Reports of the important recent IMF conference ‘Rethinking Macro Policy II: First Steps and Early Lessons’ suggest that it was refreshing and informative. What appears (from the reports) to have been largely overlooked at the conference, however, was a rethinking of the interrelationships and scope for improved coordination between monetary and fiscal policy. From a macroeconomic perspective, greater coordination between monetary and fiscal policy will be necessary if governments are to be able to create economic stimulus without increasing public debt.
Currently, monetary and fiscal policies are generally determined in separate silos, a hangover from the period of high inflation (when monetary policy independence was justifiable).
In many afflicted countries fiscal austerity is the ruling paradigm. This is still the case even though Blanchard and Leigh (‘Growth forecast errors and fiscal multipliers’, IMF Working Paper, WP/13/12013) and De Grauwe and Ji (‘Panic-driven austerity in the Eurozone and its implications’, VoxEU.org, 21 February 2013) have demonstrated that austerity policies have been counter-productive. These policies are not achieving their objectives and are leading to deeper recessions/depressions and higher public debt.
Budget deficits are expected to be substantial in the years ahead. These prospective budget deficits will need to be financed. If they are financed by selling new government bonds then interest rates and public debt will be higher than might otherwise be the case (see below). This will increase the risk of recurring financial crises in the context of weakening GDP and rising public debt burdens. Continued austerity is simply not sustainable.
Further Quantitative Easing
In Japan, the United States and the UK, the prevailing monetary policy paradigm is ‘further quantitative easing’ even though short-term interest rates are at or near zero bound. Further quantitative easing has been justified on various grounds: to lift consumer price inflation, to stimulate private investment and to change expectations. The reality is that despite years of quantitative easing there is no substantial evidence that quantitative easing is working as intended to achieve these objectives with sufficient force or speed.
In the United States, for instance, consumer price inflation has fallen back to around 1 per cent, and inflationary expectations are lower than in 2012. Quantitative easing (asset purchases by the central bank) is designed solely as a means to increase ‘asset’ prices. Quantitative easing is not designed to raise ‘consumer good prices’ (see Bernanke. B, ‘Japanese Monetary Policy: A Case of Self-Induced Paralysis’, Presentation as ASSA Meeting, December 1999). It is inexplicable why the Bank of Japan could justify further quantitative easing on the basis that it will reverse deflation and produce consumer price inflation of 2 per cent.
Enterprises in the United States are generally profitable and have considerable excess financial capacity. Enterprises do not need further quantitative easing.
The commercial banks have massive unproductive balances in their reserve accounts held at the central bank. The commercial banks cannot use the new money already created by earlier quantitative easing. The commercial banks do not need further quantitative easing.
And what benefits do consumers obtain from further quantitative easing? Not many, if any. Ordinary consumers and the disadvantaged (with relatively high marginal propensities to consume) are not the recipients of the new money used to finance bond and asset purchases under quantitative easing: that new money doesn’t get into the real economy. Ordinary households hold, directly, only a relatively small proportion of government securities on issue. Investors and the financial institutions are the principal holders of government securities. So when the central bank purchases government bonds the beneficiaries are the commercial banks, the traders, the speculators, the investors, the hedge funds, etc. These entities have very low marginal propensities to consume the goods and services that are included in consumer price indices. Those entities and speculators re-invest their profits, further raising asset prices. At the same time, those consumers dependent on low-risk interest income are denied a safe source of revenue, and consumption is adversely impacted as a consequence of that.
To the extent quantitative easing lowers medium to longer-term interest rates, the yield curve and the pricing of risk throughout the economy become distorted. Ordinary citizens are forced to invest in more risky assets. Time and interest rate-dependent purchasing, investment, leverage, production and savings decisions are all distorted.
Given that quantitative easing is now being undertaken on a massive scale there will, potentially, be massive consequences for central bank balance sheets, bond prices, share prices, housing prices, commodity prices, other asset prices and exchange rates in foreign countries. Already there is concerning evidence that some of these trends are already apparent. When these new bubbles are pricked new financial crises will follow.
Using further quantitative easing on a massive scale in the hope of changing expectations is fraught with uncertainty as suggested by Blanchard (“Rethinking Macroeconomic Policy’, VoxEU.org, 9 May 2013), and, therefore, a very remote basis to justify the largest monetary expansion in modern history.
Quantitative easing has increased ‘base money’ dramatically, but it has not significantly raised the ‘money supply’ in circulation in the real economy. So what possible purpose could there be behind a doubling of the already elevated ‘monetary base’ in Japan by December 2014?
The European Central Bank has been criticised for being too defensive, and not sufficiently attune to the flagging fortunes of many countries, including periphery countries. It is to be hoped — based on the experiences in Japan, the United States and the United Kingdom — that the European Central Bank does not engage is large-scale quantitative easing as pressure upon it mounts for the reflation of Europe.
Rethinking Monetary and Fiscal Policy Coordination
Current monetary and fiscal policy orthodoxies are demonstrably failing. New macroeconomic policy paradigms are needed in afflicted countries to address gross deficient private demand, deflationary tendencies and high and rising public debt.
Policy makers must prepare to deliver economic stimulus in order to raise aggregate demand, GDP and employment. They must do so in a way that does not increase public debt further or create new destructive asset price bubbles.
Policy interest rates are at zero bound. The options to better coordinate monetary and fiscal policies are, therefore, highly limited, but greater overall policy effectiveness is necessary, none-the-less.
Monetary and fiscal policy officials need to rethink their policies: to do that comprehensively they need to think outside their current boxes, urgently. They could begin by asking whether the new money creation, now directed to the benefit of financial institutions and speculators through quantitative easing, could be better directed to reach the consumers, the disadvantaged and the ordinary people in the real economy through financing budget deficits. This policy approach has, in the past, been recommended by Abba Lerner, Milton Friedman and Ben Bernanke. This policy approach is judged to be more effective than new bond financing of fiscal deficits, as it does not cause crowding-out of private sector activity or raise public debt.
The way forward in this regard is to use new money creation to finance stimulatory fiscal policies. In this way monetary and fiscal policies can be coordinated, synergistically, to achieve GDP and employment growth. Unemployment would stop rising, and fall. Public debt-to-GDP ratios would stop rising, and fall. Asset price bubbles and currency wars would be avoided.
Existing out-dated treaties and out-dated conventional wisdom need to be undone. New operational paradigms need to be developed, and implemented to give effect to this policy reversal: the sooner the better.
For details of how this plan could be developed in practice see Wood, R (Solving the European Economic Crisis: Challenging orthodoxy and creating new policy paradigms, Amazon Books, December 2012) and Wood. R (‘Periphery economies: national governments must be prepared to provide stimulus’, VoxEU.org, 4 March, 2013).
Richard has published papers on wages policy, the taxation of financial arrangements and macroeconomic issues in Pacific Island countries. Views expressed in these articles are his own and may not be shared by his employer.