Debt, Money and Mephistopheles: How do we get out of this mess? - - PowerPoint PPT Presentation

Debt, Money and Mephistopheles: How do we get out of this mess?

Cass Business School 6 February 2013

Adair Turner

1

Monetary policy and macro-demand: Two issues

 Targets:

• Inflation rates or price levels
• Nominal GDP growth rates or levels

 Tools to achieve targets:

• Fiscal or monetary or macro-prudential
• Interest rates or QE or credit easing
• Helicopter money

2

Devilish money creation: Faust Part II

“All this activity degenerates into inflation, destroying the monetary system because the money rapidly loses its value”

Jens Weidman, Money Creation and Responsibility, September 2011

3

Money finance as normal procedure: Friedman and Simons

‘Under the proposal, government expenditures would be financed entirely by tax revenues or the creation of money, that is, the issue of non-interest bearing securities… The chief function of the monetary authority [would be] the creation

• f money to meet government deficits and

the retirement of money when the government has a surplus” “The powers of the government to inject purchasing power through expenditure and to withdraw it through taxation, i.e. the powers of expanding and contracting issues of actual money and other obligations more or less serviceable is money – are surely adequate to price level control. … in other words, the monetary rules should be implemented entirely by, and in turn should largely determine, fiscal policy.”

Milton Friedman, A Monetary and Fiscal Framework for Economic Stability, America Economic Review, Vol 38, June 1948 Henry Simons, Rules and Authorities in Monetary Policy, The Journal of Political Economy, Vol 44, No. 1, February 1936

4

Helicopters and old bottles: Friedman and Keynes

“Let us suppose that one day a helicopter flies over this community and drops an additional $1000 in bills from the sky, which is, of course, hastily collected by members of the community” “If the Treasury were to fill old bottles with bank notes, bury them at suitable depths in disused coal mines… and leave it to private enterprise on tried principles of laissez faire to dig the notes up again… there need be no more unemployment… and the real income of the country… would then become a good deal greater than it actually is.”

Milton Friedman, The Optimum Quantity of Money, Chapter 1, (1969) John Maynard Keynes, The General Theory, Chapter 10, Section 6 (1936)

5

1. Macro demand levers and effects 2. Friedman 1948: monetary policy and the structure of banking 3. Financial stability and macro-demand management: the crucial role

• f leverage

4. Appropriate targets: prices or nominal GDP? Rates or levels? 5. Conventional and unconventional monetary policy: limits to effectiveness and potential adverse effects 6. Pure fiscal policy: limitations and risks 7. Overt money finance: Definition and advantages Dangers and constraints Central bank independence 8. Possible implications today: Japan, US, Eurozone and UK 9. Conclusions

• 10. Mephistopheles, Money and Debt

6

Levers and effects

Macro-Prudential policy:

• Bank capital and

liquidity standards Aggregate Nominal Demand = Nominal GDP

Prices Real

• utput

Central Bank private credit support:

• US “credit easing”
• UK “FLS”

Monetary policy:

• Interest rates
• QE
• Forward guidance

Fiscal policy: deficits or surpluses Macro-Prudential policy:

• Bank capital and

liquidity

7

Levers and effects

Aggregate Nominal Demand

Prices Real

• utput

Central Bank private credit support:

• US “credit easing”
• UK “FLS”

Monetary policy:

• Interest rates
• QE
• Forward guidance

Fiscal policy: deficits or surpluses

O.P.M.F.

Macro-Prudential policy:

• Bank capital and

liquidity standards

8

Levers and effects

Aggregate Nominal Demand Prices Real

• utput

Division determined by

• Spare capacity in labour or physical capital
• Flexibility of price setting processes in

labour or product markets

9

The “independence” assumption

Aggregate Nominal Demand

Prices Real

• utput

Central Bank private credit support

Macro-Prudential policy:

• Bank capital and

liquidity standards

Monetary policy Fiscal policy Macro- Prudential Division of the effect between prices and real output is independent of the tools used to stimulate nominal demand

O.P.M.F.

10 10

Possible contraventions of “independence”

Aggregate Nominal Demand

Prices Real

• utput

Central Bank private credit support Monetary policy Macro- Prudential

Supply enhancement?

Fiscal policy

O.P.M.F. Unconventional monetary policy or O.P.M.F. create expectations of future price effects? Fiscal expenditure or credit support targeted to achieve supply increase as well as demand?

11 11

“The essence of [the] proposal is that it uses automatic adaptations to the current income stream to offset, at least in part, changes in

• ther segments of aggregate demand and to change appropriately

the supply of money. Under the proposal, government expenditures would be financed entirely by tax revenues or the creation of money, that is, the issue of non-interest bearing securities… The chief function of the monetary authority [would be] the creation of money to meet government deficits and the retirement of money when the government has a surplus”

Milton Friedman, A Monetary and Fiscal Framework for Economic Stability, America Economic Review, Vol 38, June 1948

12 12

Friedman’s 1948 proposal: a simple illustration

Suppose:  Nominal GDP = 100 and money supply = 50  Sensible aim is to grow nominal GDP at 4% per annum, allowing for 2% real growth and 2% inflation Then:  Equilibrium money supply growth might be around 4%  Appropriate increase in money supply is achieved by running fiscal deficit of 2% of GDP, financed entirely by money  Money supply grows by 2 (=4% for 50)

13 13

Two simplifying assumptions

 Stable relationship between money supply and money GDP (constant velocity)  All money is base money: no fractional reserve banks; no private money creation “A reform of the monetary and banking system to eliminate both the private creation or destruction

• f money and discretionary control of the growth
• f money by the central bank authority”

(Friedman, 1948)

14 14

From fractional reserve to 100% reserve banking

100% Reserve Banking

Notes & Coins Reserves

Central Bank Commercial Banks Money supply A L

Reserves Deposits

Deposit money = Reserves at central bank Total money supply = Base money Deposit money = Multiple of reserves at central bank Total money supply = Multiple of base money

Fractional Reserve Banking

Central Bank Commercial Banks Money supply A L

Notes & Coins Reserves

Notes & coins & bank deposits

A L

Reserves Loans Deposits

Notes & coins & bank deposits

15 15

Laissez faire economics and the banking exception

“in the very nature of the system, banks will flood the economy with money substitutes during booms and precipitate futile effects at general liquidation afterward” “private initiative has been allowed too much freedom in determining the character of our financial structure and in directing changes in the quantity of money and money substitutes.” Henry Simons, Rules versus Authority in Monetary Policy, Journal of Political Economy, Vol 44, February 1936.

16 16

Arguments for fractional reserve banks: Up to a point

Some private credit and money creation, may:  Be essential to optimal mobilisation of savings  Facilitate welfare enhancing smoothing of consumption across life cycle

• Abolishing fractional reserve banks

almost certainly not optimal

• But good argument for dramatically

increasing − The fraction of liquid reserves and/or − The fraction of capital resources

See Adair Turner “Monetary and Financial Stability: Lessons from the Crisis and from some old Economics Texts”, South Africa Reserve Bank, November 2012.

17 17

Two (lost) insights of early laissez faire writers

 Banking is special: arguments for laissez faire in

• ther sectors of the economy are not applicable

 Monetary and financial stability are closely interlinked

18 18

1. Macro demand levers and effects 2. Friedman 1948: monetary policy and the structure of banking 3. Financial stability and macro-demand management: the crucial role

• f leverage

4. Appropriate targets: prices or nominal GDP? Rates or levels? 5. Conventional and unconventional monetary policy: limits to effectiveness and potential adverse effects 6. Pure fiscal policy: limitations and risks 7. Overt money finance: Definition and advantages Dangers and constraints Central bank independence 8. Possible implications today: Japan, US, Eurozone and UK 9. Conclusions

• 10. Mephistopheles, Money and Debt

19 19

Three drivers of financial instability

Debt contracts create specific risks Unregulated bank credit and private money creation is inherently unstable Lending secured against real assets can be strongly pro-cyclical

Real economy leverage, credit creation dynamics, and credit/asset price cycles are crucial macro-economic variables, and phenomena

20 20

Leverage in the real and financial sectors

Source: Oliver Wyman

UK debt as a % GDP by borrower type (1987-2007), Debt Liabilities on B/S

Household Corporate Financial 0% 100% 200% 300% 400% 500% 600% 1 9 8 7 1 9 8 9 1 9 9 1 1 9 9 3 1 9 9 5 1 9 9 7 1 9 9 9 2 1 2 3 2 5 2 7

USA debt as a % GDP by borrower type (1929-2007)

Household Corporate Financial

1987 1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1990 1996 2002 2007 10% 50% 100% 150% 200% 250% 300% 1987

21 21

Private non-financial corporate deposits and loans: UK 1964 – 2009

Source: Bank of England Tables A4.3, A4.1 0% 5% 10% 15% 20% 25% 30% 35% 40% 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

%

• f G

D P

Securitisations and loan transfers Deposits Loans

22 22

Household deposits and loans: UK 1964 – 2009

Source: Bank of England, Tables A4.3, A4.1 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 %

• f G

D P Securitisations and loan transfers Deposits Loans

23 23

Private credit to GDP ratio and growth

Source: S. Cecchetti, BIS Working Paper No. 381 "Reassessing the impact of finance and growth"

24 24

Lending to UK business

Source: Bank of England “Trends in Lending”

• 20
• 10

10 20 30 40 50 1964 1970 1976 1982 1988 1994 2000 2006 2012

All currency loans

Percentage changes on a year earlier

25 25

Lending to individuals

• 5

5 10 15 20 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Percentage changes on a year earlier

Secured Unsecured Individuals

Source: Bank of England “Trends in Lending”

26 26

Japan-policy rate vs credit growth per annum

• 8
• 4

4 8 12 16

Dec-85 Dec-87 Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11

Private credit growth (%pa) BoJ Policy rate

Source: Datastream

%

27 27

Sectoral financial surpluses/deficits as % of GDP: Japan 1990 – 2012

Source: IMF, Bank of Japan Flow of Funds Accounts

• 15
• 10
• 5

5 10 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 PNFCs Government

%

28 28

Japanese government and corporate debt: 1990 – 2010

Source: BoJ Flow of Funds Accounts, IMF WEO database (April 2011), FSA calculations

% GDP

50 100 150 200 250

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 20010 Banking lending to non-financial corporates General Government debt

29 29

Shifting leverage: private and public debt-to-GDP

Source: ONS Note: PNFC = private, non-financial corporates; Public = central and local government

UK

Source: BEA Note: PNFC = private, non-financial businesses; Public = federal, state and local government

US

Source: ECB Note: PNFC = private, non-financial corporates; Public = central and local government

Spain

30 30

Alternative possible targets

Exclusively price focused Price and real output / employment focused

 Alternative inflation rate measures (e.g. excluding “one-ff” tax or commodity price effects  Higher inflation rate (permanently

• r for a period of time)

 Guidance implying loose policy even after inflation rate back on target  Price level trend  Circumstance contingent future guidance (loose policy till unemployment below x%)  Money GDP growth rate (as permanent rule or temporarily)  Money GDP level trend

Blanchard et all Federal Reserve , Autumn 2012 Woodford, August 2012 Carney, December 2012

31 31

UK inflation: Bank of England forecasts and actual

1 2 3 4 5 6 2009Q3 2009Q4 2010Q1 2010Q2 2010Q3 2010Q4 2011Q1 2011Q2 2011Q3 2011Q4 2012Q1 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2 Aug 09 Projection Aug-10 Aug-11 Actual CPI Inflation target

%

32

Arguments for changed targets

 High potential for non-inflationary growth  Erosion of excess debt levels (public or private) via higher inflation  Forward commitments to future accommodative policy

33 33

Public debt to GDP: US and UK

50 100 150 200 250 300 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 % G D P

Source: DMO, ONS

National debt as % of GDP

34 34

GDP Growth rates 1950 – 1970

Real annual average GDP growth % Nominal annual average GDP growth %

Source: BEA (US), ONS (UK), FSO (DE), Cabinet Office (JP), Madison, FSA calculations

35

Arguments for changed targets

 High potential for non-inflationary growth  Erosion of excess debt levels (public or private) via higher inflation  Forward commitments to future accommodative policy

36

New targets?

Potential for non- inflationary growth Erosion of debt via inflation Forward commitments to accommodative policy

 Reasonable case to consider alternatives  But as temporary not permanent regime change Particular attractions in:  Circumstance contingent pre-commitment (Federal Reserve policy)  Taking account of nominal GDP level… but not Woodford’s “return to trend” approach

?

37 37

Levers and effects

Aggregate Nominal Demand = Nominal GDP

Prices Real

• utput

Central Bank private credit support:

• US “credit easing”
• UK “FLS”

Monetary policy:

• Interest rates
• QE
• Forward guidance

Fiscal policy: deficits or surpluses Macro-Prudential policy:

• Bank capital and

liquidity standards

38

Monetary, credit support and macro-prudential levers beyond the ZLB

 Standard QE – buying government bonds  Wider QE – private bonds, equity, property, FX  Liquidity support – LTRO  Direct credit subsidy – FLS  Macro-prudential policy – relaxation of capital or liquidity standards

39 39

Central Bank policy rates

Source: Central Banks 1 2 3 4 5 6

J a n

• 8

A p r

• 8

J u l

• 8

O c t

• 8

J a n

• 9

A p r

• 9

J u l

• 9

O c t

• 9

J a n

• 1

A p r

• 1

J u l

• 1

O c t

• 1

J a n

• 1

1 A p r

• 1

1 J u l

• 1

1 O c t

• 1

1 J a n

• 1

2 A p r

• 1

2 J u l

• 1

2 O c t

• 1

2 J a n

• 1

3

European Central Bank Bank of England Bank of Japan US Federal Reserve

40 40

Central Bank balance sheets as %GDP

Japan UK US EU

41

Monetary, credit subsidy and macro-pru levers

Potential limitation?

Levers work via indirect channels:  Credit growth – demand and supply  Search for yield  Asset price / wealth effects

Adverse side effects?

Potentially limited if:  Borrowers focussed on strengthening balance sheets  Long as well as short term interest rates approaching ZLB  Low interest rates over many years (decades?)  Stimulus to private leverage

• Hair of the dog that bit us

 Relaxed prudential standards → financial stability risks  Exchange rate spill-over effects

42 42

Japan – 10 year nominal yield

Source: Bloomberg

1 2 3 4 5 6 7 8 9 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

%

43 43

UK trends in lending: % 12-month growth rates

(% 12-month growth rates)

• 10
• 5

5 10 15 20 2 7 2 8 2 9 2 1 2 1 1 2 1 2 Q 1 2 1 2 Q 2 2 1 2 Q 3 2 1 2 Q 4 Lending to UK businesses Secured lending to individuals Consumer credit

Source: Trends in Lending, data as of 04/01/2013

%

44 44

Gross lending to and repayments by UK non- financial businesses (£bn)

10 20 30 40 50 60

2011 Q2 2011 Q3 2011 Q4 2012 Q1 2012 Q2 2012 Q4

SME gross lending LB gross lending SME repayments LB repayments

Source: Bank of England, Trends in Lending, January 2013

45

Funded fiscal stimulus

Advantage: But offset by: Puts money directly into the “Income Stream”  Crowding out  Ricardian equivalence

46

Delong and Summers: The case for pure fiscal stimulus

“When interest rates are constrained by the zero nominal lower bound, discretionary fiscal policy can be highly efficacious as a stabilisation policy tool. Indeed, under … plausible assumptions, temporary expansionary fiscal policies may well reduce long run debt financing burdens”

 Fiscal multipliers low in ‘normal times’ because central bank

• Is itself following appropriate monetary

policy to achieve non-inflationary growth

• Will respond to fiscal stimulus by

monetary tightening  Fiscal multipliers far higher when interest rates at the ZLB and if central bank committed to keeping them there  Stimulus to growth can avoid ‘hysteresis’ effects which will otherwise depress long- term output potential

47 47

Japanese Government debt as % of GDP

Source: Bank of Japan, data as at end 2012, Japan Post Holdings accounts end March 2012

50 100 150 200 250 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Minus Bank of Japan Minus Japan Post Minus domestic commercial banks

46% of GDP

Gross debt minus Government + social security holdings 30.6% of GDP

33.7% of GDP

%

48

Bernanke 2003: The case for a money financed tax cut

 “A tax cut for households and businesses that is explicitly coupled with incremental BoJ purchases of government debt, so that the tax cut is in effect financed by money creation”  Important to be clear “that much or all of the increase in the money stock is viewed as permanent”  Consumers and business will spend the tax cut since “no current or future debt service burden has been created to imply future taxes” (i.e., no Ricardian equivalence offset)  Debt to GDP ratio will fall: no increase in nominal debt but “nominal GDP would rise owing to increased nominal spending”  Same principle “could also support spending programmes to facilitate industrial restructuring, for instance”

49

Advantages of OMF

Versus monetary, credit support and macro-pru stimulus Not offset by: Works directly  Crowding out  Ricardian equivalence Versus funded fiscal stimulus

50 50

Levers and effects

Aggregate Nominal Demand

Prices Real

• utput

Central Bank private credit support:

• US “credit easing”
• UK “FLS”

Monetary policy:

• Interest rates
• QE
• Forward guidance

Fiscal policy: deficits or surpluses

O.P.M.F.

Macro-Prudential policy:

• Bank capital and

liquidity standards

51 51

10 20 30 40 50 60 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955

Post-facto money finance: US 1940 to 1951

Large wartime budget deficits ‘funded’ by government debt issues Federal Reserve commitment to keep interest rates at 2.5% - buying bonds to achieve target

Source: Friedman and Schwarz, Monetary History of the United States

• Post-facto permanent

money finance

• No subsequent

reversal / ‘exit’ High powered base money

52 52

Japanese Government debt as % of GDP

Source: Bank of Japan, data as at end 2012, Japan Post Holdings accounts end March 2012

50 100 150 200 250 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Minus Bank of Japan Minus Japan Post Minus domestic commercial banks

46% of GDP

Gross debt minus Government + social security holdings 30.6% of GDP

33.7% of GDP

%

53 53

The “independence” assumption

Aggregate Nominal Demand

Prices Real

• utput

Central Bank private credit support

Macro-Prudential policy:

• Bank capital and

liquidity standards

Monetary policy Fiscal policy Macro- Prudential Division of the effect between prices and real output is independent of the tools used to stimulate nominal demand

O.P.M.F.

54

OMF: Technically safe, politically dangerous

“The proposal has of course its

• dangers. Explicit control of the

quantity of money by the government and the explicit creation of money to support actual government expenditures may establish a climate favourable to irresponsible government action and to inflation”

 Admitting possibility of OMF carries political economy risks  OMF has taboo status  Taboos can be useful constraints

Milton Friedman, 1948

55

OMF: A policy that dare not speak its name

Optimal policy requires “Policy action that should stimulate spending immediately, without relying too much on expectational channels” “The most obvious source of a boost to aggregate demand that would not depend solely on expectational channels is fiscal stimulus” Need to be clear that some part of “the increase in the base money is intended to be permanent” Michael Woodford, August 2012

56 56

Source: McCulley and Pozsar 56

Varying actual and appropriate policies: McCulley and Pozsar’s framework

57 57

57 Source: McCulley and Pozsar

Private and public leverage cycles

58 58

58

y Leveraging "M M" Deleveraging Conventional

• Unconv. Radical Nuclear

x Rates "Z B" QE FMC Monetary Independence ~ A u s te r i t y P

• l

i c y B " Fi s c a l " B S u r pl u s e s Private Sector Deficits Surpluses S t i mu l u s De f i c it s

Plain Asset Purchases Reverse Volcker Moment Helicopter Money

• Source: McCulley and Pozsar

Varying actual and appropriate policies: McCulley and Pozsar’s framework

59

“It is important to recognise that the role of an independent central bank is different in inflationary and deflationary environments. In the face of inflation, which is often an associated with excessive monetisation of government debt, the virtue of an independent central bank is its ability to say “NO” to the government. [In a liquidity trap] however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. [Under these circumstances] greater cooperation for a time between the central bank and the fiscal authorities is in no way inconsistent with the independence of the central bank”. Bern Bernanke, 2003

60

Constraining OMF with rules and authorities

 Amount of OMF determined by central bank in pursuit of defined target (inflation or, temporarily, nominal GDP)  Amount limited to cyclical element of deficit (as determined by independent authority e.g. OBR)  OMF used only for one-off bank recapitalisation

61 61

Two Policy options

Several £100bns of QE with commitment to future reversal Funding for lending Relaxation of bank capital and liquidity standards

+ +

Several £10bns of OMF of increased fiscal deficit (tax cuts

• r public spend increasing)

… with commitment that this will be permanent

Option 1 Option 2 Which will:

 Be most effective in stimulating nominal demand?  Have least adverse side-effects?

62

Implications by country and currency zone

Bernanke was right Current policy mix optimal, may post-fact be OMF, but is it worth saying so? Optimal policy blocked by incomplete currency union Supply constraints may be as important as demand

63 63

Fiscal adjustment required for long-term debt sustainability

Actual today Required for debt sustainability

Debt as % of GDP 2011 Cyclical adjusted primary balance 2011 Cyclical adjusted primary surplus 2020-2030 Required adjustment Spain 69 UK 82 US 103 Italy 120 Japan 126 Gross Debt Net Debt

• 5.1
• 3.7
• 5.3

2.0

• 7.7

5.5 5.7 7.5 12.6 7.6 + 10.6 + 9.4 + 12.8 + 20.3 + 5.6 To get to 60% debt to GDP by 2030

To get to 80% debt to GDP

64 64

Money finance in Japanese system?

 Close to money financing of deficits  Closer still if government owns banks  Which it does in case of Japan Post Money claims of Japanese households & corporates

Current and deposit accounts at zero interest Government bonds at close to zero interest

Commercial Banks Government

65 65

Japanese Government debt as % of GDP

Source: Bank of Japan, data as at end 2012, Japan Post Holdings accounts end March 2012

50 100 150 200 250 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Minus Bank of Japan Minus Japan Post Minus domestic commercial banks

46% of GDP

Gross debt minus Government + social security holdings 30.6% of GDP

33.7% of GDP

%

66 66

Nominal GDP in four major economic areas: 2007 – 2011

GDP (Q1 2007 = 100) 85 90 95 100 105 110 115 Q 1 2007 Q 2 2007 Q 3 2007 Q 4 2007 Q 1 2008 Q 2 2008 Q 3 2008 Q 4 2008 Q 1 2009 Q 2 2009 Q 3 2009 Q 4 2009 Q 1 2010 Q 2 2010 Q 3 2010 Q 4 2010 Q 1 2011 Q 2 2011 UK US EA JPN

Source: ONS, BEA, Eurostat, Cabinet Office (Japan)

Q1 2007 = 100

67 67

Developed economies’ GDP growth

Q1 2007 = 100

Source: McCulley and Pozsar

68 68

Breaking down of NGDP growth from trough (2009) to peak

∆ Nominal GDP ∆ Prices (GDP deflator) ∆ Real

• utput

UK: +8.1% US: +5.2% Eurozone: +3.8% UK: +2.2% US: +6.5% Eurozone: +3.1% UK: +10.4% US: +12.0% Eurozone: +7.1%

69 69

Breakdown of NGDP growth from trough: 2009 to 2012

20 40 60 80 100 Eurozone US UK Share of NGDP change due to prices Share of GDP change due to real output % % % % % %

70

Conclusions

 Leverage and the credit cycle matter a lot  Banks are different – arguments for freer markets don’t apply  Excess leverage crises are followed by attempted deleveraging – which changes appropriate macro-demand policy  In the deleveraging cycle, monetary, credit support and macro prudential levers alone may … become powerless … have adverse side effects  Fiscal multipliers are higher when interest rates are at ZLB … but long term debt sustainability matters  Governments and central banks together never run out of ammo: OMF is possible and

• May have less adverse side effects
• In technical terms, is no more inflationary than other levers

 But the political economy risks of OMF are huge

• So need strong disciplines to constrain misuse

 Overt money finance should not be a taboo subject

71 71

Faust (Part II) and OPMF: how bad was it?

“Mephistopheles leaps to a single conclusion, that there has been too much deflation and austerity and what was lacking was money. There is, he says, plenty of gold and silver beneath the earth, and the Emperor simply needs to issue pieces of paper in the form of claims against the underground metallic

• treasure. The Emperor is suspicious of this clever advice.

But everything in the empire improves as a consequence of the introduction of paper money. The generals are pleased because the soldiers are paid once more, the treasurer finds that he can pay off all the debts, tailors are busily making new clothes, ladies become more willing to embark on well paid romantic adventures, the property market booms.” Harold James, Germany should re-read Goethe’s Faust Part II, Financial News, October 2012

72

END