Economics Essay 104: Monetary Policy Transmission Mechanism

 Explain how the monetary policy transmission mechanism works when the Monetary Policy Committee (MPC) raises Bank Rate.

When the Monetary Policy Committee (MPC) decides to raise the Bank Rate, it aims to tighten monetary policy and control inflation. The transmission mechanism explains how this policy action affects the broader economy. Here's an overview of the monetary policy transmission mechanism when the MPC raises the Bank Rate:

1. Commercial Banks: The change in the Bank Rate directly affects the interest rates commercial banks charge on loans and pay on deposits. When the Bank Rate increases, commercial banks are likely to raise their lending rates, making borrowing more expensive for businesses and individuals. This reduces the demand for loans and can slow down investment and consumption.

2. Borrowing Costs: Higher lending rates have an impact on various forms of borrowing, including mortgages, personal loans, and corporate borrowing. As interest rates rise, the cost of servicing existing debt increases, which can put financial strain on borrowers and reduce their spending capacity.

3. Consumption and Investment: Higher borrowing costs and reduced access to credit can discourage consumer spending and business investment. Individuals may cut back on discretionary purchases, leading to lower retail sales. Similarly, businesses may delay or reduce their investment plans, which can have a negative impact on economic growth.

4. Aggregate Demand: The decline in consumer spending and business investment, resulting from higher borrowing costs, can lead to a decrease in aggregate demand. This reduction in demand can contribute to a slowdown in economic activity and potentially dampen inflationary pressures.

5. Price Levels: The tightening of monetary policy through an increase in the Bank Rate aims to control inflation. Higher borrowing costs can reduce consumer spending, which may moderate price increases and help keep inflation in check. By curbing demand, the policy action can alleviate inflationary pressures in the economy.

6. Exchange Rates: A change in interest rates can also affect exchange rates. If the Bank Rate increases, it can make the currency more attractive to investors seeking higher returns. This increased demand for the currency can lead to an appreciation, making exports relatively more expensive and imports cheaper. This, in turn, can impact the trade balance and competitiveness of domestic industries.

It's important to note that the transmission mechanism is not instantaneous, and the full effects of a change in the Bank Rate take time to filter through the economy. The responsiveness of the transmission mechanism can vary depending on factors such as the financial system's health, the level of household and corporate debt, and the overall economic conditions.

In summary, when the MPC raises the Bank Rate, it influences borrowing costs, which can affect consumption, investment, aggregate demand, price levels, and exchange rates. The overall impact on the economy depends on how businesses, households, and financial markets respond to the change in interest rates.

Economics Essay 80: Impact of Currency Appreciation

Evaluate the possible impact on the cost of living and the standard of living in the UK of a sustained rise in the value of the pound sterling against other currencies, such as the euro and the US dollar.

A sustained rise in the value of the pound sterling against other currencies, such as the euro and the US dollar, can have both positive and negative impacts on the cost of living and the standard of living in the UK. Let's evaluate these effects:

1. Cost of living:

   • Imported goods: A stronger pound reduces the cost of imported goods and raw materials. This can lead to lower prices for imported products, such as electronics, clothing, and fuel. As a result, consumers may benefit from a decrease in the cost of living, as they can purchase these goods at a more affordable price.
   • Imported inflation: On the flip side, a stronger pound can increase the cost of goods and services that are heavily reliant on imported inputs. If businesses pass on the higher costs to consumers, it can lead to inflationary pressures, which may erode the purchasing power of households and increase the cost of living.

2. Standard of living:

   • Purchasing power abroad: A stronger pound enhances the purchasing power of UK residents when they travel abroad or make overseas purchases. It allows them to buy more foreign currency, resulting in greater affordability of goods and services in other countries. This can contribute to an improved standard of living for individuals who engage in international travel or frequently import goods.
   • Export competitiveness: A stronger pound makes UK exports relatively more expensive in foreign markets. This can pose challenges for exporters, as their goods become less competitive compared to those of countries with weaker currencies. Reduced export competitiveness can have adverse effects on employment and income levels, potentially impacting the standard of living of those employed in export-oriented industries.
   • Economic growth: The impact on overall economic growth is an important consideration. A sustained rise in the value of the pound may dampen economic growth if it hampers export performance and reduces business investment. Slower economic growth can have implications for job creation, wage growth, and overall living standards.

It is worth noting that the actual impact on the cost of living and the standard of living will depend on several factors, including the magnitude and duration of the currency appreciation, the structure of the UK economy, the responsiveness of businesses to exchange rate fluctuations, and the policy responses of the government and central bank.

In summary, a sustained rise in the value of the pound sterling can have mixed effects on the cost of living and the standard of living in the UK. While it can lower the cost of imported goods and enhance purchasing power abroad, it may also lead to imported inflation and challenges for exporters. The overall impact on living standards will depend on how these factors interact and the ability of the economy to adjust to changes in exchange rates.

Economics Essay 79: Floating Exchange Rates

 Explain how a government or central bank can intervene to prevent the value of its currency rising.

A government or central bank can intervene in the foreign exchange market to prevent the value of its currency from rising through various measures. Here are some common interventions:

1. Foreign exchange market operations: The central bank can directly buy or sell its own currency in the foreign exchange market. If the currency is appreciating, the central bank can sell its own currency and buy foreign currencies, increasing the supply of its currency in the market and reducing its value. Conversely, if the currency is depreciating, the central bank can buy its own currency and sell foreign currencies to decrease the supply and increase the value of its currency.

2. Monetary policy adjustments: The central bank can implement monetary policy measures to influence the value of the currency. For instance, it can decrease interest rates or engage in quantitative easing, which increases the money supply. These actions can make the currency less attractive to foreign investors, leading to a decline in its value.

3. Capital controls: Governments can impose restrictions on capital flows to prevent excessive inflows of foreign capital that could lead to currency appreciation. They may impose limits on foreign investment, restrict the repatriation of funds, or implement taxes or levies on certain capital transactions. These measures aim to reduce the demand for the domestic currency and prevent its value from rising.

4. Intervention coordination: Governments or central banks can coordinate with other countries to intervene collectively in the foreign exchange market. This can involve joint actions to buy or sell currencies to stabilize exchange rates and prevent excessive currency fluctuations.

It is important to note that currency interventions are subject to certain limitations and can have both short-term and long-term effects. Here are some considerations:

1. Effectiveness: The impact of currency interventions may vary, and their effectiveness in influencing exchange rates depends on market conditions, the size of the intervention, and the overall economic factors at play.

2. Costs and risks: Currency interventions can involve significant costs and risks. For example, buying or selling large amounts of foreign currencies can deplete foreign exchange reserves, potentially leading to reduced financial stability. Moreover, interventions may be seen as market manipulation, potentially undermining investor confidence.

3. Policy credibility: Frequent or unpredictable interventions can raise questions about a government's or central bank's commitment to market principles and exchange rate stability. This can erode market confidence and have unintended consequences.

4. Trade implications: Currency interventions can affect trade competitiveness. A weaker currency may make exports more competitive but also increase the cost of imports, potentially impacting a country's trade balance.

Overall, currency interventions can be a tool for governments or central banks to manage exchange rate movements. However, their effectiveness and appropriateness depend on specific circumstances, and policymakers need to carefully consider the potential costs, risks, and trade-offs associated with such interventions.

Strict inflation targets for central banks have caused economic harm

 Edward Chancellor in The FT

A great experiment in monetary policy is drawing to a close. Last week, the European Central Bank announced its largest rate hike in two decades, taking its benchmark rate back to just zero per cent. Never before, over the course of some 5,000 years of lending, have interest rates sunk so low. Those who rue the consequences of easy money are quick to blame central bankers. But the problem originates with the strict inflation mandates they are required to follow. 

In 1990, the Reserve Bank of New Zealand became the first central bank to adopt a formal target. In 1997 a newly independent Bank of England was also given a target, as was the ECB when it opened for business a year later. After the global financial crisis, both the Federal Reserve and Bank of Japan jumped on board. What BOJ governor Haruhiko Kuroda called the “global standard” — an inflation target in the range of 2 per cent — performed several functions: providing central banks with a clearly defined benchmark, anchoring inflation expectations and relieving politicians of responsibility for monetary policy. 

The trouble is that whenever an institution is guided by a specific target, critical judgment tends to be suspended. As the late political scientist Donald Campbell wrote, “the more any quantitative social indicator is used for social decision-making”, the higher the risk it will distort and corrupt the processes involved. This problem is well known in monetary policymaking circles. In the 1970s Charles Goodhart of the London School of Economics noted that whenever the BoE targeted a specific measure of the money supply, this measure’s earlier relationship to inflation broke down. Goodhart’s Law states that any measure used for control is unreliable. 

Inflation-targeting runs true to form. Thanks in large measure to globalisation and technological advances, inflationary pressures abated in the 1990s, allowing central bankers to lower interest rates. After the dotcom bust at the turn of the century, fears of deflation induced the Federal Reserve to set its Fed funds rate at a postwar low of 1 per cent. A global credit boom followed. The ensuing bust unleashed even stronger deflationary pressures. The Fed proceeded to cut its policy rate to zero. In Europe and Japan, rates turned negative for the first time in history. 

Throughout the following decade, central bankers justified their actions by reference to their inflation targets. Yet these targets produced a number of corruptions and distortions. Ultra-low interest rates pushed the US stock market to near record valuations and provided the impetus for the “everything bubble” in a wide variety of assets ranging from cryptocurrencies to vintage cars. Forced to “chase yield”, investors assumed more risk. The fall in long-term rates hurt savings and triggered a massive increase in pension deficits. Easy money kept zombie businesses afloat and swamped Silicon Valley with blind capital. Companies and governments availed themselves of cheap credit to take on more debt. 

Most economists assume that interest rates simply reflect what’s going on in what they call the “real economy”. But, as Claudio Borio at the Bank for International Settlements argues, the cost of borrowing both reflects and, in turn, influences economic activity. In Borio’s view, the era of ultra-low interest rates pushed the global economy far from equilibrium. As he puts it, low rates begot even lower rates. 

During the pandemic central bankers were still striving to meet their inflation targets when they lowered interest rates and printed trillions of dollars, much of which was used by their governments to meet the extraordinary costs of lockdowns. Now, inflation is back and central banks are scrambling to regain control without crashing the economy or inducing yet another financial crisis. The fact that policy rates trail far below inflation, on both sides of the Atlantic, suggests that monetary policymakers are no longer blindly following their inflation targets to the exclusion of all other considerations. 

This is welcome. But elected politicians cannot continue to shirk responsibility. They need to reconsider central banks’ mandates, taking into account the impact of monetary policy not just on near-term inflation, but on asset valuations (especially real estate), leverage, financial stability and investment. The experiment with zero and negative rates has done considerable harm. It must never be repeated. As Mervyn King, the former BoE governor, says: “We have not targeted those things which we ought to have targeted and we have targeted those things which we ought not to have targeted, and there is no health in the economy.”

Stagflationary global debt crisis looms – and things will get much worse

 


The global financial and economic outlook for the year ahead has soured rapidly in recent months, with policymakers, investors and households now asking how much they should revise their expectations, and for how long. That depends on the answers to six questions.

First, will the rise in inflation in most advanced economies be temporary or more persistent? This debate has raged for the past year but now it is largely settled: “Team Persistent” won, and “Team Transitory” – which previously included most central banks and fiscal authorities – must admit to having been mistaken.

The second question is whether the increase in inflation was driven more by excessive aggregate demand (loose monetary, credit, and fiscal policies) or by stagflationary negative aggregate supply shocks (including the initial Covid-19 lockdowns, supply-chain bottlenecks, a reduced US labour supply, the impact of Russia’s war in Ukraine on commodity prices, and China’s “zero-Covid” policy). While demand and supply factors were in the mix, it is now widely recognised that supply factors have played an increasingly decisive role. This matters because supply-driven inflation is stagflationary and thus raises the risk of a hard landing (increased unemployment and potentially a recession) when monetary policy is tightened. That leads directly to the third question: will monetary-policy tightening by the US Federal Reserve and other major central banks bring a hard or soft landing? Until recently, most central banks and most of Wall Street occupied “Team Soft Landing”. But the consensus has rapidly shifted, with even the Fed Chair, Jerome Powell, recognising that a recession is possible, and that a soft landing will be “very challenging”.

Moreover, a model used by the Federal Reserve Bank of New York shows a high probability of a hard landing, and the Bank of England has expressed similar views. Several prominent Wall Street institutions have now decided that a recession is their baseline scenario (the most likely outcome if all other variables are held constant). In the US and Europe, forward-looking indicators of economic activity and business and consumer confidence are heading sharply south.

The fourth question is whether a hard landing would weaken central banks’ hawkish resolve on inflation. If they stop their policy-tightening once a hard landing becomes likely, we can expect a persistent rise in inflation and either economic overheating (above-target inflation and above potential growth) or stagflation (above-target inflation and a recession), depending on whether demand shocks or supply shocks are dominant.

Most market analysts seem to think that central banks will remain hawkish but I am not so sure. I have argued that they will eventually wimp out and accept higher inflation – followed by stagflation – once a hard landing becomes imminent because they will be worried about the damage of a recession and a debt trap, owing to an excessive buildup of private and public liabilities after years of low interest rates.

Now that a hard landing is becoming a baseline for more analysts, a new (fifth) question is emerging: Will the coming recession be mild and short-lived, or will it be more severe and characterised by deep financial distress? Most of those who have come late and grudgingly to the hard-landing baseline still contend that any recession will be shallow and brief. They argue that today’s financial imbalances are not as severe as those in the run-up to the 2008 global financial crisis, and that the risk of a recession with a severe debt and financial crisis is therefore low. But this view is dangerously naive.

There is ample reason to believe that the next recession will be marked by a severe stagflationary debt crisis. As a share of global GDP, private and public debt levels are much higher today than in the past, having risen from 200% in 1999 to 350% today (with a particularly sharp increase since the start of the pandemic). Under these conditions, rapid normalisation of monetary policy and rising interest rates will drive highly leveraged zombie households, companies, financial institutions, and governments into bankruptcy and default.

The next crisis will not be like its predecessors. In the 1970s, we had stagflation but no massive debt crises because debt levels were low. After 2008, we had a debt crisis followed by low inflation or deflation because the credit crunch had generated a negative demand shock. Today, we face supply shocks in a context of much higher debt levels, implying that we are heading for a combination of 1970s-style stagflation and 2008-style debt crises – that is, a stagflationary debt crisis.

When confronting stagflationary shocks, a central bank must tighten its policy stance even as the economy heads toward a recession. The situation today is thus fundamentally different from the global financial crisis or the early months of the pandemic, when central banks could ease monetary policy aggressively in response to falling aggregate demand and deflationary pressure. The space for fiscal expansion will also be more limited this time. Most of the fiscal ammunition has been used, and public debts are becoming unsustainable.
 
Moreover, because today’s higher inflation is a global phenomenon, most central banks are tightening at the same time, thereby increasing the probability of a synchronised global recession. This tightening is already having an effect: bubbles are deflating everywhere – including in public and private equity, real estate, housing, meme stocks, crypto, Spacs (special purpose acquisition companies), bonds, and credit instruments. Real and financial wealth is falling, and debts and debt-servicing ratios are rising.

That brings us to the final question: will equity markets rebound from the current bear market (a decline of at least 20% from the last peak), or will they plunge even lower? Most likely, they will plunge lower. After all, in typical plain-vanilla recessions, US and global equities tend to fall by about 35%. But because the next recession will be stagflationary and accompanied by a financial crisis, the crash in equity markets could be closer to 50%.

Regardless of whether the recession is mild or severe, history suggests that the equity market has much more room to fall before it bottoms out. In the current context, any rebound – such as the one in the last two weeks – should be regarded as a dead-cat bounce, rather than the usual buy-the-dip opportunity. Though the current global situation confronts us with many questions, there is no real riddle to solve. Things will get much worse before they get better.

There is ample reason to fear big economies such as the US face recession and financial turmoil writes Nouriel Roubini in The Guardian

Niall Ferguson | Ukraine, Zelensky, Putin & China

 

Inflation, Prices, Interest Rates...A Policy Crisis

 

Debt levels are not an issue

The Bank of England must be clear about its focus on jobs and growth – and that stimulus needn’t spoil anyone’s sleep writes Phillip Inman in The Guardian

Bank of England governor Andrew Bailey was sure-footed at the start of the pandemic. Photograph: Reuters 



Tearing at the Tory party’s fabric is the thought of spiralling government debt. The subject triggers a cold sweat in some of the most emotionally resilient Conservative backbench MPs, such is the distress it generates.

Much as the German centre-right parties have spent the past 90 years fearing a return of hyperinflation, their UK counterparts worry about paying the national mortgage bill, and the possibility it will one day engulf and sink the ship of state.

Since the budget, there is a sense that the costs of the pandemic, of levelling up, of going green and of social care – to name just four candidates for extra spending – are scarily high.

Plenty of economists say these costs can be managed with higher borrowing. Even the experts who warned against rising debts back in 2009 have changed their minds. The International Monetary Fund and the Organisation for Economic Cooperation and Development say that after 30 years of falling interest rates, this is the moment to stick extra spending on a buy now, pay later tab. 

Yet, gnawing away at the Tory soul is the prospect of an increase in interest rates by a fragile Bank of England, an institution that owns more than a third of UK government debt. This week, Threadneedle Street’s monetary policy committee meets to discuss the state of the economy and whether it needs to adjust its current 0.1% base rate.

Last year the committee was concerned that the economic situation was so bad it might need to lower interest rates even further, pushing them into negative territory. In recent weeks, though, the success of the vaccine programme, some additional spending by Rishi Sunak in his spring budget and Joe Biden’s monster stimulus package – which has made its way unscathed through the US Congress – have turned a few heads.

Now there are warnings of a rebound in growth so strong that it will force central banks to calm things down with the much-dreaded increase in interest rates.

At Thursday’s meeting, Andrew Bailey will mark a year as governor, and will be forgiven for wanting to draw breath. Within weeks of the handover from Mark Carney, he was plunged into the pandemic and – like his counterpart in the Treasury, Sunak – forced to plot a way through the crisis.

Bailey should set aside his in-tray and do the nation a favour by making explicit what, in a post-pandemic world, the Bank’s mandate means. And what he should say is neither outlandish nor controversial.

It should not differ wildly from what Jerome Powell, the head of the US central bank, said last week. Bailey should explain that the Bank’s focus is on generating a path for growth that has momentum and is sustainable. Only when the Bank can verify that jobs are being created – and, more importantly, that pay rises of at least 4% a year are being awarded – will it begin to consider tightening monetary policy.

This means interest rates cannot increase until the government has two things working in its favour. First, that there are enough jobs and pay increases to generate the level of tax receipts that can pay for higher debt bills. Second, that there is a level of growth which means the debt-to-GDP ratio, expected to hit about 110% during this parliament, starts coming down, even as the government spends more.

If Bailey says this like he means it, those who worry about rising interest rates can switch to worrying about something else, such as the climate emergency, Britain’s spectacular loss of biodiversity and rising levels of child poverty.

Bailey’s record over his first year in charge does not augur well. While he was sure-footed at the outset of the pandemic, dusting off the 2008 crisis playbook and printing a huge sum of money to restore confidence, things soon started to go awry.

He has flip-flopped from optimist to pessimist on the economy while throwing incendiary devices on the fears of those who worry about debt. In an interview last June, for example, he claimed the bond markets brought Britain close to insolvency when the bank launched its first pandemic rescue operation. It was an exaggeration that matched the hyperbole of his recent support for the idea that consumers are ready to “binge” once lockdown eases.

If the past 10 years has taught us anything, it is that the Bank has consistently done too little to help the economy and not too much. Bailey could ask Sunak to overhaul the MPC remit, increasing the inflation target from the current 2% to 3% or 4%, or bolting on a growth target that would force the Bank to keep rates where they are until growth reaches 3% or 3.5% a year.

That could be Bailey’s legacy, for which the nation would thank him.

Economics for Non Economists 2 – Quantitative Easing Explained

by Girish Menon

Pradhip, you have asked for an ‘Idiot’s guide on Quantitative Easing and how it affects the economy’. Let me try:

The Bank of England (BOE) has been practising Quantitative Easing (QE) since 2009. The amounts are:

Time	Amount in £ Billions
Nov. 2009	200
July 2012	375
Aug. 2016	435
Mar. 2020	645
June 2020	745

Ref – The Bank of England

What exactly did the BOE do when they said they were doing QE?

The BOE created additional digital money and used it to buy financial assets (especially government bonds) which were owned by the privately owned banks, pension funds and others.

How did they create this additional money?

Unlike you or me who would be arrested if we did this; the BOE has been conferred with monopoly powers to conjure up any amount of money from thin air by typing the necessary numbers into its bank accounts. It’s as simple as saying, ‘Let there be £745 billion and it appears in the bank’s accounts.

Why do they do QE?

Post the 2008 financial crisis there was a liquidity crisis (see below for explanation of liquidity crisis). The BOE by buying the government bonds from local banks transferred cash to them thus enabling them to start their lending activities in the economy.

In 2020 too they have done the same, but this time I suspect that even if the commercial banks are willing to lend there may not be enough borrowers and so this policy may not have the intended effect of stimulating economic growth.

How does QE affect the economy?

The dominant worldview is that debt drives the world. So QE ensures that lenders have enough money to lend to prospective borrowers. Borrowers borrow money to produce and sell goods at a profit; enabling them to repay their loans with interest while creating jobs in the economy.

The above borrower will use his loan to buy machinery, employ labour…. One man’s spending is another man’s income, so the money begins to circulate among citizens in an economy and a positive spiral will push economic growth and create employment.

However, all this theory hinges on the citizens’ confidence about the future. In the current Covid climate, with firms downsizing at will and people worried about their future, I doubt if there will be a critical mass of borrowers to re-start the stalled economic activity.

Pradhip, thus the BOE does indeed have a magic wand to create money out of thin air. You may ask why is it that in a free market I am not allowed to create my own money? Now that question will be considered seditious!

----

 

What Is a Liquidity Crisis?

A liquidity crisis is a financial situation characterized by a lack of cash or easily-convertible-to-cash assets on hand across many businesses or financial institutions simultaneously. In a liquidity crisis, liquidity problems at individual institutions lead to an acute increase in demand and decrease in supply of liquidity, and the resulting lack of available liquidity can lead to widespread defaults and even bankruptcies. (Ref Investopedia)

---Also watch

Have Economists Have Changed their Views on Public Debt?

The national debt was the bogeyman in 2008/9 not anymore writes Ethan Ilzetzki in The Guardian

 

 

The chancellor, Rishi Sunak (right), visits a London market on 1 June. Photograph: Simon Walker/PA


The coronavirus pandemic has taken a calamitous toll on the economy, with unemployment in April 2020 rising faster than in any month on record. The Treasury has responded with unprecedented measures to support workers, businesses and the self-employed, leading to a public deficit of £300bn this year.

How concerned should we be about the public debt, forecast to exceed the size of the UK economy? Public debt results when the government spends more than it raises in tax revenues – runs a public deficit – and borrows money to cover the gap. The government then pays interest on this debt, which is eventually repaid or rolled over by new borrowing. As long as interest rates are low – they are currently nearly zero – this poses few costs. The economy may also grow, generating more tax revenues and making it easier to repay the debt. But if interest rates rise faster than the economy grows, the public debt may increase to unsustainable levels. These may eventually require budget cuts or tax increases, often referred to as austerity.


These views are a far cry from the calls for budgetary cuts during the global financial crisis

The Centre for Macroeconomics (CfM) – a research centre bringing together experts from institutions such as the London School of Economics, University of Oxford, University of Cambridge and the Bank of England – posed this question to a panel of some of the UK’s leading economists. Economists are a conservative lot: we like budgetary numbers to add up. So the responses might come as a surprise. With one exception, not a single panel member expressed concern about the deficit. What’s more, the majority thought that public debt should be ultimately addressed with tax increases, particularly on the wealthy; and the panel unanimously opposed public spending cuts. Several even advocated monetary financing of the deficit, in other words selling government bonds directly to the Bank of England. These days, not even economists support austerity.

These views are a far cry from the calls for budgetary cuts during the global financial crisis and reflect a substantial shift in economic thought that has been unfolding over the past few decades. The change isn’t solely a British phenomenon. German economists were particularly uncompromising on limiting deficits during the Eurozone crisis. But a new generation of German economists has been the vanguard in promoting “coronabonds”, which would mutualise debts of EU members. The International Monetary Fund (IMF) was well-known for its conservative views on public deficits. The global financial crisis brought change to the institution, with its then chief economist, Olivier Blanchard, openly advocating stimulus over austerity.

Economic stabilisation through public spending was the brainchild of John Maynard Keynes during the Great Depression. But the Keynesian moment in economic thought was relatively short-lived. The global inflation of the 1970s brought a new generation of economists, sceptical about governments’ ability to use their budgetary power to support economic recovery. Keynesian views had been pushed so far to the sidelines that the Nobel laureate economist Robert Lucas Jr pronounced “the audience starts to whisper and giggle to one another” whenever Keyensian views were espoused in economics research seminars.

These views seeped into the political consciousness to the extent that by 1976, the prime minister, James Callaghan, told the Labour party conference that the option of “spend[ing] your way out of a recession and increas[ing] employment by cutting taxes and boosting government spending” no longer existed and would only lead to inflation. These views were enshrined in the Washington Consensus, whose first principle, according to John Williamson, was: “Washington believes in fiscal discipline.”

The debate on the public debt re-emerged during the recession of 2008-9. A substantial faction in the economics profession continued to warn that fiscal stimulus was no way to recovery. At the same time, increasing numbers of mainstream economists, including the leadership of the IMF and Ben Bernanke, then head of the US Federal Reserve Board, supported the public spending expansions that the US government undertook and warned that the UK’s austerity programme would exacerbate the economic pain. The attitude shift was partly pragmatic. At the turn of the century, many economists had come to believe that central banks had the ability to resolve all macroeconomic woes. This position became less tenable when central banks around the world were running out of ammunition, having reduced interest rates to zero. 

The slow recovery in the UK and the economic carnage in southern Europe – both following austerity policies – compared with the faster recovery in the US, appeared to lend further credence to the notion that active fiscal policy could be used to support economic recovery. This new view perhaps reached its apogee in Blanchard’s 2019 presidential address to the American Economic Association, where he argued that public debt is no longer of concern when interest rates are well below the economy’s growth rate. Our confidence that high-income countries, which are still able to borrow at low interest rates, will be spared may be premature. Public debt is indeed no concern when interest rates are at zero. But history shows us that governments’ borrowing rates may change dramatically when market sentiment shifts.

Benign deficit neglect is a ultimately a rich-country luxury. The developing world is now in the midst of the greatest public debt crisis in a generation. Governments from Argentina to Zambia are financing their deficits with great difficulty. As investors repatriated their funds to the relative safety of the US, these countries have seen rising borrowing rates and tumbling currencies, and will require (or already in the process of) debt restructuring.

Governments’ top priorities should remain the public health emergency and supporting the economy through these difficult times. But it would be wise to keep half an eye on the public debt clock.

German court decides to take back control with ECB ruling

Martin Wolf in The Financial Times 

The 75th anniversary of the defeat of Nazi Germany was May 8. The 70th anniversary of the Schuman declaration, which launched postwar European integration, was May 9. Just days before both, the German constitutional court launched a legal missile into the heart of the EU. Its judgment is extraordinary. It is an attack on basic economics, the central bank’s integrity, its independence and the legal order of the EU. 

The court ruled against the ECB’s public sector purchase programme, launched in 2015. It did not argue that the ECB had improperly engaged in monetary financing, but rather that it had failed to apply a “proportionality” analysis, when assessing the impact of its policies, on a litany of conservative concerns: “public debt, personal savings, pension and retirement schemes, real estate prices and the keeping afloat of economically unviable companies”. 

Monetary policies are necessarily economic policies. But the ECB’s policies, including asset purchases, are justified by the fact that it was — and is — failing to achieve its treaty-mandated “primary objective”, which is “price stability” defined as inflation “below, but close to, 2 per cent over the medium-term”. The EU treaty says other considerations are secondary. 

The court also decreed that “German constitutional organs and administrative bodies”, including the Bundesbank, may not participate in ultra vires acts (those outside one’s legal authority). Thus, the Bundesbank may not continue to participate in the ECB’s asset purchase programmes, until the ECB has conducted a “proportionality assessment” satisfactory to the court. 

Yet the EU treaty states that “neither the ECB, nor a national central bank . . . shall seek or take instructions . . . from any government of a member state or from any other body [my emphases].” The court’s instruction puts the Bundesbank into a conflict of laws. 

The court is also assailing the right of the ECB to make its policy decisions independently. Germany fought hard to install central bank independence within the monetary union. Now, its constitutional court has decreed that unless the ECB satisfies the justices that it has taken full account of a highly political list of side-effects of monetary policies, asset purchases are impermissible. Courts in other member countries may see fit to decree that their national central banks cannot participate in policies they dislike. Pretty soon, the ECB will have been sliced and diced into a nullity. 

Above all, the German court decreed that it can ignore an earlier ruling of the European Court of Justice in favour of the ECB, because the former “exceeds its judicial mandate . . . where an interpretation of the Treaties is not comprehensible and must thus be considered arbitrary from an objective perspective.” This is an act of judicial secession. 

The EU is an integrated legal system, or it is nothing. It rests on the acceptance by all member states of its authority in areas of its competence. In a press release after the constitutional court’s judgment, the ECJ rightly responded that “the Court of Justice alone . . . has jurisdiction to rule that an act of an EU institution is contrary to EU law. Divergences between courts of the member states as to the validity of such acts would indeed be liable to place in jeopardy the unity of the EU legal order and to detract from legal certainty.” Imagine if the courts of every member state were able to decide that ECJ rulings were “arbitrary from an objective perspective”. 

What are the implications? 

If the German court is ultimately satisfied that the ECB adequately assessed the economic impact of its purchases, the PSPP might continue. But the courthas reduced the ECB’s future flexibility by limiting its holdings of any member country’s debt to 33 per cent of the outstanding total and insisting that asset purchases be allocated according to member states’ shares in the ECB. 

In the absence of other eurozone support programmes, the chance of defaults has jumped. Indeed, spreads on Italian government bonds have duly risen a little since the court’s announcement. A crisis might ultimately ensue, with devastating effects; perhaps even a break-up of the eurozone. 

Others might follow Germany in rejecting the jurisdiction of the ECJ and EU. Hungary and Poland are obvious candidates. Future historians may mark this as the decisive turning point in Europe’s history, towards disintegration. 

What can be done? The ECB cannot be accountable to a national court. But the Bundesbank could provide the court with the proportionality analysis. Maybe that would be enough, albeit also a bad precedent. Or, the decision could be ignored. If a German court can ignore the ECJ, maybe the Bundesbank can ignore that court. Alternatively, the ECB could just abandon efforts to rescue the eurozone and accept whatever outcome emerges. 

The EU could initiate an infringement proceeding against Germany. But its direct target would be the German government, which is caught between the EU organs on the one hand and the court on the other. It could not change the ruling. 

More radically, the EU could act to create the needed degree of fiscal solidarity. But the obstacles to this are large. A new treaty looks out of the question in today’s environment of intense mutual distrust. Finally, Germany could boldly secede from the eurozone. Yet, before it makes such a decision, one hopes it, too, will be required to do a full analysis of whether that would be “proportionate”.

One point is clear: The constitutional court has decreed that Germany, too, can take back control. As a result it has created a possibly insoluble crisis.

Can governments afford the debts they are piling up to stabilise economies?

Two experts debate the long-term impact on inflation of the Covid-19 rescue packages 

Stephanie Kelton and Edward Chancellor in The FT

YES - It poses no inherent danger to states that issue their own currency 

The Covid-19 pandemic has forced governments around the world to spend large sums in an effort to stabilise their economies, writes Stephanie Kelton. Gone, for now, are concerns about how to “pay for” it all. Instead we are seeing wartime levels of spending, driving deficits — and public debt — to new highs. 

France, Spain, the US, and the UK are all projected to end the year with public debt levels of more than 100 per cent of gross domestic product, while Goldman Sachs predicts that Italy’s debt-to-GDP ratio will soar above 160 per cent. In Japan, Prime Minister Shinzo Abe has committed to nearly $1tn in new deficit spending to protect a $5tn economy, a move that will push Japan’s debt ratio well above its record of 237 per cent. With GDP collapsing on a global scale, few countries will escape. In advanced economies, the IMF expects average debt-to-GDP ratios to be above 120 per cent in 2021. 

---Also watch

---

While most see big deficits as a price worth paying to combat the crisis, many worry about a debt overhang in a post-pandemic world. Some fear that investors will grow weary of lending to cash-strapped governments, forcing countries to borrow at higher interest rates. Others worry governments will need to impose painful austerity in the years ahead, requiring the private sector to tighten its belt to pay down public debt. They should not. 

While public debt can create problems in certain circumstances, it poses no inherent danger to currency-issuing governments, such as the US, Japan, or the UK. This is not, as some argue, because these countries can currently borrow at very low cost, or because a strong recovery will allow them to grow their way out of debt. 

There are three real reasons. First, a currency-issuing government never needs to borrow its own currency. Second, it can always determine the interest rate on bonds it chooses to sell. Third, government bonds help to shore up the private sector’s finances. 

The first point should be obvious, but it is often obscured by the way governments manage their fiscal operations. Take Japan, a country with its own sovereign currency. To spend more, Tokyo simply authorises payments and the Bank of Japan uses the computer to increase the quantity of Yen in the bank account. Being the issuer of a sovereign currency means never having to worry about how you are going to pay your bills. The Japanese government can afford to buy whatever is available for sale in its own currency. True, it can spend too much, fuelling inflationary pressure, but it never needs to borrow Yen. 

If that is true, why do governments sell bonds whenever they run deficits? Why not just spend without adding to the national debt? It is an important question. Part of the reason is habit. Under a gold standard, governments sold bonds so deficits would not leave too much currency in people’s hands. Borrowing replaced currency (which was convertible into gold) with government bonds which were not. In other words, countries sold bonds to reduce pressure on their gold reserves. But that’s not why they borrow in the modern era. 

Today, borrowing is voluntary, at least for countries with sovereign currencies. Sovereign bonds are just an interest-bearing form of government money. The UK, for example, is under no obligation to offer an interest-bearing alternative to its zero-interest currency, nor must it pay market rates when it borrows. As Japan has demonstrated with yield curve control, the interest rate on government bonds is a policy choice. 

So today, governments sell bonds to protect something more valuable than gold: a well-guarded secret about the true nature of their fiscal capacities, which, if widely understood, might lead to calls for “overt monetary financing” to pay for public goods. By selling bonds, they maintain the illusion of being financially constrained. 

In truth, currency-issuing governments can safely spend without borrowing. The debt overhang that many are worried about can be avoided. That is not to say that there is anything wrong with offering people an interest-bearing alternative to government currency. Bonds are a gift to investors, not a sign of dependency on them. The question we should be debating, then, is how much “interest income” should governments be paying out, and to whom? 

 The writer is a professor of economics and public policy at Stony Brook University and author of the forthcoming book “The Deficit Myth” 

 No — This dangerous monetary practice ensures inflation is around the corner 

How to pay for the fathomless costs of fighting a pandemic? All the state’s expenses, whether a Green New Deal, jobs-for-all or the economic lockdowns, can be met simply by printing money. That is what modern monetary theory claims, writes Edward Chancellor. 

Adherents of this unorthodox school of economics would have us believe, like Alice in Wonderland, six impossible things before breakfast. Governments can never go bust. They don’t need to raise taxes or issue bonds to finance themselves. Borrowing creates savings. Fiscal deficits are not the problem, they are the cure. We could even pay off the national debt tomorrow. 

As theory, MMT has been rejected by mainstream economists. But as a matter of practical policy, it is already being deployed. Ever since Ben Bernanke, as governor of the US Federal Reserve, delivered his “helicopter money” speech in November 2002, the world has been moving in this direction. As president of the European Central Bank, Mario Draghi proved that even the most indebted countries need not default. Last year, the US federal deficit exceeded $1tn at a time when the Fed was acquiring Treasuries with newly printed dollars — that’s pure MMT. 

This crisis has accelerated the process. Fiscal and monetary policy are now being openly co-ordinated, just as MMT recommends. The US budget deficit is set to reach nearly $4tn this year. But tax rises are not on the agenda. Instead, the Fed will write the cheques. Across the Atlantic, the Bank of England is directly financing the largest peacetime deficit in its history. MMT claims that money is a creature of the state. The Fed’s share of an expanding US money supply is close to 40 per cent and rising. Again, we are seeing MMT in practice. 

The lockdown is a propitious moment to implement MMT. During crises, the public has an abnormally high demand to hold cash; debt monetisation appears less of a problem. But governments can print money to cover their costs for only as long as the public retains confidence in a currency. When the crisis passes, the excess money must be mopped up. 

Proponents of MMT claim this shouldn’t be a problem. But then they admit that nobody has a good inflation model. We cannot accurately measure the economy’s spare capacity, either. This means that politicians are unlikely to raise taxes in time to nip inflation in the bud. Bonds can always be issued to withdraw money from circulation. But once inflation is under way, bondholders demand higher coupons. From a fiscal perspective, it makes more sense to issue government debt when rates are low — as they are today — than to print money now and pay higher rates later. 

Great historic inflations have been caused not by monetary excesses but by supply shocks, say MMT exponents. It’s likely that coronavirus will turn out to be one of those shocks. Besides, history casts doubt on attempts to explain inflation by non-monetary factors. The closest example of MMT in implementation comes from France’s experiment with paper money. In 1720, the Scottish adventurer John Law served as French finance minister and head of the central bank. The bank printed lots of paper money, the national debt was repaid and France enjoyed brief prosperity. But inflation soon took off and crisis ensued. 

The truth is that governments have an inherent bias towards inflation, especially under adverse conditions such as wars and revolutions. The Covid-19 lockdown is another such condition. Tomorrow’s inflation will alleviate some of today’s financial problems: debt levels will come down and inequalities of wealth will be mitigated. Once excessive debt has been inflated away, interest rates can return to normal. When that happens, homes should be more affordable and returns on savings will rise. 

But the evils of inflation should not be overlooked. Economies do not function well when everyone is scrambling to keep pace with soaring prices. Inflations produce their own distributional pain. Workers whose incomes rise with inflation do better than retirees. Debtors will thrive at the expense of creditors. Profiteers arise, along with populists who feed on social discontents. 

Modern monetary practices ensure another inflation is around the corner. MMT provides the intellectual gloss. It promises a free lunch. Even Alice shouldn’t believe that.

The writer, a financial historian, is author of a forthcoming history of interest