Mervyn King opposes merging fiscal and monetary policy – he’s wrong.

Advocates of Modern Monetary Theory (and other groups, e.g. Positive Money and the New Economics Foundation) tend to favour merging fiscal and monetary policy. That is, they advocate that in a recession, the government / central bank machine (gcbm) should simply create new money and spend it (and/or cut taxes). And if inflation looms, “the machine” should do the opposite: cut spending / raise taxes and “unprint” the money collected or saved. Certainly Abba Lerner suggested the idea on p.40 here. And Milton Friedman suggested the idea (p.250) here.

Mervyn King opposed the idea in this speech and for four reasons, none of which stand inspection. His reasons were as follows.

1. A merge would give a central bank (CB) a say over strictly political decisions, like what proportion of GDP is allocated to public spending.

2. It would give politicians access to the printing press.

3. Stimulus done in a “merge style” would be more difficult to reverse than fiscal or monetary stimulus done separately.

4. CBs must have a stock of government debt in order to influence what King calls “monetary conditions”.

King’s speech.

The relevant part of King’s speech is the three paragraphs starting “Over the past three years…”, and I’ve put the three paragraphs in full at the end of this article because they consist of 370 words: a rather long passage which would interrupt the flow the argument.

Let’s take King’s four claims in turn.

1. Central banks would have a say over political decisions?

If the decision as to how much money to “create and spend” is given to some sort of independent committee of economists (as advocated by for example Positive Money), it’s hard to see why that gives the committee any say over what proportion of GDP is allocated to public spending. Indeed, we ALREADY HAVE a committee that takes decisions on stimulus in the UK: the Bank of England Monetary Policy Committee (MPC). And no one has ever suggested the MPC can force government to change the proportion of GDP allocated to public spending, or that the MPC can induce government to spend more on defence and less on education or vice versa.

To illustrate, if an MPC type committee decided an extra £Xbn of spending was warranted, it would say as much to government, plus supply government with the relevant funds. Government, assuming it wanted to behave in a democratic manner would then boost public spending and private spending in accordance with the way the electorate thought GDP should be split as between public and private spending.

Of course a government would have the power to ignore the electorate’s wishes. But then political parties, once in power, frequently ignore manifesto promises. So nothing new there.

2. Politicians would get access the printing press?

As to King’s second claim, namely that a merge would give politicians access to the printing press, that is equally mysterious. In as far as a central bank is genuinely independent (and the degree of independence varies from country to country) politicians do not influence MPC type committees. Thus there is equally little reason to suppose they would influence and “MPC type” committee.

3. Reversing stimulus.

King then claims, “It is peculiar, to say the least, that some of the same people who believe that the Governor of the Bank is too powerful also believe that he should stand on the steps of Threadneedle Street distributing £50 notes – a policy which you will appreciate is rather hard to reverse. For the same reason, the Bank could not countenance any suggestion that we cancel our holdings of gilts. The Bank must have the ability  to reverse its policy – to sell gilts and withdraw money from the economy – when that becomes  necessary. Otherwise, we run the risk of losing control over monetary conditions.”   

Now there is a big problem with that point, which is that as King himself rightly says, a helicopter drop or “distributing £50 notes” is the same as merging monetary and fiscal stimulus combined. (See final paragraph in passage quoted below). So if £50 note distributions are difficult to reverse, then monetary and/or fiscal stimulus must be equally difficult to reverse.

4. Monetary conditions.

As just mentioned, King claims that CBs need a stock of government debt in order to influence what he calls “monetary conditions”  - presumably he means interest rates.

Well the problem with that point is that it is irrelevant to the main argument. That is, the question or “main argument” is: should the government / central bank machine have a separate fiscal and monetary policy, or should the two latter be merged?

If we implement a merge, then stimulus (or its opposite) does have a monetary element. To that extent, King’s complaints about an MPC type committee not being able to influence “monetary conditions” are invalid.

However, King does have some sort of point here. That is, if the ONLY form of stimulus effected is “merge stimulus”, then that by definition rules out having monetary policy act independently of fiscal policy. And contrary to King’s suggestions, there are some very good arguments for abandoning interest rate adjustments. See this submission to the Vickers commission.

However, one COULD HAVE a system in which the BASIC regulatory tool was having gcbm creating (destroying) money and spending (withdrawing) it as required, with interest rate adjustments playing only a backup role.

But a CB  does not need a stock of government debt in order to adjust interest rates.

If a CB has no stock of government debt at all, and for example wants to raise interest rates, it can simply announce that it is willing to borrow at above the going rate of interest. Of course a CB may not  be able to do the latter under the rules that currently govern CBs in  some countries. But that is irrelevant: those rules or laws can easily be changed. That is just a legal or technical point.

As to where a CB gets the money from to pay interest on the debt it has incurred, it wouldn’t need to find the money for a year (assuming interest is paid annually). And that ought to give enough time for the MPC type committee and government to raise taxes so as to fund the interest.

Conclusion.

Contrary to Mervyn King’s suggestions, merging monetary and fiscal policy needn’t reduce politicians’ or the electorate’s freedom to take strictly political decisions. Second, it needn’t involve politicians getting near the printing press. Third, merging monetary and fiscal stimulus would not be any more difficult to reverse than monetary or fiscal measures alone. Fourth, an absence of government debt in the hands of a central bank does not stop a central bank withdrawing money from an overheating economy.

________

The three paragraphs from King’s speech.

“Over the past three years, the Bank of England has bought £375 billion of government bonds – gilts – from the private sector to create a lot of new money. Many – perhaps some of you – are understandably concerned about the use of such an unusual and unfamiliar policy. Some people talk about the dangers of money creation. I want to explain why it is important to distinguish between “good” and “bad” money creation. In essence, the argument is very simple. “Good” money creation is where an independent central bank creates enough money in the economy to achieve price stability. “Bad” money creation is where the government chooses the amount of money that is created in order to finance its expenditure. Insufficient money creation can lead to a contraction of the money supply and a depression. We saw that in the United States during the Great Depression and we see it today in Greece. Excessive money creation leads to accelerating inflation and ultimately the collapse of the currency.

The role of the Bank of England is to create the right amount of money, neither too much, nor too little, to    support sustainable growth at the target rate of inflation. We are not doing it at the behest of the    Government to help finance its spending. It is the independence of the Bank that allows us to create money    without raising doubts about our motives. But just as it is crucial that governments do not control the printing    of money, so too the unelected central bank must not determine the levels of taxes and public spending.    Fiscal policy is a matter for elected governments.   

There has been some talk about the possibility that money created by the Bank could be used directly to finance additional government spending, or even that money could be given away. Abstracting from the colourful metaphor of “helicopter money”, such operations would combine monetary and fiscal policies.”