<\/p>\n\n\n\n
Rational Monetary Policy Returns<\/strong><\/p>\n\n\n\n For decades neoliberal ideology\ndrove discussions and practice of monetary policy. The essence of neoliberal monetary policy,\nenthusiastically adopted by neoclassical economists, has a simple premise\nleading to a simpler policy process. <\/p>\n\n\n\n The neoliberal approach assumes\nthat market economies tend to automatically adjust to full utilization of\nresources with a stable price level. \nInflation causes instability and excessive public sector expenditure is\nthe cause of inflation. Sound fiscal\npolicy requires balanced budgets, and monetary policy reinforces fiscal policy\nby repressing inflation. Central banks\nrepress inflation through the management of interest rates. To achieve successful monetary management\ncentral banks must be independent of political influence.<\/p>\n\n\n\n The neoclassicals criticized\nKeynesians for allegedly unsuccessful attempts to use fiscal policy to manage\nthe economy — fiscal “fine tuning”. However, neoliberal monetary dogma demanded faith\nin the monetary equivalent. If one\naccepts the questionable claim that inflation causes systemic instability, the\nneoliberal policy response requires acceptance of a more dubious hypothesis,\nthat small changes in interest rates would have a substantial impact on\ninflation rates without a substantial impact on output.<\/p>\n\n\n\n So-called inflation targeting set\nprecise and low inflation goals, typically in the 2-3% range (2% or less for\nthe European Central Bank and within one percentage point of 2% for the Bank of\nEngland). The central bank rate served\nas the instrument to achieve the target. \nOne must marvel that this simplistic hypothesis reached a level of\nacceptance to become policy in many countries — that in a complex economy open\nto international trade and capital flows, small changes in domestic central\nbank rates would quickly produce predictable changes in the rate of change of\nthe price level.<\/p>\n\n\n\n More importantly, in the\nneoliberal era monetary and fiscal policy consciously contradicted rather than\ncomplemented each other. To the limited\nextent that fiscal policy acted in an expansionary manner — before 2008 —\nmonetary policy sought to constrain demand and prices. After 2010 obsession with balancing budgets\nconstrained recovery, while monetary policy sought ineffectively to stimulate\nrecovery (so-call Quantitative Easing).<\/p>\n\n\n\n Monetization and the Virus Crisis<\/strong><\/p>\n\n\n\n In early April of this year as\nthe virus raged in Britain, the Chancellor announced further extraordinary budget\noutlays. This expansion in spending made FT<\/em> headlines<\/a> by the manner in which\nit would be financed. Rather than\nfinancing through offering public debt in financial markets (“gilts”\nas the bonds are called for historical reasons), the Treasury would sell the\nbonds directly to the Bank of England.<\/p>\n\n\n\n This financing arrangement involves an exchange within the public sector. In a rather strange comment, a former Bank of England official reassured the FT<\/em> that the financing “was unlikely to turn Britain into Zimbabwe”. The comment was strange to the point of economic illiteracy because bonds sales by governments to central banks have a long history among advanced market countries.<\/p>\n\n\n\n For example, this April the Federal\nReserve System held 15.8%<\/a> of the US\npublic debt, while other\nfederal agencies owned an additional 10%<\/a> (the largest being the Social\nSecurity Trust Fund), for an\nintra-government total of 26%. In the\nUnited Kingdom the intra-governmental ownership of public debt is higher. Before the April policy announcement the Bank of England\nheld about 30%<\/a> of UK debt.<\/p>\n\n\n\n Why Use Monetization<\/strong><\/p>\n\n\n\n Acceptance of the neoliberal\nhypothesis and its implied framework of an otherwise stable economic system led\nto the reduction,\ntrivialization, of monetary policy<\/a> to interest rate management. The pre–neoliberal emphasis on central banks\nbuying and selling public bonds faded to obscurity. This earlier approach derived from an\nanalysis that considered interest rates an ineffective tool for short term\neconomic management. In place of\ninterest rate adjustment central bank bond transactions sought directly to\nincrease (bond purchases) and decrease (bonds sales) bank liquidity.<\/p>\n\n\n\n The bond transactions could be\nused to reinforce the effects of fiscal policy, making macroeconomic policy\nmore effective. As I explain in detail\nin my new book Debt Delusion<\/a><\/em>,\ngovernments “live within their means” by use of taxation and\nborrowing to fund expenditure. In a\ndemocratic society social necessity determines public expenditure. Rational governments use taxation and\nborrowing to fund those expenditures in a manner that maintains economic\nstability and fullest possible utilization of resources.<\/p>\n\n\n\n In times of extreme economic and\nsocial need such as wars, recessions and the current covid-19 crisis, public\nborrowing serves as a major instrument to maintain stability and protect health\nand livelihoods. The role of borrowing\ninvolves more than funding, though that is its immediate purpose. The interaction of spending — fiscal policy\n— and borrowing — allows monetary policy to play a central role in economic\nstabilisation.<\/p>\n\n\n\n This interaction becomes clear by\ninspecting the two vehicles for managing public bond sales, financial markets\nand the Bank of England. Current\nspending needs associated with the health crisis provide an instructive\nconcrete example. At the end of February\n2020 the central government annual budget involved borrowing of about \u00a340\nbillion or 1.8% of GDP. Almost all\nrevenue comes from general taxation; there are few taxes “earmarked”\nfor specific expenditures. Thus, the \u00a340\nbillion in borrowing and the \u00a3790 billion in annual revenue funded composite\nexpenditure. <\/p>\n\n\n\n Having identified (however\naccurately) needed expenditure, the government has the choice of what vehicle\nto use for the borrowing, bond sales to financial markets or to the Bank of\nEngland. At least three considerations\ninfluence which vehicle to use. First,\nthe desired rapidity of fiscal expansion plays a major part in deciding how to\nfinance expenditure. Bond sales in financial markets leave the monetary base\nunchanged; the sale takes money out of circulation and the subsequence\nexpenditure returns it. A government\nmight prefer this sequence if the economy is near full utilization.<\/p>\n\n\n\n Providing the private sector with\na safe asset is second reason for bond sates to financial markets. Evidence suggests that the demand for bonds\nby banks and other financial institutions is\nfrequently quite high<\/a>; indeed, that financial markets could\nabsorb a considerable amount of bonds<\/a> given the uncertainty caused by the\ncorona crisis.<\/p>\n\n\n\n If the economy is depressed, the\ncombination of a fiscal stimulus and a monetary boost is appropriate. Selling bonds to the Bank of England combines\nmonetary expansion with a fiscal boost. \nThe bond sale creates new credit which the government spends.<\/p>\n\n\n\n The regulation of interest rates\nprovides another motivation for monetization. \nIn the early 2010s several EU governments suffered speculative attacks\non their bonds that drove interest rates to unsustainable levels. This speculation severely undermined the\nability of governments to service their debts. \nHad EU rules not prohibited it, the governments could have prevented\nthat speculation by selling their bonds to their central banks or directly to\nthe European Central Bank. The British\ngovernment faces no effective restriction on sales to the Bank of England. This implies that monetization provides an\neffective mechanism for regulating the interest rate on the debt. If the government offers bonds for sale and\nprivate buyers do not purchase them, the Bank of England serves as fault buyer\nat the prevailing bond rate.<\/p>\n\n\n\n Preventing speculation and complementing fiscal policy provide strong motivations for monetization. Possible inflationary effects provide the main argument against. I address that possibility in a separate blog.<\/p>\n\n\n\n