Central banks and fiscal policies

3 Jul, 2020 at 12:50 | Posted in Economics | 18 Comments

Suppose a UK government became extremely irresponsible, and enacted large tax cuts during an economic boom. The Bank would, following its remit, attempt to put the lid on inflationary pressure by raising interest rates. Suppose further that the markets panicked, and refused to buy UK government debt except at ridiculously high interest rates. In that situation I think it is extremely unlikely that the Bank would intervene and buy government debt, because it would believe that economic stability was best served by the government cutting its deficit.

fsAcademics have sometimes speculated about such a standoff. In this game of chicken would the government give in and raise taxes or cut spending, or would the Bank give in and “monetise” the deficit by buying government debt? I think this debate is a little academic, because a government so intent on creating an inflationary boom would also think nothing about telling the Bank what to do. The governor would be ordered to monetise the deficit and if he refused he would be replaced by someone who would.

No governor of a central bank wants to be put in that situation. It is for this reason that Mervyn King said: “Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.” Obsession can breed irrationality. Which brings us back to 2010, which is much more like recent events than our hypothetical economic boom. Perhaps this irrational fear of deficits may help explain why during the largest recession since the war King ignored standard macroeconomic theory and practice and encouraged the austerity that proved so disastrous. A lesson may be that while you can trust central bankers to deal with a short-term panic in the government debt market during a recession, you should never trust them to be objective when talking about fiscal policy.

Simon Wren-Lewis / The Guardian

18 Comments

  1. I’m baffled by Wren-Lewis’s suggestion in the first of his above paragraphs that if government was totally irresponsible and implemented far too large a deficit, the Bank of England might remedy the situation by buying government debt. That’s where he says “I think it is extremely unlikely that the Bank would intervene and buy government debt.”

    Actually, given excess inflation, central banks do not BUY government debt: they sell it!!! And just at the moment, central banks have an absolutely HUGE pile of government debt to sell, if they so choose, as a result of QE.

  2. Wren Lewis is not looking at the impact on Sterling. When there was pressure on Sterling, the central banks (BOJ, Fed, ECB) gave out a credit line to the BOE in a coordinated action, proving the dollars and euros when there heavy selling pressure on Sterling. The City, who obviously were actually involved in this selling, identified the real problem as the crisis being in the context of Britains underlying dependence on inward capital flows due to balance of payments reasons. The foreign CB’s guarantees is what really made Johnson’s huge fiscal expansion possible following the Covid outbreak. But the Bank of England has a duty to the other CBs that bailed England out to get this back under control – at some point. There is also little possibility of having a functioning interest rate adjustment mechanism until this happens. They already had this problem before Covid19.

    The best way to study this is to look at what happened during 1920s and 1930s. There is a view, largely reflecting high profile figures in the academic profession, that getting off the gold standard made macro-expansions possible. But this is very simplistic. if you go really into the historical literature you will understand that many actions had to be taken and economic conditions met before even this was possible. In Japan’s case at least, this meant getting large amounts of both central bank and government paper amassed in the early 1920s under control.

    As Hicks points out in an earlier post on this blog, you really need to go into the history to get a properly informed view. And this will always trump economic theory.

    Perhaps King understands this.

    Britain also needs to tread carefully now. We are out of Europe; the ECB might not thinking that bailing out Britain is a priority if there are other matters it has to deal with in the Eurozone. And the US under Trump? Well, put away your rational choice models right now!

    • “the Bank of England has a duty to the other CBs that bailed England out to get this back under control”
      .
      Why? The Fed and BoE expand their balance sheets, and can keep them there indefinitely. No taxpayers need suffer.The Fed creates dollars to swap for created Sterling, and the BoE creates more sterling as needed to buy dollars to swap back to the Fed. The rates are negotiated, administered, away-from-market. Any “discipline” seems to be confined to punishing scapegoats (“the poor”) via austerity.
      .
      In other words, I am challenging the Fed’s recent announcement:
      .
      “The tools that the Federal Reserve is using under its 13(3) authority are for times of emergency, such as the ones we have been living through. When economic and financial conditions improve, we will put these tools back in the toolbox.”
      .
      But when they started to put the Quantitative Easing tool back in 2019, markets panicked, and they went right back to printing money, several months before the coronavirus event.
      .
      We should be pushing for more use of central bank currency swaps as a backstop to currencies. Central bank currency swap networks are a proxy for one world central bank. With one bank, you never need experience runs because the top bank manufactures the best money. Bank runs are a policy choice. If the ECB refuses to make good policy choices, they should be called out and exposed by all of us world citizens …
      .
      Note: before this last crisis, I argued with many who said central bank currency swaps would be unlikely to be used again in a crisis. But they have been used liberally. And no taxes are needed to pay for them.
      .
      Also, Wren-Lewis completely ignores that central banks are currently, as in 2008, buying a lot of privately-created debt that can no longer clear markets. Private debt is being monetised, too.

      • “I argued with many who said central bank currency swaps would be unlikely to be used again in a crisis. But they have been used liberally. And no taxes are needed to pay for them.”
        .
        But at some stage foreign currency has to be acquired and the swaps be unwound.

        • 1) Fed swaps $100 billion to BoE for 80 billion pounds.
          .
          2) BoE gives $100 billion to British banks with US dollar obligations they can’t meet.
          .
          3) Say the British banks default.
          .
          4) BoE gets unlimited rollovers from the Fed, so the defaults can be delayed.
          .
          5) If British banks still don’t repay the dollar loans, BoE can always digitally print Sterling to buy dollars to unwind the swap. Or it can sell assets.
          .
          6) No taxes needed.

          • “If British banks still don’t repay the dollar loans, BoE can always digitally print Sterling to buy dollars to unwind the swap.”
            .
            And blow up Sterling.

            • The Fed is supplying liquidity through other channels, so the Sterling price of dollars probably goes down before the swap unwinds.
              .
              The Fed acts as a “value investor” for Sterling. If Sterling drops, the Fed will swap dollars for pounds at away-from-market rates, without capacity limits. This implicit backstop is recognized by markets, so Sterling doesn’t blow up despite the dismal predictions of economists. JP Morgan’s research department would probably be recommending carry trades as the cross-currency basis went further negative, but mainstream economists don’t understand any of that so it doesn’t enter into their stories. Thus their predictions of blown-up Sterling are wrong, again and again …

              • RM you are assuming that the US will be prepared to remain the ultimate guarantor of the multilateral system. including the multilateral monetary system. That’s an assumption that will be tested as the US has made it clear, and even Merkel has acknowledged, that it no longer feels obliged to perform this role. It’s irrational, of course; they will lose their hegemonic status, including the world’s reserve currency which is partly a result of US dollar liquidity circulating the world. But this is geopolitics, and rationality is not a given. There are other issues here – including the effects on the term structure of interest rates of a huge build up in claims that ultimately lead to governments and central banks. But the bottom line is Brexit Britain is now, to borrow Edgerton’s phrase, a rule taker rather than a rule maker. It is a small country now that, like Canada or Australia, must worry about its terms of trade and current account deficit. And again Model won’t help: Britain won’t gain from exchange rate depreciation because of the lack of import substitutes due to many decades of deindustrialisation and smaller oil reserves.

                – BTW mainstream economists have made blanket statements like “countries with their own currencies don’t have to worry about government deficits”. That is a gross generalisation that depends on the country and currency. Outside central banks and City firms, they have not properly understood the existential problem facing Sterling.

                • In my view, terms of trade are swamped by financial flow volume. Current account deficits are irrelevant. There is demand for Sterling entirely apart from real economy trade goods. For example, Mexico issues Sterling bonds. The amount of Sterling flowing through trade of purely financial goods dwarfs real goods trade.
                  .
                  The opportunity cost of thinking in timid ways that focus on real goods trade rather than the far more substantial financial goods trade is that you badly underestimate the value of Sterling. Short it, if you believe your predictions. But smart players hedge so they make money no matter which way Sterling moves.
                  .
                  It’s funny because I agree with you, Nanikore, when you’ve said elsewhere that history is key to understanding economics. The reason Grant vetoed the 1874 Inflation Bill, as I went into in another post, is an example of how a lobbying effort started by one man influenced the final veto decision. A story told by one man changed economic history …
                  .
                  “the US will be prepared to remain the ultimate guarantor of the multilateral system. including the multilateral monetary system. That’s an assumption that will be tested as the US has made it clear, and even Merkel has acknowledged, that it no longer feels obliged to perform this role.”
                  .
                  I think you are confusing NATO and the Fed. The Fed is currently buying foreign corporate bonds. The Fed’s commitment to maintaining global financial stability by supplying unlimited liquidity is very firm; look at transcripts of Fed meetings such as the September 16, 2008 FOMC transcript in which Dudley forcefully presents the view that the Fed’s support for world markets should be open-ended. I bet when current transcripts are released you will see the same “whatever it takes” attitude.

          • ” This implicit backstop is recognized by markets, so Sterling doesn’t blow up despite the dismal predictions of economists.”
            .
            It depends on how the currency crisis goes. If the swap arrangements do add confidence to the markets then all is well. If the Brits have to support Sterling in the markets with dollars and exhaust their dollars then the Brits have to sell off Sterling down the track, unless they can organize another swap.

            • “unless they can organize another swap.”
              .
              Swap lines are permanent and without capacity limits; that in itself supports Sterling, psychologically. The City knows this; mainstream economists don’t.

  3. If the Brits feel they “have to defend” Sterling and exhaust their dollar or Euro reserves doing so, that might be the outcome of a misconception of the mechanisms involved. The “deficit myth” is not the only delusion that can mislead policy.
    .
    Britain is a debtor with an outsized financial sector. Luckily, that financial sector is not particularly invested in or dependent on Sterling; unluckily, the City interests may have an outsized influence on the financial policy of the State nevertheless.
    .
    Fiscal policy encompasses taxation as well as spending. The core idea ought to be to sustain the customary exchange of goods for money. As long as people want Sterling to buy British goods or want to sell Brits goods to get Sterling, Britain and its pound will be fine. As dependent as Britain is on imports, it must find ways to tax economic rents earned on the sale of imported goods and resist the attempts of the EU to prevent Britain from earning rents on production it now controls. (It would nuts to let the EU bully their way to continued control of fisheries.)

    • “As long as people want Sterling to buy British goods or want to sell Brits goods to get Sterling, Britain and its pound will be fine.”

      The problem is that British people want foreign goods. Including goods that Britain does not, or cannot produce, or produce enough of. That includes food and fuel and inputs for its manufactures. So ultimately there has to be currency exchange. So the terms of trade matters. Ultimately a currency (noun) has to have currency (adjective) to purchase that foreign currency; the currency of foreign trade today is the USD. To purchase USDs your own currency has to have a certain amount of purchasing power.

      As I stated it matters less for a largely self-sufficient economy not heavily reliant on foreign capital and goods. Adding to this problem is that Britain has a structural deficit on the balance of payments. (Until recently its trade deficit was covered by invisible receipts; that has been steadily decreasing.) Britain will now lose its privileged access to EU markets and say over EU rules, and it will not get its way at the WTO.

      Non-substitutable imports and a structural deficit on the balance of payments is a problem, even under managed/floating exchange rates.

      Britain is compared to the US, China, Japan or the EU, a small open economy. Think of a few countries before the Euro. A currency depreciation will affect living standards. There are historical examples in pre-Euro Europe itself of the destabilising effects on living standards of very large scale currency depreciation. And there has been very similar pressure on Sterling even this year. As I said, it was ultimately contained by foreign central bank guarantees.

      The central bank guarantees are and outcome of foreign policy and international alliances. We are seeing signs now that this is on increasingly shakier ground.

      If you asked me what was the really big cause of the Great Depression. Well for sure there were many factors – and not just the one Friedman emphasised. You need to go into the history to see how this played out, but the underlying big one was the diminished ability of Britain to underwrite the international monetary and trading system. Periods of transition in the balance of power are the most unstable. This was the situation in the interwar period. It could only be resolved when the US emerged as the clear winner after WWII and then showed a strong commitment to the multilateral system. The USD by then had completely replaced Sterling’s role.

      We are not in the 1920s yet. But we are in a situation where the US is less committed to the multilateral system, which ultimately its economic and political power underwrites.

      • I should add, it was not just foreign policy alliances at play; for there was a concern that a sterling crisis would be the spark of international financial and economic turmoil in an already fragile environment. But arguably we are seeing less willingness by the US to act as the world’s ultimate guarantor of peace and prosperity (and add to that human rights, environment and heath). And this trend was arguably in evidence even before Trump. Also, I agree with Chomsky: the US is still able to fulfil this role, it is just less willing to the play the role of the world’s rescuer.

        • I should think it is pretty clear that the U.S. no longer has any margin of resource to underwrite the role of hegemon: large parts of its industrial capacity has been liquidated and the welfare of large sectors of the population cashiered to get it this far. A corrupt elite wants to go on, but a legitimacy crisis is underway at home and abroad reputation is in ruins.

  4. @ Henry Rech and Nanikore:
    .
    Reading https://www.bis.org/publ/cgfs65.pdf I was reminded of this discussion. I believe the two of you are still too tied to the system described in the paragraph beginning:
    .
    “Before the GFC, a major source of protection against risks related to foreign
    currency exposure was countries’ own foreign exchange reserves (a form of selfinsurance). […]”
    .
    I’m trying to express the following paragraph’s point:
    .
    “During and since the GFC, a network of bilateral central bank swap lines has been
    established, covering a range of currencies […] These were initially set up in
    response to US dollar funding shortages in the GFC (Annex A) and were seen as
    effective in reducing pressure in funding markets by providing an important signal
    and acting as a vital liquidity backstop.”
    .
    The new signaling supercedes the older system.

  5. Willem Buiter’s essay is a must-read, for both its insight and its blindness.

    https://voxeu.org/article/three-strikes-against-fed

    The acceptance of negative-rates as a new normal is a measure of how crazy reactionaries will get, before accepting the unavoidable pain of simply writing off massive amounts of public and private debt.

    Everything Buiter says about the dilemma facing the Fed applies to the ECB, but without a solution space.

    • “Like all other central banks, it accepts the Effective Lower Bound”
      .
      Is Buiter unaware that the Bank of Japan and Swiss National Bank currently have negative rates?
      .
      “For those (risky) Fed programs for which both a maximum scale and a Treasury guarantee/equity injection can be established easily, we find up to $1,950 billion of potential Fed exposure and a mere $195 billion of Treasury equity to back it up.”
      .
      Treasury gets equity from the Fed anyway so the Fed’s capital is a trivial concern. The Fed moves markets by buying bonds, thus in essence insuring itself against loan losses. Also, loans can be rolled over forever. No taxes are needed to back up the Fed; Treasury pays bond redemptions from new bond sales, many of which are bought by the Fed, thus providing non-taxpayer equity for Treasury. When Powell says that the Fed needs Treasury equity, he is being disingenuous at best …
      .
      I agree with you (Bruce Wilder) that debts should be forgiven but see no need for pain. The Fed can take debt on to its balance sheet and hold it forever, at a marked-up away-from-market value. No losses need be shifted onto taxpayers. Most likely however no losses will occur because markets front-run the Fed, buying whatever the Fed buys so the Fed’s assets will always be profitable.
      .
      (I hope I’m not posting so much I’ll get shadow-banned again. It’s just that discussion here is very stimulating!)


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