The continuing crisis has spawned inappropriate and unsustainable policy responses in the United States, Japan and the Eurozone. Conventional policy responses cannot simultaneously address debt problems and return these economies to strong growth and full employment. The central issue for policy makers today is the following: if, because of fiscal policy constraints, it is decided that new money creation is desirable to create economic stimulus, what is the best way to deploy that new money. The following note explores an appropriate policy proposal.
Quantitative easing, fighting debt with more debt, and austerity
It is becoming clearer that some countries need to address both falling output and high and spiraling public debt at the same time. These dual problems are currently most acute in Eurozone periphery countries.
In a crisis, debt is like a fire. Debt ownership becomes widespread involving private banks, central banks, governments, private creditors and international institutions. Banks, and other debtors and creditors pass-off debt, and send it around and along. New lenders step up, creating even more debt. ‘Bail-out’ packages, so-called, add to the debt burdens, including those of periphery countries. As the debt builds-up and becomes combustible, the ECB buys up government bonds in a costly, risky and defensive strategy aimed to contain the fire, but not extinguish the source of the blaze. Crude fiscal austerity is imposed to control the debt spiral, but that approach lowers demand, production and government revenues, adding further upward pressure on deficits and debt.
Fighting falling output and rising debt with austerity policies cannot succeed, particularly when applied across a number of neighbouring countries simultaneously. On the other side of the globe, ‘quantitative easing’ policies failed in Japan, and, with interest rates already at historically low levels, have not ignited private investment in the United States. Rather, unproductive commercial bank reserve accounts at the Fed have risen substantially and the yield curve has been distorted. Current policy orthodoxies are failing.
An alternative macroeconomic strategy
It is possible to envisage an alternative plan that could be applied in a worst-case scenario. It is generally not possible for the central bank to directly finance the budget deficit without increasing ‘public debt’: as defined, public debt includes the government bonds held by the central bank. Under the alternative plan, outlined below, the Ministry of Finance (Treasury) creates new currency and uses these funds to finance the deficit without raising public debt as measured, as a means to stimulate the economy.
To give effect to this policy, under Plan A the Treasury/Ministry of Finance could print new Government currency notes (Treasury-created currency) and finance the budget deficit directly with those notes. The Treasury/Ministry of Finance would require that, sooner or later, the central bank drain off the extra liquidity injected through this method of budget financing, as there is already excess liquidity in many financial systems, and an excess of government bonds on the central bank balance sheets.
Plan A would require that two currencies circulate together. This has occurred before without difficulty in the United States and in other countries. The central bank would agree to redeem the Treasury/Ministry of Finance-created currency.
Under Plan B, the Treasury and the central bank both create new currency of equivalent value, matching, say, the value of the budget deficit. As soon as the two tranches of currency are created, they are swapped. The Treasury then holds central bank-created currency and the central bank holds Treasury-created currency. The central bank holds an asset (the Treasury-created currency) and a liability (the obligation attaching to the central bank-created currency). The Treasury pays for new public works infrastructure and other new spending using the central bank-created currency. Under Plan B there is no need for two currencies to circulate at the same time.
‘Current’ public debt does not include the ‘perpetual’ liability that is created whenever new money is created. Under Plan A and Plan B there is no increase in ‘current’ public debt
The fear of inflation is widespread in countries like Germany and the United States, whenever there is new money creation, as with, say, quantitative easing. This fear even exists when there is high unemployment and there is no demand-pull, or cost-push, inflation evident. In relation to Plan A and Plan B, in order to avoid adding to already existing excess liquidity, the Treasury would ask the central bank to sterilise the injection of new money at an appropriate time. This would ensure that inflation cannot rise as a consequence of the proposed approach. The Treasury would leave it to the central bank to decide when and at what pace such sterilisation should take place. To give effect to the sterilisation the central bank would need to sell some of its pre-existing large stock of government bonds into the secondary market.
By that stage, of course, the Treasury will have achieved its primary objective. The Treasury will have injected new money into the economy and financed the first round of additional public expenditures. This spending would place the new currency into the hands of the unemployed, those living below the poverty line and other disadvantaged, marginal businesses and those whose incomes benefit from public infrastructure spending. These economic agents have relatively high marginal propensities to consume. There will have been no increase in public debt (other than the perpetual liability that arises whenever new money is created), and the central bank, via sterilisation, will have ensured that the inflation rate remains appropriate.
The plan’s main two functions are: a) to create a substantial economic stimulus and, simultaneously, b) to immediately stop current public debt rising. Such results would give periphery countries, for instance, some time to reform and adjust their economies, in an attempt to avoid debt default. The plan may also assist Japan with high public infrastructure requirement following the earthquake. Both Japan and the United States need to stimulate activity, to contain rising debt, better coordinate monetary and fiscal policy and avoid further credit downgrades.
The plan discussed here addresses the principal source of the on-going debt problem, the budget deficit. Resources focused there (at the seat of the fire) will be more effective in stopping the spreading of the debt fire than resources focused on trying to contain the debt load by austerity after the fire has been subject to continuing ignition (from on-going deficits).
In summary, creating new money for purposes of quantitative easing has not worked. Austerity is self-defeating in a crisis. Creating new money to purchase bonds (as proposed for Eurozone periphery countries) is defensive and only treats symptoms. The only way to stimulate the economy without raising current public debt is to allow governments to issue new money directly for the limited and tightly constrained purpose of financing budget deficits.
Borio, Claudio (2011), “Central Banking Post-Crisis: What Compass for Unchartered Waters”, BIS Working Paper no 353.
Ugolini, Stefano (2011), “What Future for Central Banking? Insights from the Past”, VOX, 11 December.
Wood, Richard (forthcoming, 2012), “Delivering Economic Stimulus, Addressing Rising Public Debt and Avoiding Inflation”, Journal of Financial Economic Policy, Volume 4, Issue 1.
The writer is an Australian economist. The abovementioned article forthcoming on this subject, ‘Delivering Economic Stimulus, Addressing Rising Public Debt and Avoiding Inflation’, can now be accessed on the Emerald EarlyCite website.