Friday, 26 October 2018

Monetary policy is nonsense.

Let’s start by illustrating the reasons for thinking monetary policy is nonsense by reference to a simple barter economy that introduces money for the first time.

In practice when money is introduced for the first time it has normally been some sort of ruler or king who does it, and with a view to making tax collection easier. That is, rulers have announced what the form of money shall be (e.g. metal coins of some sort), plus they announce that taxes must be paid using that form of money. That creates a demand for the “king’s money”, which gives it value.

The fiat money issued by 21st century governments and their central banks comes to essentially the same thing, and I’ll jump a few centuries and assume that form of money is in operation. (Money issued by private banks will be considered briefly at the end of this article).

The more money people have, the more they are likely to spend, so clearly the amount of money distributed or issued in an economy that introduces money for the first time needs to be enough to induce the population to spend at a rate that brings full employment, but no so much that excess inflation ensues.

Another possibility is for government to issue too much money and then contain the resultant excess demand and excess inflation by borrowing back some of that money at interest. But that’s a clearly nonsensical policy: what’s the point of implementing stimulus in the form of issuing or spending money into the economy and then negating some of that stimulus? Deliberately doing that is pointless, though of course there may be occasions when government issues too much money by mistake and with a view to reining in demand, it temporarily raises interest rates.  (Incidentally, the word government is used here to refer to government and its central banks, assuming it’s a central bank that issues the country’s basic form of money (base money)).

In practice what happens in the real world is that interest rate raising “mistakes” of the sort mentioned above for the most part take the form of politicians (i.e. governments) borrowing too much because that is what politicians are always tempted to do, as pointed out by David Hume almost three hundred years ago: a phenomenon which Prof Simon Wren-Lewis calls “deficit bias”. The net effect is that mortgagors and other borrowers have to pay an artificially high rate of interest for years on end just to enable monetary policy to be used. To put it politely, it is not obvious why that’s a strategy that maximises output per hour of the workforce.

To summarise so far, the optimum rate of interest (i.e. the rate that government pays to borrow back its own money) is zero. That is, such borrowing should not happen ideally, and if there is no such borrowing, then there are no bonds for government to buy back with a view to cutting interest rates.

The claim that the optimum rate of interest is zero is not of course to say that the optimum rate for other borrowers, e.g. mortgagors, should be zero. The rate for mortgages and similar will always be significantly above zero.

The claim that the optimum rate of interest is zero is not original. Milton Friedman advocated that idea as did Warren Mosler. But as far as I know they did not actually claim monetary policy is nonsense, though clearly what they were saying was close to saying it is nonsense. (For Friedman, see his para starting “Under the proposal…”.)

Astute readers will have noticed that while simply creating new money and spending it into the economy is possible (and is indeed advocated by various groups like Positive Money), in practice nowadays, new money is introduced by a more indirect method. That is, governments borrow $X, spend it and give $X worth of bonds to lenders. Then the central bank creates new money and buys back  whatever proportion of those new bonds it thinks is appropriate. Indeed, while QE was in operation, almost all those new bonds were being bought back.

But clearly it does not make much difference whether bonds are issued first and then bought back a few weeks later, or whether new money is created first with government borrowing that money back a few weeks later and issuing bonds to lenders.

Borrowing to fund infrastructure.

A possible objection to the above argument is that far from  government borrowing making no sense, such borrowing can be justified if it funds public investments like infrastructure. Indeed, the UK Labour Party’s new “fiscal rule” is the latest of a long line of instances of that idea being invoked.

In fact the latter “infrastructure” argument is weak in the extreme.

One weakness is that education is one huge investment, but for some strange reason no one ever claims that publically funded education should be paid for via borrowing. At least state education for kids up to about eighteen in most countries is funded basically via tax rather than borrowing. Thus advocates of the “public investment justifies borrowing” idea have clearly not got their act together.

But even if there are particularly good arguments for funding public investments via borrowing, there is another problem for the “pro borrowing” brigade as follows.

Interest rate cuts (and indeed QE) are effected by having the central bank create new money and buy back bonds. But that clashes with the idea that there are particularly good reasons for funding public investments via borrowing. That is, if relevant bonds are bought back  by the central bank, then relevant investments will then have been funded not by borrowing but by money printing!

In short, the whole idea that public investments should be funded via borrowing is in a mess at the moment.

Apart from the latter public investment excuse for government borrowing, there are a host of other alleged reasons for such borrowing. They are all as hopeless as the above “investment” reason as I show in section two here. (Title of that article is “The arguments for a permanent zero interest rate.”)

Fiscal policy.

Having argued that monetary policy is nonsense, that does not necessarily mean that traditional fiscal policy is vastly better. That’s fiscal policy as in “government borrows $X, spends the money and gives $X of bonds to lenders”.

The obvious anomaly with that ploy is that while the latter spending is stimulatory, the borrowing element is “anti-stimulatory”. It’s a bit silly doing something anti-stimulatory (i.e. deflationary) when the object of the exercise is stimulus!

On that basis, the best form of stimulus is simply to have the state (government and central bank) create new money and spend it (and/or cut taxes).

Commercial bank issued money.

Having based the above argument on the assumption that the only form of money is central bank money (base money), obviously it is relevant to say something about the fact that in reality in 21st century economies the majority of money is issued by commercial banks.

In fact that does not make much difference to the argument. Reason is that all commercial banks do is to lever up base money: i.e. whatever size economy we’re talking about, it is normal for commercial banks to create roughly ten times as much money as central banks. So, to illustrate, the statement made near the outset above that if too much base money is issued, the result  will be excess inflation still holds: that is, commercial banks may well lever up the latter new money, making the latter inflation even worse. Though notice that they will not necessarily do that: there has been a vast and unprecedented increase in the stock of base money over the last five years or so as a result of QE, but there has certainly not been a pro rate increase in the stock of commercial bank money.

1 comment:

  1. I'm reminded of Fischer Black's 1986 essay "Noise" ( ):

    "I believe that monetary policy is almost completely passive in a country like the U.S. Money goes up when prices go up or when income goes up because demand for money goes up at those times. I have been unable to construct an equilibrium model in which changes in money cause changes in prices or income, but I have had no trouble constructing an equilibrium model in which changes in prices or income cause changes in money."

    I trust Black's opinion more than Wren-Lewis, because Black's equations are still present, in some form, in pricing tools used by traders today. His work contributed to financial pricing and he says prices are arbitrary to a factor of two, at least; and ten percent of the time prices are arbitrarily arbitrary:

    "we might define an efficient market as one in which price is within a factor of 2 of value, i.e., the price is more than half of value and less than twice value. The factor of 2 is arbitrary, of course. Intuitively, though, it seems reasonable to me, in the light of sources of uncertainty about value and the strength of the forces tending to cause price to return to value. By this definition, I think almost all markets are efficient almost all of the time. 'Almost all' means at least 90%."

    If markets are not efficient at least ten percent of the time, and only noisily efficient to a factor of two the rest of the time, then inflation need not be treated as a constraint on public policy. We can print money at least as fast as prices rise, distributing it to everyone, and thereby maintain real purchasing power stability. Nominal price inflation ceases to be relevant.


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