The Nature of Current Macroeconomic Problems
The focus of this article is principally on Europe (including the UK, Cyprus, and others), Japan and the United States, and other countries suffering generally from inadequate private demand, high unemployment, a deflationary tendency, a liquidity trap and a high level of public debt.
Some of these countries have experienced, and still are experiencing, banking crises. Here it is assumed that these banking crises will be resolved by regulatory, prudential, recapitalisation, deleveraging and sectoral-specific policies such that they are not a principal domain for the assignment of corrective macroeconomic policies.
The purpose of this article is not to ask how the current macroeconomic problems developed but, rather, how they might be resolved.
We now have the experience of observing the operation of a range of different monetary and fiscal policies in a number of countries over the past 6 or so years. As well, many valuable, instantly communicated policy articles and analyses are available to inform policy-makers and to speed up the policy review process.
In so far as the current macroeconomic problems are concerned, four things stand out.
- Aggregate private demand is grossly inadequate relative to labour and capital resources and potential capacity in most countries.
- While deflation has occurred principally in Japan and some southern European countries, there are, it seems, consumer price deflationary tendencies at work generally.
- While public debt is arguably excessive in many countries, a given high level of public debt is most serious in respect of those countries that do not have control over their own monetary policy, do not have their own national currency, and have a currency value determined by membership of a currency union.
- From a policy-making perspective, where unemployment rates are already intolerably high and where financial crises are threatening, there is a need to resolve the ‘’inadequate demand’’ and ‘’high debt’’ problems more or less simultaneously. This is the most difficult and challenging case, and the one that that this article focuses upon.
This article does not discuss exchange rate policy. It is assumed here that competitive devaluations are totally inappropriate as, when conducted by a number of countries simultaneously or sequentially, they are at best zero-sum games, with great potential to reverberate and to distort relative inflation performances, world trade and international capital flows. It is assumed, therefore, that currencies remain neither overvalued nor undervalued. Obviously this is an artificial assumption in today’s volatile world where currency conflicts are in evidence, but it is adopted as a simplification to make the discussion manageable.
The Failure of Recent Monetary and Fiscal Policies
It is generally the case that the monetary policy (lowering the policy rate) and fiscal policy (higher budget deficits) adopted at the depth of the initial crisis were effective in avoiding a slide into depression and providing needed economic stimulus.
However, those policies had adverse side-effects, and the policies and policy reversals that have followed have compounded and complicated the initial problems. Successive macroeconomic policy failures have largely led us to the current predicament, in concert with banking and structural weaknesses.
Fiscal policy applied in the early years of the crisis relied upon “new bond financing” to fund increased budget deficits and to provide stimulus in the face of falling GDP. One side-effect of this financing policy was that it contributed to the rise in public debt. This should stand as a lesson for the management of future crises of this nature.
Subsequently, in Europe, bond financed fiscal stimulus was reversed as public debt increased, and ‘’fiscal austerity’’ was imposed in its place. However, the “austerity” policies have failed to reach their objectives and, in fact, have proven to be counter-productive. Budget deficits and public debt have been under upward pressure, GDP has fallen, the public debt burden has risen, and unemployment has continued to grow to intolerable levels.
In the United States, Japan and the United Kingdom, monetary policy relied largely on “quantitative easing” which sought to lower longer-term interest rates and, thereby, flatten the yield curve. The yield curve governs the pricing of risk and risk assumption throughout the entire economy. Artificially flattening the yield curve distorts all time-and-interest rate-dependent investment, production, savings, purchase, sale and consumption decisions. It distorts debt/equity financing decisions. It adversely affects the incomes of those dependent on income from safe government bonds. It forces people to chase yield and, disturbingly, to enter higher risk investments. Artificially flattening the yield curve maintains inefficient business operations, and seeks to bring forward future investment activity, creating a potential lack of investment possibilities in later time periods. By artificially lowering longer-term interest rates, capital outflows develop and, in turn, these capital flows artificially drive-up exchange rates in other countries. Those countries become destabilised, particularly if they already have overvalued exchange rates, or need to raise interest rates to counter excess domestic liquidity or asset price bubbles.
“Quantitative easing” has failed to raise consumer price inflation or reverse deflationary tendencies. Inflation has fallen in the United States, as have inflationary expectations. Inflation expectations in Japan have not increased. That the policy of quantitative easing has failed to lift inflation should not be surprising as it is a policy based on “asset purchases”, not on the purchases of “consumer goods”. Quantitative easing is designed to raise “asset prices’’, to the benefit of the financial economy – banks, investors, traders, hedge funds and speculators: they have a very low marginal propensity to consume the ordinary goods and services included in consumer price indexes. The new money does not get into the real economy. When quantitative easing is withdrawn bond and share price bubbles and other asset price bubbles will collapse, cancelling out any benefits they may possibly have delivered, creating capital losses and financial instability. The faster the exit, the greater the risks, uncertainties and costs, including to the central banks’ balance sheets.
But any such benefits for the real economy from further quantitative easing are ephemeral, as there is no convincing evidence that quantitative easing has boosted business investment or GDP as a consequence of its application over many years.
In the Eurozone, monetary policy has essentially been ‘’defensive’’. At times the policy interest rate was taken upward inappropriately, or generally remained unnecessarily high. With successive crises, new money has been deployed to lower excessive country-specific bond yields as risk premia increased. The latest Outright Monetary Transaction twist is a ‘’last-stand’’ firewall-type policy also aimed in that general direction, although if deployed its limits would need to be agreed and defined.
Policy Instruments and Policy Objectives
Viewed from the present, there is an urgent need to abandon both ”austerity” and “quantitative easing” policies, as they are not achieving their objectives.
This implies a need to re-think the monetary and fiscal policy framework. The relative merits of alternative conventional and unconventional monetary and fiscal policies need to be established and agreed. An assessment is needed as to whether monetary policy should continue be determined separately by an independent central bank with fiscal policy determined in a separate silo by the Treasury; or whether synergies could be created if monetary and fiscal policies are subjected to much greater coordination.
As to the main medium-term macroeconomic policy objectives, it is clear that in many countries there is a need to introduce economic stimulus to restore economic growth and to lower unemployment. At the same time it is essential that the new monetary and fiscal policies do not increase public debt.
Because of current extreme circumstances, and because there are two main policy objectives, it is essential that the policy objectives should, desirably, be addressed simultaneously. It is essential that policies aimed at improving one of the objectives not be allowed to cause deterioration in the other. That is to say, for example, a policy that lifts economic growth is of little value if at the same time it lifts public debt to even higher levels. Equally, a policy that reduces public debt is of little value if at the same time it causes further economic contraction.
In this article it is assumed that ‘public debt’ is measured as general government debt (used by credit rating agencies). It is also assumed that government bonds held by the central bank are included in general government debt.
This section identifies 5 alternative monetary and fiscal policy options.
Option 1) New bond financed budget deficit: The Treasury issues new government bonds to the private sector in order to raise funds to finance a budget deficit and create economic stimulus.
Option 2) New money financed budget deficit: The note issuing authority creates new money which is used by the Treasury to finance the budget deficit and create economic stimulus.
Option 3) Austerity to lower public debt: The government reduces public spending and/or raises taxation in an attempt to lower the budget deficit and reduce the increase in public debt.
Option 4) Further quantitative easing: Assuming the short-term policy rate is at zero bound, this policy aims to lower longer-term interest rates in order to raise private investment and consumer price inflation. However, thus far this policy has increased base money and idle bank reserves without increasing the money supply in the real economy.
Option 5) Bond financed budget deficit plus further quantitative easing: This approach combines Options 1) and 4), with the aim of keeping interest rates constant and providing economic stimulus.
Evaluation of Policy Options
The table below summarises the effects of the different policy options: + is an increase, – is a fall, and 0 is no effect.
Figure 1: Effects of Different Policy Options
Remember that the objective of this exercise is to identify options that provide economic stimulus without increasing public debt. In summary:
- Options 1), 3) and 5) increase public debt. Such policies risk the creation of new financial crises.
- Options 3) and 4) lower GDP, or do not increase GDP, contributing to higher unemployment.
- The increase in GDP under Option 2) is greater than the increase in GDP under Option 1). This follows because under Option 1) resources are withdrawn from the private sector to provide the finance needed to fund the budget deficit, and interest rates rise as a consequence. Under Option 2) no resources are withdrawn from the private sector.
- Under Option 2) the new money flows directly into the real economy and to those with a relatively high marginal propensity to consume. Option 2) increases GDP without increasing public debt. There are no increases in interest rates, no asset price bubbles and no distortions to the pricing of risk.
On the basis of the above, Option 2) is the best policy option.
In circumstances where large-scale deleveraging is necessary further quantitative easing is likely to be totally impotent, as it aims to further lower interest rates (already at historical lows) when the demand for credit is constrained, not by interest costs, but by the imperative for deleveraging. In such circumstances the better, more effective policy is to direct new money creation to raise consumer demand directly via money financing of budget deficits (Option 2).
If Option 2) is to be adopted it would require that monetary and fiscal policies be changed: ‘further quantitative easing’ and ‘austerity’ would both be wound-down. In the Eurozone, Article 123 would presumably need to be amended or rescinded, and greater policy variability according to country-specific circumstances permitted.
There should be no conflict between winding-back quantitative easing over time and moving forward early with Option 2). If, for instance, the Treasury (rather than the central bank) creates the new money under Option 2) then the central bank does not need to acquire more government bonds. Consequently, the timing of the winding-back on quantitative easing could be simply left to the central bank to manage.
Clearly, over the medium to longer-terms, adequate fiscal consolidation as circumstances permit would be desirable. Medium-term fiscal consolidation would be more manageable once stronger economic growth is established.
Given the high levels of labour and capital underutilisation, inflation would not prove to be a problem in the near term, if at all. Should liquidity ever become excessive as economies approach full capacity then the new money created under Option 2) could be sterilised.
For periphery countries that are uncompetitive, trade account adjustment within the Eurozone is likely to be most effectively and less painfully achieved by the use of centrally coordinated wage and price policies and competition policies. Such policies are to be preferred over punishing austerity and slow-acting market forces which, amid current labour and product market rigidities, can create unwarranted and unnecessary reductions in real wage incomes.
(Further details on the mechanics of money financing policy can be found at Wood. R, ‘Helicopter Money Debate: Lord Turner and Professor Woodford’, EconoMonitor, 22 May, 2013. Also see other related articles published on EconoMonitor and Vox Economics websites). 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.