Many readers have asked me to comment on the recent financial reform proposals from the Obama Administration. Some have tied their questions into more general requests to outline a specific modern monetary approach to the reform process. So I thought I would take this Sunday blog time to put some notes together in this regard. I cover the treasury and central bank in this blog. At some later point I will consider how to better regulate the commercial banks and the role of governments in deposit insurance.
Last week, President Obama addressed Wall Street as part of the dubious anniversary of the fall of Lehmans. Here is the full text of the speech. You can see some video of the talk – Part 1 and Part 2. The President said that sweeping reforms of the financial system and the bodies that are intended to regulate the system are required.
He started by noting that the so-called GFC required large-scale government intervention because the crisis had moved into the real economy.
This was no longer just a financial crisis; it had become a full-blown economic crisis, with home prices sinking, businesses struggling to access affordable credit, and the economy shedding an average of 700,000 jobs each month.
We could not separate what was happening in the corridors of our financial institutions from what was happening on factory floors and around kitchen tables. Home foreclosures linked those who took out home loans and those who repackaged those loans as securities. A lack of access to affordable credit threatened the health of large firms and small businesses, as well as all those whose jobs depended on them. And a weakened financial system weakened the broader economy, which in turn further weakened the financial system.
I could take exception to the way he constructs the government bail-out and subsequent events but that would be peripheral to the objectives of this blog. For example, he keeps talking about the taxpayer funds being used and with the banks now returning some of the injection to the government he says the “taxpayers have actually earned a 17-percent return on their investment”. No they haven’t. The government has reduced the net financial assets in the economy by draining some of the initial injection.
Anyway, Obama motivates his agenda by saying:
While full recovery of the financial system will take a great deal more time and work, the growing stability resulting from these interventions means we are beginning to return to normalcy. But what I want to emphasize is this: normalcy cannot lead to complacency.
So while many of us are thinking that with the crisis over the neo-liberals will return to business as usual Obama intends to make some changes to prevent that. Good luck to him.
My reading of the current situation is that the bank and corporates have been saved by the fiscal stimulus packages launched in various guises around the world but they will be leading the charge through their mouthpieces (media, lobbyists, conservative politicians) against any continued stimulus which might actually help the disadvantaged (many of whom will remain unemployed long after the executives have returned to the golf course and long lunches).
But Obama said this:
Unfortunately, there are some in the financial industry who are misreading this moment. Instead of learning the lessons of Lehman and the crisis from which we are still recovering, they are choosing to ignore them. They do so not just at their own peril, but at our nation’s. So I want them to hear my words: We will not go back to the days of reckless behavior and unchecked excess at the heart of this crisis, where too many were motivated only by the appetite for quick kills and bloated bonuses. Those on Wall Street cannot resume taking risks without regard for consequences, and expect that next time, American taxpayers will be there to break their fall.
The upshot of this sentiment is that Obama claims that his administration is “most ambitious overhaul of the financial system since the Great Depression” and the reforms will “set clear rules … that promote transparency and accountability”. He believes that the reforms will “make certain that markets foster responsibility, not recklessness, and reward those who compete honestly and vigorously within the system, instead of those who try to game the system”.
I won’t go into the detail of the institutional changes he proposes. They include the establishment of a new agency to help consumers get better financial advice on the products available.
Now from the perspective of modern monetary theory, what changes would I like to see instituted. Most of this can be taken as applicable to all sovereign governments (those states that issue their own fiat currency and run flexible exchange rates) even if sometimes I am talking about the institutional arrangements that are in place in Australia.
Role of the national government
Before we establish specific arrangements in the financial markets etc, we need a clear statement of purpose for any national government. I think some of the erroneous reasoning in the media and within the broader debate stems from a lack of clarity about what it is that the national government should be doing on our behalf.
From the perspective of modern monetary theory, the national government which issues the currency as a monopolist has a charter to advance public purpose (welfare) at all times even if, in doing this, specific private interests are impeded. In general, the advancement of public interest will provide a sound basis for private benefit also. But at times this will not be the case.
From that broad charter, full employment, poverty alleviation and environmental sustainability become the most significant expressions of public purpose although in choosing those policy targets I am expressing my values rather than making an economic statement.
However, it is highly unlikely that an economy will perform to potential if these policy targets are compromised in any way so I think there is a good case for making them the starting points in the pursuit of public purpose.
Conduct of Treasury
The Department of Treasury in any country implements fiscal policy on behalf of the elected government. At present most governments have voluntary arrangements in place which resemble the constraints they faced under the Gold Standard. These relate to constraints on net spending and the necessity to borrow from the non-government sector (either domestically or foreign) every time they net spend a new dollar.
These arrangements are a denial of the opportunities that a fiat monetary system offers the elected government. They open the government to criticism from the conservative elements in the society who equate the government budget with the household budget. An examination of the reasoning behind these constraints typically uncover ideological statements along the lines of needing to put a strong check on government so they deliver fiscal discipline.
Of-course, the conceptualisation of “fiscal discipline” is far-fetched and biased towards the government running surpluses and reducing its command of the economy’s resources. This manifests as the government being bullied into reducing its spending, particularly on social welfare and public goods (education, health etc) and reducing taxes for the high income earners). But there is a sickening hypocrisy displayed when it comes to payments to business (so-called corporate welfare).
This form of government spending is never challenged by those who receive them and criticised as being wasteful or undermining incentive and action. Accompanying this rhetoric is a firm belief in self-regulation of private markets, which means that transparency and accountability are reduced.
The voluntary constraints, in turn, create political constraints on the government such that it has been pressured to maintain high rates of labour underutilisation for the last 35 years in most countries because they are unable to run deficits that are required to match the saving desires of the non-government sector.
As a consequence, aggregate demand has been restricted and even undermined in recent decades by the pursuit of budget surpluses and the non-government sector has been pushed into dis-saving (and increased indebtedness).
These voluntary constraints thus lead to unsustainable outcomes but the costs of the dysfunction that follows are borne mainly by the less advantaged groups in the society.
In that regard, I would abandon all voluntary constraints on net spending and the institutional machinery that has arisen to implement these constraints (for example, the Australian Office of Financial Management which was created to place government debt issues into the private markets).
That is, I would recognise the differences and advantages that a government in a fiat monetary system has over one operating in a convertible currency system (Gold Standard) and create behaviours and institutions that allowed the the government to exploit those advantages.
Specifically, I would stop issuing Treasury debt instruments – that is, stop public borrowing.
Such borrowing is unnecessary to support the net spending (deficits) given that the national government is not revenue-constrained. There is nothing positive in terms of advancing the primary goals of the national government
This would mean that the net spending would manifest as cumulative excess reserve balances at the central bank.
Some people will immediately ask: so this will be the “printing money” option that is spelled out in the macroeconomic textbooks.
To which I say: it has nothing to do with “printing money”. All government spending occurs in the same way – altering bank account balances in the private sector or issuing cheques that end up in bank account balances.
What the government does otherwise doesn’t alter that. Taxation – is just the reversal of the spending processes (debiting bank accounts).
In the case of debt issuance, the government only really borrows as part of monetary policy – to manage the reserve impacts of the net spending. So the issuance of Treasury bonds allows the central bank to maintain a positive target rate of interest at the short end of the term structure which, in turn, conditions the longer maturity interest rates.
It is clear that this leads to higher interest rates than would be the case if there was no debt issued and it is hard to imagine why this would be seen as being economically beneficial. If the government wants the private sector to have less spending capacity at any particular time, then it can use taxation increases to accomplish this goal.
Further, the government can always instruct the central bank to pay a return on excess reserves if it wanted to maintain a positive overnight interest rate. As you will see soon, I don’t think this is necessary because typically the central bank should run a zero interest rate policy.
I also note that the issuance of Treasury bonds acts like corporate welfare for the purchasers who typically are financial institutions and foreign governments. Why should they enjoy a risk-free government annuity? There is nothing to be gained from that. The futures traders use the government bond as a pricing vehicle (as the risk-free asset).
But why couldn’t they develop a private benchmarking asset to fulfill the same function but which wouldn’t carry the public transfer of funds connotation? The answer is that they clearly could and their continual claims that the government has to issue debt to maintain financial stability in futures markets etc are just special pleading and are spurious.
What about sovereign funds? These involve the national government via its treasury speculating in financial markets through the purchase and sale of financial assets. There is no public purpose that can be achieved by using net spending to build stockpiles of financial assets.
Typically, this behaviour is constructed as the government “storing its surpluses” in some asset for later use – to permit some future liability (public pensions, public service superannuation, ageing-society demands etc) to be “funded” more easily. But, of-course, that logic is inapplicable to a sovereign government in a fiat monetary system which is not revenue-constrained.
The purchase of the financial assets is not “storing surpluses” – it is just plain government spending – in this case on financial assets instead of other uses that the spending could be put to – such as, better schools, better hospitals, higher employment, more generous research funding etc.
While the true test of the benefits of any government spending is what you might be doing otherwise with the spending, I cannot imagine that it could ever be “better” to buy shares in some company as a speculative venture rather than to improve public education or health. Further, we know that great discoveries come from research. Perhaps the next dollar spent by the government on research in the university system will discover the cure for cancer! That will never come from speculating on the share price of a telecommunications company (as an example in Australia of this sort of behaviour).
Thus, as an operational rule I would ban the government from purchasing speculative financial assets (note I am not including the central bank in this rule).
Conduct of the Central Bank
The central bank should manage the liquidity (cash) system to maintain a zero overnight interest rate as a permanent feature of the monetary system. All adjustments to aggregate demand are better made using fiscal policy.
A zero interest rate policy would reduce the rates right across the term stucture and would be beneficial to investment, output and employment. This policy would to some extent alter the behaviour of saving (positive interest rates reward savers) but any desired adjustments to the behavioural changes (reduced saving) can be accomplished via fiscal policy.
The notion of a natural rate of interest (derived from Wicksell) which is neutral with respect to output is not sustained in the acceptable research literature. The short-term rate of interest which would emerge if the non-government sector was net saving and the government was maintaining full employment (with positive deficits – as a matter of accounting) would be zero. The central bank would have to do something (artificial) like sell bonds to alter that “natural” tendency.
At times the central bank lends to its member banks (those who have reserve accounts with the central bank). This lending should never be constrained and should be priced at whatever the current rate for lending to banks is (this is called the federal funds rate in the US). No special arrangements are needed to facilitate this.
For example, reflecting on Obama’s proposals, the US central bank (Federal Reserve) currently requires collateral from the banks it lends to despite the fact that the assets used already fall under the Fed regulative ambit. So as long as the regulator is ensuring the assets held by the banks are viable then demanding collateral is a waste of time.
Some analysts think that if the central bank restricts its lending to the banks, then this will serve to restrict credit. If it is thought that there is too much private borrowing then this would suggest that the central bank should not offer unlimited loans to the member banks.
But once we reject the “money multiplier” view of the world, then we learn that commercial bank lending is not reserve-constrained (as it is in the text book models that students learn from). That is, banks lend to any credit worthy customer and worry about getting the necessary reserves after the fact. So constraining the central bank lending to the banks will not alter their own lending.
What will happen though is that the rate it lends to banks and its target interest rate will be affected. The central bank has to offer whatever reserves are demanded by the commercial banks if it wants to maintain control over these two rates. Further, by making this offer the interbank market would disappear and that eliminates the inefficient process of banks borrowing and lending reserves between each other.
Still to come … how to regulate the commercial banks.
The general point is that once you jettison the mainstream economics, the institutional machinery that governs the behaviour of the financial markets and the way in which the government (treasury and central bank) interact with the private financial organisations alters significantly.
Once you decouple public borrowing from net spending then all the debt and inflation hysteria would turn to inflation hysteria. That is a much easier pathology to deal with because it becomes obvious every quarter how fast the price level is accelerating. It is virtually impossible to de-condition notions such as “public debt eating our kids” via the regular release of economic data.
The fact that no kid ever gets eaten seems to be overlooked!