Monday, 24 March 2014

Does an infinite supply of money throw out the case for austerity?

This is a guest post written by Simon Wan.

Last week, in its Quarterly Bulletin, the Bank of England published a nice article explaining the process of money creation in a modern economy. David Graeber, writing in the Guardian, read the main headlines, ignored most of the details, and then proceeded to make the bizarre claim that this revelation “throws the theoretical basis for austerity out the window”. To be fair to Graeber, it is not entirely clear what he is trying to say in his piece. There are so many non sequiturs and overlapping claims that it is difficult to isolate the actual message. I will try to interpret the piece as charitably as I can, and respond to each of the possible interpretations in turn.

Interpretation 1: Banks can create unlimited (broad) money. Hence there is infinite money to fund government spending. Austerity is therefore meaningless and/or unnecessary.

This is what I read from paragraphs such as the two following ones:
It's this [false commonplace] understanding that allows us to continue to talk about money as if it were a limited resource like bauxite or petroleum, to say "there's just not enough money" to fund social programmes, to speak of the immorality of government debt or of public spending "crowding out" the private sector. What the Bank of England admitted this week is that none of this is really true.  
What this means is that the real limit on the amount of money in circulation is not how much the central bank is willing to lend, but how much government, firms, and ordinary citizens, are willing to borrow. Government spending is the main driver in all this (and the paper does admit, if you read it carefully, that the central bank does fund the government after all). So there's no question of public spending "crowding out" private investment. It's exactly the opposite.
It is true that there are no fundamental limits on the creation of broad money. As long as the banking sector as a whole is willing to issue loans to borrowers, it can create an unlimited quantity of credit. The problem is that for any unit of credit created, there is a corresponding unit of debt. This means that none of the bank, the individual borrower, or the economy, is wealthier as a whole in the sense that it can command a greater quantity of goods and services. The banking sector expands its loan book (its claims on the economy), but this is funded simply by increasing the quantity of deposits (the claims of the economy on the banking sector). There is no net gain, unfortunately. The individual borrower has gained a line of credit, but this is funded merely by issuing the bank claims on his or her assets/future income.

Money (both broad and narrow) is just like any other debt instrument. It allows us to bring forward consumption from the future to the present (for borrowers) and to defer consumption (for savers). The more credit creation by the banking sector, the more this intertemporal substitution of consumption is occurring. It allows us to consume more today, but this is merely at the expense of consumption we would otherwise enjoy tomorrow (government consumption today comes at the expense of taxation in the future). Credit creation does not expand the intertemporal consumption set. And shifting spending from the future to the present, without expanding the current supply of goods and services is likely to simply lower the value of credit relative to these items—that is, cause inflation (more on this below).

Of course, governments may wish to deliberately shift the burden of deficits onto future generations. Routine demand management through monetary/fiscal policy may aim to deliberately bring about inflation and lower interest rates to shift consumption forward. And of course the presence of macroeconomic growth changes the picture entirely. But these are not the same thing as saying that there is infinite money and hence there can be infinite spending.

Where Graeber has gone wrong is to think of money merely as a means of exchange, and hence wealth, rather than as an IOU (this despite his headline): the thinking being that since “money is used to pay for stuff”, and “there is infinite money”, the government must be able to buy an infinite amount of goods and services. But money is also credit (and hence debt) and so the “more stuff” you consume now (assuming there is no inflation) is offset by the “less stuff” you will able to consume in the future.

Strangely enough, the reason why money is misunderstood is probably because we are so familiar with it as a means of exchange that when we hear that banks can issue an infinite supply of it, we infer that there are infinite possibilities for consumption. But if someone claimed "General Electric can achieve infinite possibilities for consumption because it can issue an infinite supply of GE commercial paper" we would immediately recoil. We would (correctly) point out that this process is constrained because supplying more and more GE debt would lower the value of these claims with respect to the rest of the economy since investors would demand a higher return (GE "money" would experience inflation), and GE would still have to repay the paper it had issued.

Intepretation 2: There is infinite money, so we do not need to worry about “crowding out”.

This is again what I read from the two paragraphs quoted above. I think what Graeber is saying is this: government deficits do not cause crowding out because the banking sector can always create new loans/deposits to fund private sector investment. At the risk of belaboring the point, I will just make a couple of quick responses.

First, once again, a greater volume of credit increases the claims of the economy on consumption and capital goods without doing anything to increase the current supply of these goods. A fall in the relative value of these claims (or equivalently, a rise in the price level) is likely to occur. This means that the real stock of investment is scarce.

Second, while theoretically there are no limits to bank credit creation, there are of course practical considerations that serve as effective constraints. For instance, when banks create credit, they perform a maturity transformation, creating very short-term liabilities (deposits) in order to fund long-term assets (loans). This introduces liquidity risk (and capital quality risk if the loan turns bad) and so, for a given level of central bank reserves in circulation, credit creation is constrained.

Interpretation 3: Austerity is unnecessary because the central bank can monetise government debt.

A disclaimer: Graeber’s piece actually doesn’t make this claim, which is unfortunate because it happens to be the most plausible argument for the idea that deficits don’t matter due to the nature of fiat money. There have been some serious suggestions that the ECB attempt to do this.

The problem with the argument, of course, is that it doesn't actually reduce the size of government debt. All it does is swap one type of government liability (bills, notes and bonds) for another (central bank money), and all government liabilities have to be paid for by the private sector via taxation—either explicit taxes levied on income/consumption in the case of bonds, or inflation in the case of central bank liabilities. Wyplosz (link above), while making the case for monetisation, also notes the exit problem associated with inflation.

Of course, the vast asset purchase programmes by the Fed, BoE and BoJ have not led to rampant runaway inflation. There are two simple reasons for this. First, all things being equal, the world is in a very deflationary state. Second, and more importantly, the Fed, BoE, and BoJ have not been monetising government debt. In fact, policymakers are at pains to point out that they are doing nothing more than routine open market operations.

A related question I sometimes hear--which bears also on the relationship between monetary and fiscal policy, is this: By buying securities, are you "monetizing the debt"--printing money for the government to use--and will that inevitably lead to higher inflation? No, that's not what is happening, and that will not happen. Monetizing the debt means using money creation as a permanent source of financing for government spending. In contrast, we are acquiring Treasury securities on the open market and only on a temporary basis, with the goal of supporting the economic recovery through lower interest rates. At the appropriate time, the Federal Reserve will gradually sell these securities or let them mature, as needed, to return its balance sheet to a more normal size.
Here is BoJ deputy governor Yamaguchi at around the same time:
If by any chance such massive purchase of the JGBs is interpreted, apart from the necessity in monetary policy conduct, as aiming at fiscal monetization, confidence in the Bank could be eroded considerably and long-term interest rates could rise substantially. That will affect significantly the government which issues the JGBs and financial institutions which hold the JGBs, thereby could impair the stability of the financial system and the real economy. In order to avoid such things, the Bank considers it important to firmly convey the idea to the market that the Bank will not carry out fiscal monetization. In addition, so that the market can always check the Bank's actions, the Bank will continue to disclose the state of purchases under the Program in a transparent manner.
In short, central banks have made it clear that these programmes (QE) are temporary demand management policies rather than permanent deficit financing tools. Markets therefore do not expect the vast expansion of base money to be permanent and so expectations of inflation remain incredibly low. Given the highly deflationary shocks we're facing, it's not clear whether limited but permanent monetisation would lead to high inflation. Nevertheless, it remains incorrect to claim that all deficits can be monetised without ill consequence.

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