A recent essay by Yanis Varoufakis illustrates a frequent problem with media discussion of central bank policies:
Central bankers once had a single policy lever: interest rates.
Actually, the policy lever was open market operations; interest rates were one of the variables affected by those operations. A tight money policy might raise interest rates if the liquidity effect dominated or it might reduce interest rates if the Fisher effect dominated. Changing interest rates was not a monetary policy; it was the effect of a policy. (To be clear, changing the interest rate on bank reserves (IOR) is a monetary policy; Varoufakis is discussing the previous (pre-IOR) policy regime.)
Varoufakis says he favors a monetary policy of higher interest rates, but doesn’t tell us whether that is to be achieved via the liquidity effect or the Fisher effect. One would hope that the rest of the article provided enough context to figure out his actual preference. Unfortunately, the subsequent explanation was somewhat confusing:
Of course, central banks fear that hiking interest rates will render governments bankrupt and cause a serious recession. That’s why the increase in interest rates should be supported by two crucial policy moves.
First, because a serious restructuring of both public and private debt is unavoidable, central banks should stop trying to avoid it. Keeping interest rates below zero to extend into the future the bankruptcy of insolvent entities (like the Greek and Italian states and a large number of zombie firms), as the European Central Bank and the Fed are currently doing, is a fool’s wager. Instead, let us restructure unpayable debts and increase interest rates to prevent the creation of more unpayable debts.
Here Varoufakis is clearly focused on the long run path of interest rates. He’s not calling for a brief spike in rates that would be followed by a deep recession and a subsequent fall in rates (such as what the ECB did in 2011), rather he advocates a new regime with persistently higher interest rates. That can only be achieved with an expansionary monetary policy, a higher inflation rate.
Second, instead of ending QE, the money it produces should be diverted away from commercial banks and their corporate clients (which have spent most of the money on share buybacks). This money should fund a basic income and the green transition (via public investment banks like the World Bank and the European Investment Bank). And this form of QE will not prove inflationary if the basic income of the upper middle class and above is taxed more heavily, and if green investment begins to produce the green energy and goods that humanity needs.
This is confusing. If higher interest rates are to be delivered via an expansionary monetary policy, then how is that not inflationary? Is he claiming that an expansionary monetary policy will permanently raise real interest rates? If so, how?
QE creates base money, which is currency plus bank reserves. As a practical matter, bank reserves earn interest under most QE programs, at least when market interest rates are positive. If the central bank did QE in a positive rate environment without paying IOR then you’d end up with hyperinflation, as we’ve seen in some developing countries with fiscal problems. Because of the payment of IOR, there is no revenue bonus from QE to use to finance government spending. Interest bearing reserves are swapped for interest bearing Treasury debt.
Yes, the creation of currency produces a modest annual flow of revenue for the Treasury (called seignorage), but that’s true whether or not they also do QE. To actually bring in the sort of money you’d need to finance major spending programs you’d need the sort of extreme money creation that leads to hyperinflation. That’s not going to happen and Varoufakis clearly indicates he does not favor high inflation.
Once hyperinflation is off the table, a few basic points become clear:
1. The Fed can only control nominal interest rates in the long run; real rates are determined by the market. There is no magic wand by which the Fed controls interest rates. It can permanently raise nominal interest rates, but only by creating inflation.
2. Money creation (including QE) does not provide a large enough revenue source to fund major government programs. Any basic income program or spending on major green initiatives will be funded by fiscal authorities, not a central bank.
3. Existing QE programs (at least in the US) did not fund things like stock buybacks.
Last time I looked, the Fed earned about $80 billion/year in profits, which is turned over to the Treasury. There would be an immediately outcry if the Fed suddenly announced it was going to spend that $80 billion on UBI or carbon abatement. Those decisions are and should be made by elected officials.
READER COMMENTS
Andrew_FL
Nov 17 2021 at 11:23pm
Gosh, who could’ve ever given them the idea that there was almost limitless room for expansionary policy without inflation, it couldn’t be the folks that bemoan the failure to return to the trend line from twelve entire years ago for twelve entire years
Scott Sumner
Nov 18 2021 at 1:08am
Not sure how your comment relates to this post. Perhaps you didn’t understand the post.
Andrew_FL
Nov 18 2021 at 7:26pm
You accept no responsibility for the rising tide of inflationist ideology in which you played an instrumental part
Scott Sumner
Nov 18 2021 at 7:54pm
That’s right.
Matthias
Nov 18 2021 at 3:06am
When money gets spend on stock buybacks, it doesn’t disappear from the economy.
So I’m not even sure how the allegation works.
MarkLouis
Nov 18 2021 at 8:55am
Low real rates and massive wealth-to-gdp seem like the defining economic questions of our time, I wish economists would spend more time debating it.
Here is something half-baked: What if wealth accumulation has greater utility than consumption? I can clearly see how that might be true for the top x% of the wealth distribution as added consumption probably has very little utility.
Further, the utility of wealth accumulation may be driven by expected real returns on that wealth. It’s also reasonable to expect that people extrapolate past real returns.
So now an equilibrium emerges: as inequality widens more people find that wealth accumulation has greater utility than consumption. As a result, consumption slows for a given level of wealth. We respond with lower interest rates, which lowers the discount rate and increases returns to existing financial assets. Those returns get extrapolated and inequality widens further – both of which serve to further increase the relative utility of wealth accumulation over consumption. In the end, you get massive wealth:gdp, very low real rates, and a repeated lack of demand for a given level of stimulus.
There is the added wrinkle that those wealthy constituencies become very powerful, making this equilibrium very difficult to change from a political perspective.
Thoughts?
MarkLouis
Nov 18 2021 at 9:09am
I would add that the normal economist response to wealth accumulation having higher utility than consumption would be that this would compress returns on wealth and therefore lower its utility. But when you respond to wealth accumulation with a lower discount rate that doesn’t seem to be true.
Perhaps the end-game is when real rates can’t fall any further. If you believe long-term inflation is capped at 2% (despite our current Fed letting things overshoot) and that nominal rates have a 0% floor, then the lowest the real risk-free rate can go is -2%. So we are basically there (although long-term rates could still fall further).
At this point expected returns on wealth “should” fall as should the utility of accumulating wealth. If wealth is then more inclined to fund consumption (or inflation hedges) you will see a pickup in economic activity.
That pickup will be inflationary. If the central bank responds with higher real rates asset values will stagnate or fall and the equilibrium i outlined will begin to come back into balance. However, if the central bank fears the “financial stability” impact of higher rates (or if politics intervenes) then you will be forced to accept higher inflation. Might that describe what’s going on right now?
Sven
Nov 19 2021 at 8:45am
MarkLouis excellent point.
This is how capitalism is working. Wealth creates more wealth due to eagerness to have more wealth. Higher amount of wealth creates higher level of prestige, pride, and power. Otherwise, why would Warren Buffet work to earn billions while he already has billions?
And yes income equality leads to low interest rates. It is a downward spiralling mechanism. It constantly creates lack of aggregate demand that needs to be offset with debt.
However, the root cause of this economy is the monetary system. Expansionary monetary system causes the values of goods and services to be remained high permanently. It leads to imperfect competition. Therefore, the rich get richer. And the economy follows a permanently deflationary cycle. It is a vicious circle in the long run.
The response ordinary economists giving to this vicious circle like the monetary policy options have been stuck globally. It is unsustainable in the long run.
I explained in my book here how the system is actually working.
https://www.academia.edu/50822011/The_Theory_of_Capitalism
Scott Sumner
Nov 18 2021 at 11:50am
I don’t get any utility from wealth (at the margin), so I’m skeptical of the claim that this is an important source of utility. Perhaps if I were less affluent I’d get some utility from wealth at the margin, but you seem focused on the affluent.
MarkLouis
Nov 18 2021 at 12:05pm
I have to disagree with you. Would be curious to know what others think.
I know quite a few hyper-wealthy people and they take great pride in how much wealth they’ve accumulated. They often don’t show much interest in additional consumption. Wealth has value as “insurance” (see blog post below), confers status, and greatly enhances ones influence in a variety of life situations.
Do standard macro models based on aggregate demand fall apart if wealth accumulation has greater utility than consumption for a subset of very wealthy people?
Wealth as insurance…
https://www.interfluidity.com/v2/3487.html
Scott Sumner
Nov 18 2021 at 7:56pm
“Do standard macro models based on aggregate demand fall apart if wealth accumulation has greater utility than consumption for a subset of very wealthy people?”
Not market monetarist models of AD, which assume that AD is determined by monetary policy.
MarkLouis
Nov 19 2021 at 5:55pm
The problem is the only tools available to the monetarist partially work via the asset price channel. You can cut rates or purchase safe assets – that’s it. Both of those increase asset values which, if we extrapolate past returns, further increases the relative utility of accumulating wealth. So the “solution” to an AD shortfall may also exacerbate the AD shortfall.
I prefer this to the vague “savings glut” theory which just supposes such things are random.
Scott Sumner
Nov 21 2021 at 4:02pm
I disagree with your claim, as they money could be introduced in all sorts of ways, and the effect would be quite similar. And if money creation boosted asset values, why did financial assets do so poorly during the Great Inflation of 1966-81? That’s not the key monetary transmission channel.
Scott H.
Nov 19 2021 at 8:08am
Wouldn’t any time you choose to save you are doing so because of the utility of wealth at the margin?
Also, another thought I’m exploring is quantifying the utility of wealth accumulation to the greater society. I know that the driver of capitalism is capital accumulation — so it’s obviously useful — but does more unequal dispersion of wealth contribute to greater capital availability? Is it a coincidence that the US suddenly has a space industry now that Musk and Bezos are gazillionaires?
My own experience with wealth is that you’ve got to have a lot of it before you’re willing to risk a lot of it.
Scott Sumner
Nov 21 2021 at 4:04pm
“Wouldn’t any time you choose to save you are doing so because of the utility of wealth at the margin?”
No, you might save for future consumption.
Jose Pablo
Nov 22 2021 at 8:43pm
You also invest for future consumption.
After all, you don’t enjoy the money that you don’t expend.
Roger Sparks
Nov 18 2021 at 9:00am
I am thinking about the Fisher effect here. It seems to be based on private sector lending; that is, the lending of money already in existence.
So we have a company looking for a loan to fund a revised business plan, wherein, the plan calls for higher wages funded by higher prices for the product. Initial funding is needed because wages must be paid before higher income from sales can arrive.
The private lender looks at this situation and deems it ‘an inflationary plan that he is being asked to fund’. Should he fund it at existing rates, he will not get enough money returned at end of period to keep pace with inflation. Hence, private lender increases the interest rate enough to at least cover inflation.
Radford Neal
Nov 18 2021 at 11:01am
“Last time I looked, the Fed earned about $80 billion/year in profits, which is turned over to the Treasury.”
A technical question… Is this really the right measure of how much of US government expenditures are financed by money creation? I had thought that if the US were to go the route of financing the government by “printing money”, it would take the form of the Fed buying newly-issued government bonds, and I don’t see this would necessarily lead to a “profit” for the Fed, in an accounting sense. And in reality, it looks more like a loss, if one assumes that these bonds will never really be repaid (just rolled over on maturity). Wouldn’t something like the increase in the amount of government bonds owned by the Fed be a better measure?
Scott Sumner
Nov 18 2021 at 11:47am
That’s another valid approach, but it should be only bonds purchased with currency, not those purchased interest bearing bank reserves (which doesn’t give any net revenue to the government.) So it’s still in the $80 billion/year ballpark
rsm
Nov 19 2021 at 1:35am
Why should hyperinflation be off the table, when we can print money faster than prices rise but distribute it directly to individuals via a basic income (thus obviating the “Cantillon effect”)?
Sven
Nov 19 2021 at 8:31am
Prof. Sumner,
I agree with you there is no magic wand. The main reason is that monetary policy options are very limited to reach Varoufakis’s goals in an ultra-low interest rate environment. Yes, low interest rates create problems such as these- Keeping interest rates below zero to extend into the future the bankruptcy of insolvent entities (like the Greek and Italian states and a large number of zombie firms)-, Varoufakis claim. He is such a person always create opinions about certain problems.
The main problem is fiscal policy. And it is not about the fiscal policy of such as US or UK. It is about surplus countries such as Germany, China, Japan. These countries constantly creating savings and exporting them to other countries. This pattern is generating global savings glut. Therefore, it is not possible to have a stable macro economy for an individual country unless capital controls are implemented.
So, interest rates will not go up in any foreseeable future. Therefore, those problems Varoufakis points out will be here to remain.
I would want to hear about your position on those issues. Since as far as I can observe you are content with the economy so long as NGDP is on track whether other macro problems remain unsolved.
P.S. you say; 3. Existing QE programs (at least in the US) did not fund things like stock buybacks. Do you have any strong reason to claim that in a zero lower bound interest rate environment?
Jose Pablo
Nov 19 2021 at 5:13pm
“corporate clients (which have spent most of the money on share buybacks)”
I never understand this vilification of share buybacks.
Why cash in the company bank account is “better for society” (whatever it means) that this very same cash in the bank accounts of the shareholders?
Scott Sumner
Nov 21 2021 at 4:05pm
I agree.
MarkLouis
Nov 20 2021 at 8:32am
Amazing amount of confusion out there even among economists. I’d like to request another blog post titled: “No, Monetary Policy is not the Answer for Increasing the Labor Share”
Scott Sumner
Nov 21 2021 at 4:05pm
I’ve already done such posts.
Comments are closed.