. Now in nearly all countries the government has ultimate power, so it could force the central bank’s hand (although at perhaps a very high political cost). However the one exception is the ECB. The ECB is in a better position to resist fiscal dominance than any other central bank.

So we should see much less of a concern about budget deficits from the ECB than from other central banks, yet we actually see the opposite. I can think of only three explanations for this apparent contradiction. The first is that the ECB does not understand its own position. The second is that the ECB is really concerned about the distributional effects if countries pursue different fiscal paths. Yet if that was the case, they should be focusing on relative fiscal positions, rather than always suggesting lower deficits are good. The third possibility is that the ECB is using its position of authority to pursue other economic or political goals that have nothing to do with its mandate. The ECB is also fairly unique in its lack of accountability. Perhaps for that reason, it feels no inhibition in being free with its opinions on economic issues, even when they have no bearing on its ability to control inflation.

This third explanation may also help explain the reluctance of the ECB to act as a sovereign lender of last resort. We had two years of an existential Euro crisis before OMT was introduced. The argument that is generally used to explain this reluctance is the ECB’s fear of fiscal dominance. However, as I have argued, the ECB has much less to fear on this account than others central banks, yet other banks were quick to undertake Quantitative Easing. As this piece reminds us, and as is noted by Peter Dorman here, pressure from the bond market can be very useful in helping achieve certain economic and political goals. So even though these goals have nothing to do with the ECB’s mandate, the ECB might be reluctant to see those pressures reduced by its own actions.

I would like to be wrong about this. But if I am not, I think it is important to understand what it reveals. To quote Peter Dorman: “In their own minds they probably see neoliberal reforms as self-evidently beneficial to the point that there is no need to spell them out or argue for them: everyone they know understands that this has to be the solution.” They are just giving good economic advice, advice that is needed because politicians too often respond to vested interests rather than sound economic reasoning.

If this reading is correct, then we have a serious problem. In this view about what is good economics, Keynes has completely disappeared. Not only the Keynes who showed why cutting government spending at the ZLB was a foolish thing to do, but also the Keynes who emphasised that prices in financial markets may not reflect fundamentals but instead just what market participants thought that other participants would do.[1] This is the Keynes whose ideas (or interpretation of those ideas) feature heavily, and very positively, in every economics textbook, including those used by those teaching in Eurozone countries. So what remains a real mystery to me is how the elite who make policy in the Eurozone can feel it is legitimate to promote a view about what is good economics which contradicts what economists in the Eurozone teach.

For central bankers to give advice on economic issues that are outside their remit but which pretty well every economist would sign up to is one thing. Of course central bankers will have their own private views on more controversial matters. However it seems to me that to give public advice on economic issues that are outside their remit which are also highly controversial (and contradict what is in the textbooks) seems to me to be crossing a line which it is very dangerous to cross.

[1] This is the insight behind the idea, emphasised by De Grauwe, that there may be a ‘bad equilibrium’ in the market for Eurozone government debt, which the ECB through OMT can help avoid. (For those unfamiliar with this idea, a good place to start is this piece by De Grauwe and Li.)  It is interesting that the ECB, in justifying OMT, tends to favour the argument that the market has unjustified fears of Euro break up, rather than that the market is not looking at fundamentals. It is using an argument that remains consistent with Ordoliberal ideas.

Fiscal backing

In an earlier post I went through the logic of why we do not think higher government debt necessarily causes inflation, even if that debt is denominated in nominal terms, as long as the central bank does not monetise that debt. As I argued there, talk of monetisation is largely unnecessary: we just need to say that the central bank uses interest rates to control inflation, and can therefore offset the impact of any increase in government debt.

However, as Mervyn King said, central banks are obsessed with budget deficits. This seems to contradict the previous paragraph. Are there some ways in which central banks would either lose the power to control interest rates, or be forced to abandon any inflation targets, as a result of fiscal policy? 

In the previous post the thought experiment I considered was a sustainable increase in the level of government debt. By sustainable I mean that the fiscal authorities raise taxes (or cut spending) to service this higher level of debt. But suppose they do not: suppose the budget deficit increases because spending is higher, but there is no sign that the government is prepared either to cut future spending or raise taxes to a sustainable level.

In 1981 Sargent and Wallace published a well known paper which said that, in this situation, the central bank could in the short term control inflation, but in the longer term inflation would have to rise to create the seignorage to make the government budget constraint balance. In other words, to keep the economy stable the central bank would eventually be forced to monetise. This was later generalised by the Fiscal Theory of the Price Level (FTPL). If the government did not act to stabilise debt itself (which Eric Leeper called – a little oddly - an active fiscal policy, and which others - including Woodford, Cochrane and Sims - have called even more confusingly a non-Ricardian policy [1]), then the price level would adjust to reduce the real value of government debt. Fiscal policy determines inflation.

One of the critiques of this theory is that the government budget constraint appears not to hold at disequilibrium prices. See, for example, Buiter here, and a response from Cochrane. I do not want to go into that now. Let’s also concede that if the monetary authority does either follow a rule that allows the price level to rise (by fixing the nominal interest rate for example), or tries to move interest rates to both stabilise debt and inflation (as in my recent paper with Tatiana Kirsanova), then the FTPL is correct.

The case I want to focus on here is where the central bank refuses to do either of those things, but carries on controlling inflation and ignoring debt. Suppose the government is running a deficit which is only sustainable if we have a burst of inflation which devalues the existing stock of government debt, but the central bank refuses to allow inflation to rise. You can say it does this by fixing the stock of money, or by raising the rate of interest - I do not think it matters which. This is an unstable situation: interest payments on the stock of debt at the low price level can only be paid for by issuing more debt, so debt explodes. In this situation, we have a game of chicken between the government and central bank.

Now the game of chicken would probably end when the markets refused to buy the government’s debt. That would be the crunch moment: either the central bank would bail the government out by printing money, or the government would default, which forces it to change fiscal policy. But in Buiter there is an elegant equilibrium outcome: the market just discounts the value of debt by an amount that allows the central bank to set the price level, but for the government’s budget constraint to hold at that price level. We get partial default. This discount factor becomes the extra variable that solves for the tension that both fiscal and monetary policy are trying to determine the price level.

You could quite reasonably suggest that such a central bank could not exist, because the government has ultimate power. It can always instruct the central bank to monetise the debt. However suppose the central bank actually managed the currency for a whole group of nations, and could only be instructed to do anything if they all agreed to do so. Furthermore that central bank was located in the one country in that group that would never contemplate monetisation, so it would be immune to pressure ‘from the street’. That central bank should be pretty confident it could win any game of chicken. [1]

Has any of this any relevance to today’s advanced economies? It seems to me pretty clear that these governments are not playing any game of chicken. Quite the opposite in fact: they are being far too enthusiastic in doing what they can to stabilise debt, despite there being a recession. So we certainly do not seem to be in a FTPL type world. Instead monetary policy right now retains fiscal backing.

Yet in a way we are having the wrong conversation here. Rather than trying to convince central banks that their fears are groundless, we should be asking whether monetary policy should – of its own free will – raise inflation to help reduce high levels of debt. I agree with Ken Rogoff that it should, and have argued the case here. Yet however optimal such a policy might be, the chances of it happening in today’s environment are nil. It looks like we may have to go through a lost decade before we are allowed to contemplate such things. 

[1] I guess a rationale for calling this fiscal policy ‘active’ is that stable regimes in Leeper require one partner to be active and the other passive. So in the normal regime monetary policy is active and fiscal passive, and this flips in a FTPL regime. In a FTPL regime, Ricardian Equivalence no longer holds (because taxes are not raised following a tax cut) – hence the label non-Ricardian.

[2] In this situation, would buying that government’s debt ‘show weakness’ in the game? If we follow Corsetti and Dedola and treat reserves as default free debt issued by the central bank rather than money, then not at all. Instead the central bank is giving the fiscal authority the best chance it can to put its house in order, by removing any bad equilibrium, but it retains the power to force default at any point. We no longer have Buiter’s method of resolving that game, but only because the central bank has the means which could force a win. As long as the government believes that the central bank would prefer the government to default rather than see inflation rise, the government should back down.

Is it a sin for the central bank to help reduce debt?

There is a great deal of discussion about the appropriate goals for monetary policy. Should it just be targeting inflation, or should central banks also include the output gap in their objective function? Perhaps they should target nominal GDP. However, hardly anyone would dream of suggesting that monetary policy should help reduce government debt, by lowering interest rates or raising inflation. It is just accepted that we should only use costly (in welfare terms) increases in taxes, or costly cuts in government spending, to achieve debt reduction.

What I have called the consensus assignment for economies with their own currency is that the central bank stabilises demand and inflation, and the government through fiscal policy manages government debt. The first part of that assignment does not work at the zero lower bound (ZLB), although some economists find it difficult to admit this. But equally there are circumstances where the second part of the assignment is far from optimal, and where it is useful to have the central bank help reduced debt. Circumstances like when debt is much too high.

If we just think about the macroeconomics, where a benevolent policy maker operates both monetary and fiscal policy, then the reason is straightforward and pretty obvious. When debt is high, reducing real interest rates is a pretty effective means of getting debt down. If government debt is about the same size as annual GDP, then a reduction in the real interest rate on government debt of 1% is equivalent to raising taxes by 1% of GDP. If debt is only half the size of GDP, the same reduction in real interest rates is only equivalent to increasing taxes by half as much. The larger the stock of debt, the more effective interest rates are compared to fiscal instruments in reducing debt.

Will reducing interest rates to cut debt not allow inflation to rise? Of course we are compromising our control of inflation. Fiscal instruments can be used to reduce this cost: if we cut government spending as well as cutting interest rates, the net effect on inflation may be small. But the key point is that inflation is not the only thing that matters. Raising taxes or cutting spending to reduce debt is costly too. So it may be better, in terms of social welfare, to let inflation rise for a time to get debt down than to have taxes rise to do the same.

At this point you are probably thinking isn’t the whole point about the consensus assignment that monetary policy is much better at controlling inflation than fiscal policy? Yes it is in our benchmark models, but only when debt is not a problem. If we had some fairly painless way to control debt (i.e. lump sum taxes),[1] then outwith the ZLB, monetary policy is indeed the best way to control inflation.[2] But suppose instead that debt is much too high, and we need to bring it down (and there are no lump sum taxes). Suppose, as suggested above, that monetary policy is also the best way of getting debt down. In that case we are in a different world where comparative advantage applies.

If you are still having difficulties with this - and because the consensus assignment has become such a consensus you might well be - imagine if debt was ten times GDP. In that case it is so much easier to get debt down by reducing real interest rates, it would be crazy not to. Any advantage monetary policy had in controlling inflation would pale into insignificance. If monetary policy is only a bit better at controlling inflation and much better at controlling debt, the latter should have priority.

So if I’ve convinced you this is possible, what about in more realistic situations. Here I can say two things. First, in quite a lot of the DSGE work I have done with my co-author Campbell Leith, we found situations in which monetary policy was useful in reducing debt when debt was high. Here high meant something like 50% of GDP, which is pretty standard today. Second, in the real world there have been occasions when monetary policy was linked quite closely with getting debt down, such as after the second world war. (See, for example, Charles Goodhart here.)

The reason why the idea of adding debt reduction to monetary policy’s tasks seems so taboo today is that we are concerned about the non-benevolent government. A government that spends too much and taxes too little can create ‘fiscal dominance’, and an inflation rate that is permanently too high. In extreme cases it can lead to hyperinflation. As is so often the case with fiscal policy (like the specification of fiscal rules), it is the non-benevolent policy maker which determines how we think about things.

To some it will seem obvious that this should be so. Politicians can be trusted to do the wrong thing, particularly if it is in their interests. There are plenty of examples where this has happened in the past. However, many of us have been arguing that governments today seem if anything too eager to use fiscal policy to get debt down. We seem to have a twisted sort of fiscal dominance, where governments are reducing debt too rapidly, the economy is suffering as a result, yet monetary policy cannot effectively counter because we are at the ZLB. It therefore seems a little odd to be arguing that monetary policy cannot help bring debt down, because that would let fiscal policy makers off the hook. In countries like the UK, USA or the Netherlands, there is no hook, but policymakers are taking unpopular measures to get debt down nevertheless. Would they really do a complete about face if monetary policy lent them a hand?

Now with short interest rates at the ZLB, and in the US and UK with Quantitative Easing directly reducing interest rates on government debt, it would appear as if there is no conflict at the moment between keeping inflation on target and reducing real interest rates. (Although this does not stop some getting very worked up when the central bank helps to reduce current borrowing.) However there are two parts to real interest rates. To the extent that monetary policy could be more expansionary today, but at the cost of higher inflation, it could be helping to reduce debt. If it is not, and the government is benevolent, monetary policy is probably behaving sub-optimally.

[1] These are taxes which have no impact on incentives, and so do not reduce output when raised. Although Miles Kimball has written what seems like a lament to their absence, when Mrs Thatcher tried to introduce them in the UK it led to her downfall.
[2] This is also true if we are quite happy to let debt permanently rise and fall in response to shocks, as Eser et al show.

Quantitative Easing and Fiscal dominance

Unfortunately I cannot find the written source (if any exists), but I am sure I have heard Mervyn King say, probably before he became Governor, that the one thing central bankers hate more than inflation are budget deficits. One rationale for this attitude is that central banks see themselves as playing a game with the fiscal authorities. Governments may be tempted, because they are not benevolent, to occasionally ignore debt when setting fiscal policy. If the monetary authority monetises that debt, this behaviour may be encouraged. This matters because an outcome where the fiscal authority always ignores debt is very bad.
 (It is very bad if the central bank gives in, because it will lead to inflation. If the central bank does not give in, it is very bad either because it leads to a debt explosion and default, or – if you follow the Fiscal Theory of the Price Level - because you get inflation anyway. I do not think it matters in this context which bad it is – see McCallum and Nelson for an example from this debate.)

If we want to prevent this very bad outcome, so the argument goes, it is important that the monetary authorities do nothing to encourage this fiscal policy behaviour. In purely macroeconomic terms, there may well be occasions when it is efficient to use interest rates to help reduce the debt stock – particularly when the debt stock is high. One half of what I call the consensus assignment – that monetary policy should have nothing to do with debt control – therefore needs to be justified by arguments with a more political economy flavour. This particular political economy argument is the one I helped put forward in more detail here.

This concern about not doing anything to encourage ‘fiscal indiscipline’ is likely to be particularly acute at the moment because of Quantitative Easing. Printing money at a time of large budget deficits can be interpreted as fiscal dominance, so it becomes all the more imperative that the monetary authority draw a line in the sand by insisting that QE is temporary, and reinforcing that by sticking rigidly to their inflation targets.

The trouble is that what the world economy needs right now is a bit of what looks like fiscal dominance. (Brad DeLong thinks along similar lines here.) We need a temporary increase in inflation above target. As I have argued before, by focusing on inflation, and ignoring the output gap, central banks are not maximising social welfare as we normally understand it. So how do you convince central banks that their concern about fiscal dominance needs to be set to one side?

One of the potential strengths of the UK monetary policy regime is that you do not have to. The inflation target is set by the government. As I have said before, I do not know why the UK government (and the opposition) is not even thinking about changing the 2% target. If the answer is that it would be politically too difficult to sell, that becomes a very strong argument against democratic control of macroeconomic policy!

 Where central banks do have control of the inflation target, one argument that could be used is that it is quite unusual for governments to persistently and completely ignore debt when setting fiscal policy (see this research for example). Unfortunately I do not think this line will be very persuasive. Quite unusual does not mean never: see Greece most recently. Even in the US, when a good part of one of the main political parties shows a similar disrespect for numbers and facts as some in the Greek government showed before 2007, anything is possible.

The argument I would use with central bankers is this. Fiscal dominance becomes a problem when the output gap is zero or positive, and not when we have demand deficiency. So allow inflation to rise conditional on the existence of a significant negative output gap (or high involuntary unemployment). This could be done through a nominal GDP target, but it does not have to be done this way.

As regular readers of this blog will know, one of my persistent themes is that with fiscal policy we should separate short term issues of stabilisation from long term issues of debt control. Having a fiscal stimulus in a liquidity trap need not compromise long term fiscal discipline. When the long term problem gets mixed up with short term stabilisation, we get bad results. Exactly the same is true for monetary policy and long term fiscal policy: we should not let an obsession about fiscal discipline distort what we do on short term stabilisation. Central bankers understand that questions of moral hazard have to be put to one side in a banking crisis, so why is it so difficult to see that the same point applies in a macroeconomic crisis?