I haven’t much time today with travel commitments coming up at later. But I filed this story away earlier in the week in my ‘nonsense’ list but with a note that it contained a lesson, which would help people understand Modern Monetary Theory (MMT). The demonstration piece was written by the UK Daily Telegraph journalist Ambrose Evans-Pritchard (December 15, 2014) – Why Paul Krugman is wrong – which asserts a number of things about the effectiveness of fiscal policy (or the lack of it this case) and the overwhelming effectiveness of monetary policy. Indeed, apart from trying to one-up Paul Krugman, the substantive claim of the article is that the difference between the poor performance of the Eurozone and the recoveries in the US and to a lesser extent the UK is not because of the fiscal policy choices each nation/bloc made. This is articulated in a haze of confusion and misconceived discussion. So here is the lesson.
Evans-Pritchard claims that the differences between the Eurozone and the US for example, reflect the fact that:
The eurozone has been through roughly equivalent fiscal contraction over the last four years but without monetary stimulus. The lamentable consequences are before our eyes.
So according to the writer it is all down to monetary policy.
His beef with Krugman is over “whether central banks can generate inflation even when interest rates are zero” whenever they want to.
Evans-Pritchard claims that:
Central banks can always create inflation if they try hard enough.
He is actually talking about accelerating inflation rather than inflation per se, but that is a nuance.
He draws on a quote from an IMF economist who says that “The interest rate is totally irrelevant. What matters is the quantity of money. Large scale money creation is a very powerful weapon and can always create inflation.”
This is described as a “self-evident truism” and he refers back to Milton Friedman who invoked a aviation analogy to support his view that central banks can always generate inflation through monetary policy changes.
Evans-Pritchard says that:
Mr Congdon’s claim is a self-evident truism. Central banks can always create inflation if they try hard enough. As Milton Friedman said, they can print bundles of notes and drop from them helicopters. The modern variant might be a $100,000 electronic transfer into the bank account of every citizen. That would most assuredly create inflation.
He is astounded that anyone (include “Prof Krugman”) could possibly refute this idea.
Please read my blog – Keep the helicopters on their pads and just spend – for more discussion on this point.
The helicopter references comes from Milton Friedman’s suggestion in the introduction (page 4) to his collection of essays – ‘The Optimum Quantity of Money and other Essays”, Chicago: Aldine Publishing Company, 1969 – that a chronic episode of price deflation could be resolved by “dropping money out of a helicopter”.
First, the two examples – the helicopter drop and electronically crediting peoples’ private bank accounts with new deposits are not equivalent events. But that is a small issue.
Second, neither will necessarily cause the price level to accelerate more quickly (that is, increase inflation).
Why not? What if all the cash from the helicopters fell into the fields and stayed there?
What if the bank customers, fearing future unemployment and the income uncertainty that accompanies that fear, decided to build saving deposits up further and considered the electronic crediting of their accounts to be a boost to that effort.
In either case, there will be no price level effects of the central bank operation.
If, the bank customers took all the increased deposits provided by this central bank operation and used the funds to purchase TVs, food, cars, holidays etc – that is, real goods and services then there is the possibility of accelerating inflation.
If there is idle capacity in the economy and firms who supply TVs, food, cars, etc have the capacity to supply those goods and services then they will defend their market share by increasing output and sales at the current price levels on offer. Firms typically ‘quantity-adjust’ rather than ‘price-adjust’ when there is excess (idle) capacity. Otherwise, they risk losing market share.
So in that case there will be no acceleration in inflation. The increased spending will generate a positive output and employment response and the nation will enjoy higher real incomes.
The possibility of inflation will only become a reality, if the bank customers start liquidating the increased deposits through increased expenditure and the economy is incapable of meeting that increased growth in nominal spending through increased output.
When firms can no longer ‘quantity-adjust’ they ‘price-adjust’.
So it is not a self-evident truism that central banks can always increase the inflation rate.
The truism reference comes from the classical theory of inflation based on the Quantity Theory of Money. I have dealt with this previously and here is a summary of the problems.
The following graph comes out of my upcoming Eurozone book (will be published in May 2015 in English). Please read my blog – Options for Europe – Part 68 – for a detailed discussion of the graph. I only consider the right-hand side of the diagram here.
There are two arcane notions that are relied on to claim it is truistic that central banks cause inflation when they expand bank reserves (which is effectively what Evans-Pritchard is doing in his experiment).
One is just plain wrong while the other has limited applicability in a recession. The first notion is the rather official sounding concept called the ‘money multiplier’, which links so-called central bank money or monetary base to the total stock of money in the economy (the money supply).
The second notion then links the growth in that stock of money to the inflation rate. The combined causality linking these notions then allows the mainstream economists to assert that if the central bank expands the money supply it will cause inflation.
The Quantity Theory of Money (QTM) (see Figure) links the expansion of the money supply with accelerating inflation.
The QTM postulates the following relationship M times V = P times Y which can be easily described in words as follows. M is a symbol for how much money there is in circulation. V is called the velocity of circulation in the text books but simply means how many times per period (say a year) the stock of money ‘turns over’ in transactions.
To understand velocity think about the following example. Assume the total stock of money is $100, which is held by the two people that make up this economy. In the current period, Person A buys goods and services from Person B for $100.
In turn, Person B buys goods and services from Person A for $100. The total transactions equal $200 yet there is only $100 in the economy. Each dollar has thus be used “twice” over the course of the year. So the velocity in this economy is 2.
When we make transactions we hand over money, which then keeps being circulated in subsequent purchases. The result of M times V is equal to the total monetary transactions in the economy per period, which is a flow of dollars (or whatever currency is in use).
The P times Y is the average price in the economy times real output produced. So economists value the total sum of all the goods and services produced to get real GDP and then value this is some way using the price level.
So P times Y is the total money value of the output produced in the period or GDP. Clearly, all the sales of goods and services (M times V) have to equal the total money value of output or GDP (P times Y).
At this level, the relationship M time V = P times Y is nothing more than an accounting statement that total value of spending in a period must equal the total value of output, that is, a truism.
It is true by definition and at that level is totally unobjectionable. So at that level – as an accounting statement – the claim is truism.
But that does not make the truism a theory. How does the QTM become a theory of inflation? The answer is by sleight of hand.
The Classical economists who pioneered the use of the QTM assumed that the labour market would always be at full employment, which means that real GDP (the Y in the formula) would always be at full capacity and thus could not rise any further in the immediate future.
They also assumed that the velocity of circulation (V) was constant (unchanged) given that it was determined by customs and payment habits. For example, people are paid on a weekly or fortnightly basis and shop, say, once a week for their needs. These habits were considered to underpin a relative constancy of velocity.
These assumptions then led to the conclusion that if the money supply changed the only other thing that could change to satisfy the relationship M times V = P times Y was the price level (P).
The only way the economy could adjust to more spending when it was already at full capacity was to ration that spending off with higher prices. Financial commentators simplify this and say that inflation arises when there is ‘too much money chasing too few goods’.
The problem with the theory is that neither assumption typically holds in the real world. First, there are many studies which have shown that velocity of circulation varies over time quite dramatically.
Second, and more importantly, capitalist economies are rarely operating at full employment. The fact that economies typically operate with spare productive capacity and often, with persistently high rates of unemployment, means that it is hard to maintain the view that there is no scope for firms to expand real output when there is an increase in nominal aggregate demand growth.
Thus, if there was an increase in availability of credit and borrowers used the deposits that were created by the loans to purchase goods and services, it is likely that firms with excess capacity will respond by increasing real output to maintain or increase market share rather than by pushing up prices.
In other words, there is no truism at the behavioural level. Whether this central bank operation causes an increase in the inflation rate depends on the state of the economy as noted above.
If there is idle capacity then it is most unlikely that such central bank operations will be inflationary. At some point, when unemployment is low and firms are operating at close to or at full capacity, then any further spending will likely introduce an inflationary risk into the policy deliberations.
Having settled that we move on to the next lesson. Is the operation proposed by Evans-Pritchard – the helicopter drop an example of monetary policy?
He anticipates the problem:
I don’t see how Prof Krugman can refute this, though I suspect that he will deftly change the goal posts by stating that this is not monetary policy. To anticipate this counter-attack, let me state in advance that the English language does not belong to him. It is monetary policy. It is certainly not interest rate policy.
Unfortunately, it is not a matter of linguistics or nuances of the English language. Whether we term an operation by the government (whether the treasury or the central bank, noting they form together the consolidated public sector for reasons explained below), depends on the impact of a specific government operation on the net wealth of the non-government sector.
Monetary policy operations do not of themselve alter the net wealth of the non-government sector but rather result in compositional changes to the non-government wealth portfolio, which can alter interest rates and spur spending in that way. This is what Quantitative Easing is about, for example.
Please read my blog – Quantitative easing 101 – for more discussion on this point.
Fiscal policy operations whether instigated by the central bank or the treasury do alter the net wealth of the non-government sector, a point that Evans-Pritchard appears to be confused about.
He cites Ben Bernanke who said in 2002:
Sufficient injections of money will ultimately always reverse a deflation. Under a fiat money system, a government should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.
Note this quote does not support the claim by Evans-Pritchard that expanding bank reserves alone will increase the inflation rate.
Bernanke said clearly that “a government should always be able to generate increased nominal spending and inflation” – note the link – increased spending and increased inflation. That is the point here.
But is this monetary policy?
Evans-Pritchard becomes confused at this point. He starts discussing what he calls “Monetarism” and says:
The relevant monetarist prescription is to buy assets from non-banks. The authorities do not have to purchase state bonds (though to do so is convenient, politically neutral, and easily reversible). They could equally create and inject money by buying land, or herds of Texas Longhorn cattle. Central banks can buy anything they want, and it should be obvious that the effects of buying cattle do not work through the rate of interest.
Should the world fall back into a fresh recession at a time when deflationary pressures are gathering in all the major economic blocs, when rates are already zero and when fiscal policy is already stretched, we may have to resort to QE yet again. If so, let us stop buying bonds, and stop creating windfall profits for the holders of assets in the hope that some largesse will trickle down.
If we have to do it again, let us inject the money directly into the veins of the economy by spending the money on building roads, railways, high speed internet, scientific research centres, solar parks, or whatever parliaments consider to be the best investments in future prosperity.
It is obvious the proposal is a fiscal policy operation funded by an increase in central bank money. Instead of the central bank conducting what economists call an open-market operation (buying financial assets in return for increasing bank reserves and perhaps bank deposits of private citizens who may have been holding the assets), he is proposing the central bank directly purchase real goods and services.
That is a fiscal operation and it will spur output, income and empoyment and, under the conditions noted above, could spur inflation, but not before there is a real stimulus provided.
To understand the distinction between a monetary policy operation and a fiscal policy operation consider the following discussion.
Please also consult the following blogs – Why history matters – Building bank reserves will not expand credit – Building bank reserves is not inflationary – The complacent students sit and listen to some of that.
A monetary operation might see the central bank purchase a financial asset from the non-government sector (as in an open market operation or during quantitative easing exercise). What happens is this:
1. Central bank adds the sum to the reserves of the bank where the individual who sold the asset to the central bank has an account.
2. That private bank will increase the deposits of that individual equally.
3. From the private bank’s perspective – the rise in assets (reserves) exactly offsets the rise in liabilities (deposits) and there are no net changes.
4. For the individual, there assets increase by the deposits made but decline by an equal amount because they not longer have the bond (having sold it to the central bank).
5. For the individual, there is thus no change in net financial assets – bonds down, deposits up – a compositional shift.
QE works exactly like that and hopes to stimulate spending by increasing the demand for bonds and driving down yields, which then drive down competitive interest rates at the maturity of the bonds being bought. It is a very indirect effect and will not spur spending if there is no confidence that the increased borrowing would lead to an increased earnings stream.
We could document other monetary policy operations such as central bank lending funds to the private banks and all of the operations would not change the net financial asset position of the non-government sector.
Contrast this to a fiscal policy operation which does change the net financial asset position. For example, if a government was to increase net spending (that is, increase its fiscal deficit) in an attempt to revive a flagging economy, it would:
1. Spend by purchasing goods and services in the non-government sector which would increase the deposits of the sellers in their bank accounts.
2. There is no corresponding liability that the seller incurs and so there net worth rises by the proportion of the public deficit spending they enjoy. Summed across all sellers – net worth rises by the change in the fiscal deficit.
3. The private banks observe a rise in reserve balances (assets) as government cheques clear and an equal and offsetting rise in deposits (liabilities).
4. Fiscal operations in the form of increased deficits (surpluses) increase (decrease) non-government net worth.
If we consider the helicopter example, it is clear that it falls into the fiscal policy category. If the central bank was to start dropping dollar notes from the air over the suburbs or dropped funds into private bank accounts then:
1. Private citizens would have more currency (in the helicopter case) or higher deposits with no offsetting liability increase.
2. In other words, their net worth would increase.
Evans-Pritchard seemingly doesn’t understand the difference and what he is actually proposing, which is sound, is that the government spend more on real goods and services to stimulate overall demand and employment.
He thus unambiguously is advocating a fiscal expansion. Further, such an expansion may be inflationary under the conditions noted above but in the environment where a large-scale fiscal stimulus was required – that is entrenched unemployment etc – an inflationary outcome is highly unlikely.
You can find another version of these transactions in the article written by MMT colleague, Scott Fullwiler in 2010 – Helicopter Drops Are FISCAL Operations.
Finally, this should make it obvious that his claim that the Eurozone hasn’t recovered because its monetary policy hasn’t been as accomodative as in the case of the UK and UK is nonsense.
He wants to claim that “the doctrine of fiscal primacy” is wrong and that the:
… recoveries should not really be as strong as they are, especially in a depressed world of flat global trade. America has carried out the most drastic fiscal squeeze since demobilization after the Korean War without falling into recession. The economy is growing briskly. The jobless rate is plummeting.
Ditto in Britain where the alleged double-dip never actually happened …
The eurozone has been through roughly equivalent fiscal contraction over the last four years but without monetary stimulus. The lamentable consequences are before our eyes.
Which is distorting the facts.
First, the fiscal shifts in each nation/bloc have not be uniform in timing or cause. The enforced (discreationary) fiscal consolidation in the Eurozone was much larger than anything in the UK and the US. Indeed, these nations were maintaining the fiscal stimulus while the Eurozone was imposing austerity.
Second, the sharp reductions in the US fiscal deficit have come about largely because the earlier stimulus spawned growth which boosted tax revenue and allowed public spending to be modified without damaging total spending.
It comes down to timing and what has driven the deficit reductions. The Eurozone has tried to do it via discretionary austerity, which has had massive negative consequences for economic growth and employment.
The US and the UK largely have retained their discretionary stimulus and allowed the recovery in private incomes and employment to whittle away at the deficit outcome.
That is a fundamental difference and explains the fortunes of each case much more than whether the Federal Reserve engaged in QE and the ECB did not.
I am doing some research on Russia at present. I might write something next week.
That is enough for today!
(c) Copyright 2014 William Mitchell. All Rights Reserved.