Money-Financed or Bond-Financed Fiscal Stimulus?

Many governments are experiencing malfunctioning macroeconomic policies.

There is growing recognition that the austerity policies adopted in Europe are not delivering lower public debt burdens, increased confidence, higher economic activity or sufficiently lower relative prices in the uncompetitive countries. Pressures are mounting on that continent for pro-growth macroeconomic policies.

On the other side of the globe, the Japanese government has already embarked on fiscal stimulus and massive base money expansion as part of a desperate experiment designed to generate consumer inflation and economic growth, even though quantitative easing policies have been unsuccessful in the past.

In the United States, the monetary authority is sending mixed signals as to its intentions, even though inflation has fallen back to around 1 per cent, and recovery is not adequate or secure.

Thus, while Japan has launched an asset purchase program of unprecedented scale, the United States could wind-back its program, or even, incredibly, ‘fine-tune’ it!  The confluence of potentially opposing monetary policy stances could have destabilising ramifications for interest rates and exchange rates around the Pacific, and elsewhere. Exchange rate depreciation in Japan may temporarily push-up imported goods prices there, but relative dollar appreciation is the United States may push down imported goods prices there, compounding the tendency toward deflation in the United States. Overall, such policy adjustments are zero-sum, if carried through.

There does not appear to be any international coordination and, with such divergent policies internationally, there is growing confusion, scepticism, fear and uncertainty. Rising bond yields are consistent with that interpretation.

Consider quantitative easing. Asset purchases are designed to raise bond prices and targeted asset prices directly and, subsequently, to raise other asset prices, stock prices in particular. Holders of stocks are then expected to spend the profits made from rising stock prices on ordinary consumer goods and services, boosting demand and economic growth. At the same time, lower longer-term interest rates are expected to stimulate private investment. There is no compelling evidence that these channels are sufficiently functional. In the latest twist, the Japanese government has predicated its latest colossal expansion in base money on the apparent belief that it will change expectations sufficiently to reverse deflation and achieve a 2 per cent inflation rate in short order.

The underlying logic supporting these theories, policies and predictions is grossly deficient, uncertain and confused. First, quantitative easing impacts directly on asset prices and base money and has no direct impact on the money supply or consumer goods price inflation. Second, those who benefit from bond purchases under quantitative easing are the banks, speculators, traders and hedge funds, etc. They have very low marginal propensities to consume ordinary goods and services. Ordinary households do not benefit significantly. In the United States and Japan households hold directly less that 6 per cent of government securities on issue, and half of those (in the United States) are owned by high-wealth individuals (the top 1 per cent), also with a low marginal propensity to consume. Third, high-wealth individuals also hold most of the household sector’s shares. As Professor Martin Feldstein (“The Federal Reserve’s Policy Dead End,” The Wall Street Journal, 9 May, 2013) has argued, if the whole of the increase in the share price since quantitative easing began is attributed to quantitative easing, the estimated rise in consumer spending in the United States would be very small, an annual increase of 0.3 per cent. So much for the portfolio rebalancing theory.

We also know that enterprise profitability and business cash reserves have generally remained high and, therefore, that high interest costs have not constrained investment. Interest rate costs do not need to be lowered further. Commercial banks already have mountains of reserves in accounts at the central bank: they could not possibly have any use of additional funds from more quantitative easing. There are no significant, or clearly discernible, improvements in GDP growth. We are left only with the downsides. In this regard, sustained artificially low long-term interest rates distort the discount rate, the pricing of risk, risk allocation and interest-dependent investment, financing, saving, production and consumption decisions; and can create asset price bubbles, exchange rate misalignments, currency wars and exit risks.

Rather than further distort financial systems, monetary policy must be adjusted to allow new money creation to flow directly to infrastructure projects and to the unemployed and the disadvantaged who have high marginal propensities to consume. New money must be redirected away from the financial institutions and speculators and toward consumers, the disadvantaged and low income earners, in order to lift aggregate demand.

Many central bankers believe that the combination of bond financing of budget deficits and quantitative easing has the same effects as new money financing of budget deficits. This view is mistaken. If the new money used to finance the budget deficit is created by the Treasury there is no increase in public debt; whereas, when new government bonds are issued to finance the deficit public debt is increased.  This difference is critical for countries fighting declining activity and high public debt (see Wood, R. 22 May, 2013, “Helicopter Money Debate: Lord Turner and Professor Woodford,” EconoMonitor).

Lord Adair Turner challenged the profession to consider the policy of using new money creation to finance budget deficits. This policy has previously been proposed by Lerner, Friedman, Bernanke, Buiter and others. Some of those economists argue that money financing of deficits is more powerful than bond-financing. Deficits financed by borrowing from the nonbank private sector may have a more limited impact on aggregate demand than direct monetary financing, insofar as there is a compensating reduction in spending by the private sector. Government borrowing may increase domestic interest rates and reduce private investment. By way of contrast, money financing of budget deficits provides no upward pressure on interest rates or public debt, and creates a minimal inflation threat when applied in periods characterised by falling aggregate demand, excess capacity, deflation tendencies and high unemployment.

In their latest paper ‘Rethinking macroeconomic policy: Getting granular’, (31 May 2013), Blanchard, Dell’Ariccia and Mauro note that:

Surely there will be a temptation to lean on central banks to money finance deficits and keep real interest rates very low.  In this context, it is essential that monetary policy decisions continue to the sole purview of the central bank which, in turn, should base its decisions on the way the debt situation and fiscal policy impact inflation, output and financial stability.”

This statement by senior IMF economists is an important addition to the recent dialogue on the financing of budget deficits in the new era of high public debt: a period when all efforts must be directed toward stopping the further rise in that debt.  It is clear, however, that there would need to strong agreement and a high level of cooperation between the Treasury and the central bank if this plan is to be adopted.  The central bank could not operate in a vacuum if the issuance of new government bonds (public debt) is to be avoided, as there are logistical constraints, central bank balance sheet requirements, accounting standards and credit rating agencies to consider. It would seem desirable if the IMF, or other economists, could explore these issues comprehensively to minimise uncertainty going forward.

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.

One Response to "Money-Financed or Bond-Financed Fiscal Stimulus?"

  1. jack straw   June 4, 2013 at 1:26 am

    "think big…get big." it really is that simple. Japan and Europe are failing because they really haven't "measured up" to the task of "bailing out the Greatest Economy in History!' (and yes, that's how it's done folks.) this small fry approach is going to…HAS now cost both of these economies DEARLY. the USA is moving confronting with the next threats of competition and both working for and against to maximize the…what's the word i'm looking for here?…"the blah-blee-blah" i think. with trillions in natural gas just in storage..let alone oil…commodity prices rolling over…credit dirt cheap…housing exploding higher in some places (soon spreading to others), equities at record highs, treasuries at record lows, the dollar moving higher. what HASN'T this market done since 2008? oh, "pay for deficit." watch out…that's coming next too. this US economy thing is a wealth machine beyond all compare right now. if this spills over into nominal growth…well, "we'll just have to wait and see." i really find it hard to believe that it's possible actually…