Saturday, 25 January 2014

For every dollar of monetary stimulus, there has to be a dollar of fiscal stimulus, in the long term.

And that statement is not really an opinion. It’s not even really economics. The statement really derives from simple maths and the basic nature of deficits and national debts. Put another way, the statement derives from the book-keeping entries done by governments and central banks.

Moreover, that simple bit of maths supports the idea put by advocates of Modern Monetary Theory, Positive Money and others, namely that monetary and fiscal policy should be combined. That is, come a recession, government and central bank should simply create new money and spend it, and/or cut taxes.

Anyway, the “simple maths / book-keeping” point is as follows, and we’ll start with a simplifying assumption namely that there is no growth and no inflation. Plus we’ll assume that everything else, long term, is equal. In particular we’ll assume that long term, the amount of monetary base and national debt that the private sector wants to hold is constant (though that and other factors may vary over the short term, causing the occasional recession or boom).

Monetary stimulus consists of the central bank printing money and buying assets (normally government debt). The objective may be to lower interest rates, but not necessarily: certainly market monetarists support monetary policy while opposing the deliberate manipulation of interest rates, far as I can see – something I agree with.

Now that monetary stimulus will deal with the recession (unless there’s some fatal flaw in monetary stimulus which I haven’t spotted). Likewise, government could implement fiscal stimulus and that too would deal with the recession (again, assuming there isn't some fatal flaw in fiscal stimulus). But in both cases, the stimulus will be reversed when the recession is over: for example in the case of monetary stimulus, the assets bought by the government sector (i.e. government + central bank) will be sold back to the private sector. (Incidentally, very much that sort of thing may occur in connection with the large quantity of assets bought by central banks as part of QE: that is, QE may eventually be reversed).

To summarise so far, given no growth and no inflation, monetary and fiscal stimulus will always be reversed eventually. I.e. in that scenario, “for every dollar of monetary stimulus, there is a dollar of fiscal stimulus.” And the amount of that stimulus, long term, is zero.

A growth and inflation scenario.

Now let’s be more realistic and assume an economy that experiences both real growth and inflation.

In that scenario, the real value of national debt and monetary base will be constantly eaten way by inflation. And assuming the debt and base are to remain constant relative to GDP in the very long term (which they actually do, more or less), then both debt and base will have to be “topped up”. But they can only be topped up by having the government sector create and distribute base money and debt to the private sector, and that process is called a “deficit”, or “fiscal stimulus” to give it another name.

Moreover, given real growth, the base and debt will shrink relative to real GDP even if there is no inflation. So the COMBINATION of inflation and real growth make a fair amount of deficit absolutely inevitable, assuming the ratio (debt plus base) / real GDP is to remain about constant in the long term.

Indeed, in the long term, you could say there is no such thing as fiscal stimulus in the sense that all that so called stimulus does is to prevent a decline in the (debt + base) / real GDP ratio.

Monetary stimulus.

The fact that a fair amount of fiscal so called “stimulus” is inevitable give inflation and real growth, does not of itself prove that in the long term, monetary stimulus has to equal fiscal stimulus, dollar for dollar. So let’s assume the government sector implements monetary stimulus alone and see what happens.

The central bank prints money and buys assets. The money printing is OK in that it keeps the monetary base to real GDP ratio constant in the long term. But there’s a problem: assets have been transferred from the private to the government sector. Well that process can’t go on for ever! Indeed, assuming the ratio of total assets held by the private and government sectors are to remain constant in the long term, the private sector has to able to buy back those assets at some stage. Now it can only do that if the government sector distributes money to the private sector so as to enable to the latter to do that. And that “distribution” equals fiscal deficit.

And note that the private sector cannot do that with commercial bank created money: the government sector doesn’t accept commercial bank money in final settlement of debts or final settlement of any transaction. That is, the government sector only accepts central bank money, or base money to give it another name.

Conclusion: in the long term, monetary stimulus has to be equal to fiscal stimulus dollar for dollar.


P.S. (26th Jan 2014). I suggested above that employing monetary stimulus without any (or enough) fiscal stimulus leads to the government sector buying up a large or an excessive amount of private sector assets. That point is nicely illustrated by the unprecedented amount of public debt that has been bought by central banks over the last two or three years under the guise of quantitative easing.

That “QE” point does not of itself prove there is anything wrong with QE (not that I’m a QE fan). It simply illustrates the basic point in the above article, namely that monetary stimulus unaccompanied by an equal amount of fiscal stimulus leads to the government sector buying up private sector assets.

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