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Fiscal and monetary policy in a liquidity trap

By Martin Wolf

With floating fx, it’s always a ‘liquidity trap’ in that adding liquidity to a system necessarily not liquidity constrained is moot.

Part 1

What is the correct approach to fiscal and monetary policy when an economy is depressed and the central bank’s rate of interest is close to zero? Does the independence of the central bank make it more difficult to reach the right decisions? These are two enormously important questions raised by current circumstances in the US, the eurozone, Japan and the UK.

With floating fx, it’s always about a fiscal adjustment, directly or indirectly.

Broadly speaking, I can identify three macroeconomic viewpoints on these questions:
1. The first is the pre-1930 belief in balanced budgets and the gold standard (or some other form of a-political money).

Yes, actual fixed fx policy, where the monetary system is continuously liquidity constrained by design.

2. The second is the religion of balanced budgets and managed money, with Milton Friedman’s monetarism at the rules-governed end of the spectrum and independent inflation-targeting central banks at the discretionary end.

Yes, the application of fixed fx logic to a floating fx regime.

3. The third demands a return to Keynesian ways of thinking, with “modern monetary theory” (in which monetary policy and central banks are permanently subservient to fiscal policy) at one end of the policy spectrum, and temporary resort to active fiscal policy at the other.

MMT recognizes the difference in monetary dynamics between fixed and floating fx regimes.

In this note, I do not intend to address the first view, though I recognise that it has substantial influence, particularly in the Republican Party. I also do not intend to address Friedman’s monetarism, which has lost purchase on contemporary policy-makers, largely because of the views that the demand for money is unstable and the nature of money ill-defined. Finally, I intend to ignore “modern monetary theory” which would require a lengthy analysis of its own.

This leaves us with the respectable contemporary view that the best way to respond to contemporary conditions is via fiscal consolidation and aggressive monetary policy, and the somewhat less respectable view that aggressive fiscal policy is essential when official interest rates are close to zero.

Two new papers bring light from the second of these perspectives. One is co-authored by Paul McCulley, former managing director of Pimco and inventor of the terms “Minsky moment” and “shadow banking”, and Zoltan Pozsar, formerly at the Federal Reserve Bank of New York and now a visiting scholar at the International Monetary Fund.* The other is co-authored by J. Bradford DeLong of the university of California at Berkeley, and Lawrence Summers, former US treasury secretary and currently at Harvard university. **

Unfortunately, and fully understood, is the imperative for you to select from ‘celebrity’ writers regardless of the quality of the content.

The paper co-authored by Mr McCulley and Mr Pozsar puts the case for aggressive fiscal policy. The US, they argue, is in a “liquidity trap”: even with official interest rates near zero, the incentive for extra borrowing, lending and spending in the private sector is inadequate.

An output gap is the evidence that total spending- public plus private- is inadequate. And yes, that can be remedied by an increase in private sector borrowing to spend, and/or a fiscal adjustment by the public sector towards a larger deficit via either an increase in spending and/or tax cut, depending on one’s politics.

The explanation for this exceptional state of affairs is that during the credit boom and asset-price bubble that preceded the crisis, large swathes of the private sector became over-indebted. Once asset prices fell, erstwhile borrowers were forced to reduce their debts. Financial institutions were also unwilling to lend. They needed to strengthen their balance sheets. But they also confronted a shortage of willing and creditworthy borrowers.

Yes, for any reason if private sector spending falls short of full employment levels, a fiscal adjustment can do the trick.

This raises an interesting question:

Is it ‘better’, for example, to facilitate the increase in spending through a private sector credit expansion, or through a tax cut that allows private sector spending to increase via increased income, or through a government spending increase?

The answer is entirely political. The output gap can be closed with any/some/all of those options.

In such circumstances, negative real interest rates are necessary, but contractionary economic conditions rule that out.

I see negative nominal rates as a tax that will reduce income and net financial assets of the non govt sectors, even as it may increase some private sector credit expansion. And the reduction of income and net financial assets works to reduce the credit worthiness of the non govt sectors reducing their ability to borrow to spend.

Instead, there is a danger of what the great American economist, Irving Fisher called “debt deflation”: falling prices raise the real burden of debt, making the economic contraction worse.

Yes, though he wrote in the context of fixed fx policy, where that tends to happen as well, though under somewhat different circumstances and different sets of forces.

A less extreme (and so more general) version of the idea is “balance-sheet recession”, coined by Richard Koo of Nomura. That is what Japan had to manage in the 1990s.

With floating fx they are all balance sheet recessions. There is no other type of recession.

This is how the McCulley-Pozsar paper makes the point: “deleveraging is a beast of burden that capitalism cannot bear alone. At the macroeconomic level, deleveraging must be a managed process: for the private sector to deleverage without causing a depression, the public sector has to move in the opposite direction . . . by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole.

Correct, in the context of today’s floating fx. With fixed fx that option carries the risk of rising rates for the govt and default/devaluation.

“Fiscal austerity does not work in a liquidity trap and makes as much sense as putting an anorexic on a diet. Yet ‘diets’ are the very prescriptions that fiscal ‘austerians’ have imposed (or plan to impose) in the US, UK and eurozone. Austerians fail to realise, however, that everyone cannot save at the same time and that, in liquidity traps, the paradox of thrift and depression are fellow travellers that are functionally intertwined.”

Agreed for floating fx. Fixed fx is another story, where forced deflation via austerity does make the maths work, though most often at an impossible social cost.

Confronted by this line of argument, austerians (a term coined by Rob Parenteau, a research associate at the Levy Economics Institute of Bard College), make three arguments:

1. additional borrowing will add heavily to future debt and so be an unreasonable burden on future generations;
2. increased borrowing will crowd out private borrowing;
3. bond investors will stop buying and push yields up.

Which does happen with fixed fx policy.

In a liquidity trap, none of these arguments hold.

With floating fx, none of these hold in any scenario.

Experience over the last four years (not to mention Japan’s experience over the past 20 years) has demonstrated that governments operating with a (floating) currency do not suffer a constraint on their borrowing. The reason is that the private sector does not wish to borrow, but wants to cut its debt, instead. There is no crowding out.

Right, because floating fx regimes are by design not liquidity constrained.

Moreover, adjustment falls on the currency, not on the long-term rate of interest.

Right, and again, unlike fixed fx.

In the case of the US, foreigners also want to lend, partly in support of their mercantilist economic policies.

Actually, they want to accumulate dollar denominated financial assets, which we call lending.

Note that both reserve balances at the Fed and securities account balances at the Fed (treasury securities) are simply dollar deposits at the Fed.

Alas, argue Mr McCulley and Mr Pozsar, “held back by concerns borne out of these orthodoxies, . . . governments are not spending with passionate purpose. They are victims of intellectual paralysis borne out of inertia of dogma . . . As a result, their acting responsibly, relative to orthodoxy, and going forth with austerity may drag economies down the vortex of deflation and depression.”

Right. Orthodoxy happens to be acting as if one was operating under a fixed fx regime even though it’s in fact a floating fx regime.

Finally, they note, “the importance of fiscal expansion and the impotence of conventional monetary policy measures in a liquidity trap have profound implications for the conduct of central banks. This is because in a liquidity trap, the fat-tail risk of inflation is replaced by the fat-tail risk of deflation.”

The risk of excess aggregate demand is replaced by the risk of inadequate aggregate demand.

And the case can be made that lower rates reduce aggregate demand via the interest income channels, as the govt is a net payer of interest.

In this situation, we do not need independent central banks that offset – and so punish – fiscally irresponsible governments. We need central banks that finance – and so encourage – economically responsible (though “fiscally irresponsible”) governments.

Not the way I would say it but understood.

When private sector credit growth is constrained, monetisation of public debt is not inflationary.

While I understand the point, note that ‘monetisation’ is a fixed fx term not directly applicable to floating fx in this context.

Indeed, it would be rather good if it were inflationary, since that would mean a stronger recovery, which would demand swift reversal of the unorthodox policy mix.

The conclusion of the McCulley-Pozsar paper is, in brief, that aggressive fiscal policy does work in the unusual circumstances of a liquidity trap, particularly if combined with monetisation. But conventional wisdom blocks full use of the unorthodox tool kit. Historically, political pressure has destroyed such resistance. Political pressure drove the UK off gold in 1931. But it also brought Hitler to power in Germany in 1933. The eurozone should take note.

Remarkably, in the circumstances of a liquidity trap, enlarged fiscal deficits are likely to reduce future levels of privately held public debt rather than raise them.

As if that aspect matters?

The view that fiscal deficits might provide such a free lunch is the core argument of the paper by DeLong and Summers, to which I will turn in a second post.

Free lunch entirely misses the point.

Why does the size the balances in Fed securities accounts matter as suggested, with floating fx policy?

38 Responses

  1. Excellent point by point that really clarifies the degree to which the various orthodoxies refuse to get to grips with what money actually is and how basic settings of the monetary system have profound and even diametrically opposed implications depending on how they are set.

    At least, unlike Krugman, Wolf will countenance that MMT needs to be grappled with.

    But just like Krugman he’s playing gatekeeper for the status quo and can’t quite bring himself to let go of the status he holds inside the castle. I particularly enjoyed mention of the “imperative” to select celebrity writers!

    1. @jsn,

      “Wolf will countenance that MMT needs to be grappled with”

      That says it all. It’s rather like grappling with the fact that the sun will come up tomorrow, and the earth is round, not flat? This is so unbelievably comical it’s stunning, and embarrassing.

      1727 – “The Nature and Necessity of a Paper-Currency,”
      (several colonies had issued local, fiat currency for decades)

      1751 – The British bankers fight back (note how the intro here is pure propaganda)

      Revolutionary War results (over right to issue sovereign, fiat currency)

      Alexander Hamiliton sells out to the British Bankers anyway

      Jefferson/Jackson/Lincoln – arguments over sovereign control of currency continue – culminating in the 1861 Greenback Dollar.
      (there was even a Greenback political party for awhile; bankers had a better campaign lobby, and were dead serious)

      1933 – Marriner Eccles et al finally return us to fiat currency

      1944 – conquered nations beg USA to go back to a fixed-Fx, quasi gold std (Breton Woods)

      1971 – Nixon finally lets $US/gold ratio float (all remaining fixed-Fx pegs also gradually collapse)

      And Martin Wolf says that MMT needs to be grappled with? Well freaking Duh! Watching billions of people, and Paul Krugman too, neglect such simple questions is like watching reruns of the Road Runner & Coyote – except their actions are impinging upon us, not just the mythical ACME supply co.

  2. “An output gap is the evidence that total spending- public plus private- is inadequate. And yes, that can be remedied by an increase in private sector borrowing to spend, and/or a fiscal adjustment by the public sector towards a larger deficit via either a spending cut and/or tax increase, depending on one’s politics”.

    Warren, i assume this is a typo and should be: “via either a spending increase and / or tax cut”

  3. You are in warren’s kitchen, and he has a gun, and you need his business card to get out, more centrally planned state stimulus does not go where the planners want, and the users don’t care anymore anyways, they just want to be free from the system, so much so they invite the barbarians to attack rome and topple that guy with a gun.
    Perhaps Warren, in a world of 8 billion people, the solutions that seem so simple to you (under our current regime) are unwanted by the people who want out from that room, no matter the reforms, as hickey said, the political elite of the world always seem to blows themselves up in a spectacular fashion. Perhaps you need to be going to the next level indeed and thinking about post modern government world? As Roger Erickson said to me recently, perhaps 200 or so nation states is not enough liver cells, maybe we need more, like 2000 so that those 200 don’t get too powerful.

    In the terminal collapse of the Roman Empire, there was perhaps no greater burden to the average citizen than the extreme taxes they were forced to pay.

    The tax ‘reforms’ of Emperor Diocletian in the 3rd century were so rigid and unwavering that many people were driven to starvation and bankruptcy. The state went so far as to chase around widows and children to collect taxes owed.

    By the 4th century, the Roman economy and tax structure were so dismal that many farmers abandoned their lands in order to receive public entitlements.

    At this point, the imperial government was spending the majority of the funds it collected on either the military or public entitlements. For a time, according to historian Joseph Tainter, “those who lived off the treasury were more numerous than those paying into it.”

    Sound familiar?

    In the 5th century, tax riots and all-out rebellion were commonplace in the countryside among the few farmers who remained. The Roman government routinely had to dispatch its legions to stamp out peasant tax revolts.

    But this did not stop their taxes from rising.

    Valentinian III, who remarked in 444 AD that new taxes on landowners and merchants would be catastrophic, still imposed an additional 4% sales tax… and further decreed that all transactions be conducted in the presence of a tax collector.

    Under such a debilitating regime, both rich and poor wished dearly that the barbarian hordes would deliver them from the burden of Roman taxation.
    Zosimus, a late 5th century writer, quipped that “as a result of this exaction of taxes, city and countryside were full of laments and complaints, and all… sought the help of the barbarians.”

    Many Roman peasants even fought alongside their invaders, as was the case when Balkan miners defected to the Visigoths en masse in 378. Others simply vacated the Empire altogether.

    In his book Decadent Societies, historian Robert Adams wrote, “[B]y the fifth century, men were ready to abandon civilization itself in order to escape the fearful load of taxes.”

    Perhaps 1,000 years hence, future historians will be writing the same thing about us. It’s not so far-fetched.

    In the economic decline of any civilization, political elites routinely call on a very limited playbook: more debt, more regulation, more restriction on freedoms, more debasement of the currency, more taxation, and more insidious enforcement.

    Further, the propaganda machine goes into high gear, ensuring the peasant class is too deluded by patriotic fervor to notice they’re being plundered by the state.

    1. @Save America, I think Warren’s been quite clear that implementation of logical fiscal operations are necessary but not sufficient. Operations are always a tool of policy. The two are, however, interdependent, since efficient operations helps a diverse electorate explore more policies faster, and select from them better/faster/cheaper.

      1. @roger erickson,

        Some are starting to question the whole floating FX system:

        At this point, one may be tempted to say “Ahah, Friedman was right!” But remember, we are not talking about a gold standard. We are talking about an irredeemable paper money system. Money is borrowed into existence. Looking at the trade deficit from the perspective of Terms of Trade, we see that trade deficits lead to budget deficits, which leads to a falling currency, which leads to increased trade deficits. It is not a negative feedback loop, which is self-limited and self-correcting. It is a positive feedback loop.

        There is no particular limit to this vicious cycle until the country in question accumulates so much debt that buyers refuse to come to its bond auctions. And this is not a correction or a reversal of the trend; it is the utter destruction of the currency and the wealth of the people who are forced to use it.

      2. @Save America, There’s still a group formally questioning the roundness of the Earth too. 🙂

        Core issue here is that policy is beyond the bounds of MMT. MMT is necessary but not sufficient for competitive survival of the USA.

  4. I have enjoyed reading Martin Wolf in the past. I need to look this over more carefully (great post), but

    ‘With floating fx they are all balance sheet recessions. There is no other type of recession.’

    Not sure I understand this. I thought this recession was something special in contrast with the normal business cycle, precisely because it is a ‘balance-sheet’ recession (massive overborrowing in private sector). If that is the case, isn’t fiscal policy asymmetric in that cutting taxes may speed deleveraging in the private sector, but won’t do much in the near term for demand?

      1. @WARREN MOSLER,

        I”m not sure this is right. Tax rates could be zero at any given time. Even under your tax-driven money approach, the demand for dollars would persist so long as the state promised to tax in the future, right?

      2. @John Carney,

        Even if in the unlikely event federal tax rate went to zero, US states and municipalities still need taxes for revenue since they are currency users, and there would still be need to pay the feds for fines and fees in USD. So there would still be considerable enforced demand for the currency.

      3. @John Carney, Right. A tax holiday, temporal no taxes does not have the same effect as no taxation or no tax collection at all.

        @ MamMoTh:
        If those goods of absolute necessity are supplied by a monopolist then it creates indeed the need for the currency. Otherwise it seems to me customers would just change supplier.

  5. Is it ‘better’, for example, to facilitate the increase in spending through a private sector credit expansion, or through a tax cut that allows private sector spending to increase via increased income, or through a government spending increase?

    The answer is entirely political. The output gap can be closed with any/some/all of those options.

    Warren, is it entirely political? Isn’t the credit expansion approach more likely to be temporary based on apolitical economic logic alone? If the recession is the result of a shortfall of spending due to the fact that the private sector can’t spend enough to close the output gap and meet its saving desire at the same time, then attempts to induce the private sector to dissave and accumulate even more debt just seem be creating an even bigger saving vacuum that will suck up more private sector demand later.

  6. Wolf and others are clearly avoiding adopting MMT as they would have to defer to Warren for all their insights . And that would not be good for business..

    1. @walid M, It would be GREAT for business … though possibly not for their private, readership-based income as journalists.

      Even that fear is specious. I daresay they could easily explore more writing topic options. Their explanation of why NOT to examine MMT left me scratching my head. Can’t be good for readership for journalists to sound so illogical.

  7. Martin Wolf is currently on a North American speaking tour. I managed to obtain an invite to his talk yesterday, courtesy of a broker I deal with. His formal remarks were good, and would be familiar to anyone who reads the FT. He then opened it up for Q&A. I hesitated to ask any MMT related questions at that time because this wasn’t exactly an MMT friendly crowd. My plan was to try and speak with him privately afterwards. Fortunately, no one else had the same plan and I managed to have a brief private chat with him as the others were filing out of the room. He was clearly tired after a long day, but when I mentioned MMT, his eyes lit up and the conversation flowed from there. These are the main points I remember:

    1) The first thing he said to me was “Paul is wrong”. I said
    “Krugman?” He said: “Yes, Paul is wrong on banking. The MMTers are correct”. Martin Wolf has clearly been closely following the recent internet discussion between MMTers and Paul Krugman.

    2) Wolf confirmed that he will indeed be writing something soon on MMT, as he mentioned in his post. Expect him to go after Krugman at that time.

    3) In terms of the sector balances, he said that the US household desire to increase net savings has so far been mainly accommodated by the larger govt deficit, but this will not last much longer given the current political climate. Instead, it will have to be the non-financial corporations that take it from here. In other words, the huge amount of cash that is currently on the balance sheets of non-financial corporations must somehow find its way to households.
    There wasn’t time to press him on this point, but he implied that the process would be painful, including a large drop in corporate profits.

    4) He brought up Wynne Godley and functional finance without any prompting from me, so he clearly has the foundation to tackle MMT in more depth.

    5) The above notwithstanding, he did not sound totally convinced by MMT. He said that he needs to study it further, but from what he’s read so far, he thinks that MMT is too focused on accounting and not enough on human behavior. I’m not sure exactly what he meant by that comment, but he will likely elaborate in his future post on MMT.

    I wish I had more (unfortunately, his handlers ushered him out of the room at this point), but I am truly grateful for the time Martin Wolf spent with me. Say what you will about him, but I think it is exciting that a writer of that caliber is broaching MMT!

    1. @Geoff,

      Very good news. Let’s hope its a good article.

      MMT focusses on the accounting because the problem is that most economists and politicians don’t understand the accounting.

      As Warren says the currency is a simple public monopoly, and the consequences flow from that.

      Beyond that it is Keynes, Minsky and most of the Post-Keynesian work.

      We can worry about the fine tuning based around human behaviour once we’ve stopped trashing the economy with ideas driven from a misunderstanding of the accounting.

      1. @Neil Wilson, Right, let’s ignore human behavior in America. Not like the country was founded on morals or anything.

        Besides the ideas stemming from MMT are too good to be dismissed as naive.

      2. @Inoculated, The Europeans who arrived with charters in their hands were not looking for virtue. They persuaded some people to seek the Garden of Eden that couldn’t possibly be as bad as the places they were leaving.
        It requires belief in a higher power to motivate some people. Others don’t think ahead and are easy to manipulate/bribe.

    2. Glad to be of service. Wolf is certainly influential. There were a number of VIP’s in attendance, including some central bankers.

  8. This discussion treats public and private borrowing as though they will produce like outcomes. In fact, it is the vast expansion of public borrowing over private in recent years that has resulted in an unsustainable trend that currently demands more than $9 of borrowing to produce a single dollar’s worth of GDP growth at the margin.

  9. Let me just suggest we can use money to strangle the economy, but we can’t use it to make it move.

  10. I feel that the Eurozone crisis has been hindrance to the growth of the US economy. And my perception is that unless and until the Eurozone crisis cease, there is no way that the US economy is going to grow….

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