Monthly Archives: September 2009

Quantitative easing (QE – the purchase of government securities by the central bank, financed through increases in base money) in the UK is not working.  I should have written “not yet”, for posterior coverage reasons, but I’m running out of patience with a policy that (a) has been ineffective for the half year of its existence and (b) can be easily modified to make it more effective.  Credit easing (CE – the outright purchase of private securities by the central bank) in the UK really hasn’t been tried.  Of the total Asset Purchase Facility limit of £175 bn, up to £50 bn could have been used to purchase private securities outright.  Instead, out of the just under £154 billion purchased up to 24 September 2009 (see here), only £2 bn of private securities have been purchased by the Bank of England.  The rest of the £175 bn Facility has been or will be devoted to purchases of UK Treasury securities.  No doubt this gives the Chancellor of the Exchequer a warm feeling inside, but from every other perspective it looks like a poor use of Bank of England resources.

Since QE started in January 2009, the Bank of England’s balance sheet has continued to explode, as is clear from the Table below, which shows the Bank of England’s Balance Sheet at the end of July 2007 (just before the crisis) and at the end of August 2009.  The total size of the balance sheet rose from £80.3 bn to £220.3 bn.  The peak of the Bank of England’s balance sheet size so far was at the end of July 2009, when it stood at £245.3 bn, more than three times its July 2009 size.  This is the largest proportional increase in the size of the balance sheet of any of the leading central banks.

(VI) Will a fiscal stimulus work as effectively when the economy has been hit by a credit crunch?

The credit crunch is now hitting the non-financial enterprise sector hard.  How does a fiscal boost affect demand when the enterprise sector is credit-constrained?  If the constraints are tight enough, they will weaken and may even completely neutralise the effect of a fiscal stimulus on output and employment not (just) because of financial crowding out of consumer and business demand, but because of credit constraints on supply, what Alan Blinder (1987) has called effective supply failure.  This is most easily seen if production is subject to a lag (inputs go in before saleable output comes out).  This means that firms need working capital to get production going.  Increased demand can be met from inventories, and that may provide some working capital, but once inventories have been worked off, the credit constraint on production and employment becomes binding.

The notion that a credit crunch could lead to effective supply constraints being binding in the market for goods and services, even if demand is depressed, was first developed by the South-American structuralist school of Raul Prebisch and Celso Furtado, and its neo-Structuralist successors (e.g. Lance Taylor and Domingo Cavallo (1977)), although its antecedents go back much further to the Austrian school of Hayek, Mises and to Marx.

(IV). When does a fiscal stimulus boost aggregate demand?

A fiscal stimulus is a key weapon in the policy arsenal used to address an undesirable weakening of aggregate demand.  For the policy to make sense, either an increase in public spending on goods and services (public consumption or investment) or a tax cut (an increase in transfer payments) must raise aggregate demand at a given price level, wage, interest rates, exchange rates and other asset prices.  In the textbook IS-LM model this means that the fiscal measure shifts the IS curve to the right in output – interest rate space – there is no full direct crowding out, Ricardian equivalence or Minsky equivalence.

We may still not get any effect on output and employment, even if the IS curve shifts to the right, either because there could be ‘financial crowding out’ through higher interest rates, lower asset prices or a stronger exchange rate or because there is ‘real crowding out’ through scare real resources on the supply side; real crowding out or ‘factor market crowding out’ occurs through rising real wages and other real factor costs, and through rising inflationary pressures.

But unless the fiscal stimulus shifts the IS curve to the right, it achieves nothing at all – we don’t even have to investigate whether there is financial or real crowding out.

(III) Fiscal policy

With monetary policy, both conventional and unconventional, having reached the limits of its effectiveness in most of the advanced industrial countries, the only instrument left for boosting demand is fiscal policy.  By this I mean, until further notice) a cut in taxes or an increase in public spending financed either by borrowing from the public (domestic or foreign) or by borrowing from the central bank, that is, by creating base money.

Like all debt, public debt is both a wonderful and a dangerous social invention.  It permits individuals and groups of individuals, including nations, to smooth consumption over time – it permits saving to be de-coupled from investment.  In what follows it will be important not to use the word ‘debt’ as equivalent to ‘financial instrument’ or ‘financial claim’.  Equity and other profit-, loss- and risk-sharing instruments also permit the de-coupling of saving and investment and the smoothing of consumption over time and across generations.  When I refer to debt, it is narrowly defined as a financial instrument imposing fixed, non-contingent payment obligations on the borrower. Borrowing in this narrow sense creates a legal obligation to repay the debt with interest at some future date.

On September 16 and 17, the Earth Institute at Columbia University (well, at least it’s not called the Universe Institute) and the Asian Development Bank organised a conference at Columbia University on The Future of the Global Reserve System.  Papers were presented by the members of the Asian Development Bank’s International Monetary Advisory Group (IMAG), of which I am one (the other members are Prof. Jeffrey Sachs, Dr. Nirupam Bajpai, Dr. Maria Socorro G. Bautista, Prof. Barry Eichengreen, Dr. Masahiro Kawai, Prof. Felipe Larrain, Prof. Joseph Stiglitz, Prof. Charles Wyplosz, Dr. Yu Yongding).

The paper “Is there a case for a further co-ordinated global fiscal stimulus” is my take on the subject assigned to me for the New York conference: Are the coordinated stimulus plans working and are they effective? Should we continue with fiscal stimulus? Are there other approaches to aggregate demand management?”

I will publish the paper in this blog in two or three installments, as I revise the initial draft.  Installment one follows below.

Introduction

For further internationally co-ordinated expansionary fiscal policy measures to be desirable today, a number of conditions must be satisfied.

First, there must be idle resources – involuntary unemployment of labour and unwanted excess capacity.  Output and employment must be demand-constrained.

Second, there must be no more effective way of stimulating demand, say through expansionary monetary policy.

Third, expansionary fiscal policy must not drive up interest rates, either by raising the risk-free real interest rate or by raising the sovereign default risk premium, to such an extent that the fiscal stimulus is emasculated through financial crowding out.

Fourth, at given interest rates, the expansionary fiscal policy measures are not neutralised by direct crowding out (the displacement of private spending by public spending or of public dissaving by private saving at given present and future interest rates, prices and activity levels).  Such direct crowding out can occur in the case of tax cuts (strictly speaking, cuts in lump-sum taxes matched by future increases in lump-sum taxes of equal present discounted value) because of Ricardian equivalence/debt neutrality.  In economies with very highly indebted households, debt neutrality can occur when taxes on households are cut, because of what I shall call “Minsky equivalence” (see Minsky (2008)).  Increases in public spending on real goods and services (“exhaustive” public spending) can fail to boost aggregate demand because of a high degree of substitutability (in the utility functions or the production technology) between private consumption and investment on the one hand and public consumption and investment on the other.

Fifth, there must be cross-border externalities from expansionary fiscal policies that cause decentralised, uncoordinated national fiscal expansions to be suboptimal.

This paper will consider these issues in turn.  After reaching some fairly discouraging conclusions on the scope for further conventional expansionary fiscal policy now, unless there are significant political realignments in fiscally challenged nations that support coalitions in favour of significant future fiscal tightening through tax increases or public spending cuts, I briefly outline some unconventional fiscal/financial policies that may be effective in their own right and may help to enhance the effectiveness of conventional expansionary fiscal policy.  Collectively, they can be characterised as the equitization of debt – household mortgage debt, bank debt and public debt.

Until yesterday’s defeat of Roger Federer in the final of the US Open at Flushing Meadows, the most disappointing development this year was the performance of president Barack Obama and his administration – and my expectations were modest to begin with.

Science with very few (if any) data

Doing statistical analysis on a sample of size 1 is either a very frustrating or a very liberating exercise.  The academic discipline known as history falls into that category.  Most applied social science, including applied economics, does too.  Applied economists use means fair and foul to try to escape from the reality that economics is not a discipline where controlled experiments are possible.  The situation that an economically relevant problem can be studied by means of a control group and a treatment group that are identical as regards all but one external or exogenous driver, whose influence can as a result be isolated, identified and measured, does not arise in practice.

Pinn illustration

 

 

 

 

 

 

 

 

Lord Turner, chairman of the UK’s Financial Services Authority, has set the cat among the financial pigeons by making highly critical comments about the City of London and financial intermediation in general. He recommended some drastic remedies, and suggested considering a global tax on financial transactions – a generalised Tobin tax. James Tobin proposed a tax on foreign exchange transactions to stabilise floating exchange rates and achieve greater national monetary policy autonomy in a world of increasing financial integration.

The Tobin tax was never implemented, which is just as well from the perspective of its declared objectives: it could have increased exchange rate instability and was unlikely materially to enhance national monetary policy autonomy. From a political perspective, it may be more surprising that it was never implemented. Even at a very low rate, the Tobin tax could have been a massive government revenue raiser. Distortionary taxes that raise large revenues, including transaction taxes on financial and real assets – such as the UK’s stamp duty on property – are, after all, a common feature of the political landscape.

What problem would a Tobin tax on financial transactions solve? Lord Turner asserts, in an interview with Prospect magazine, that the UK financial sector has grown too big; that some financial sector activity is worthless from a social perspective; that the sector is destabilising the British economy; and that new taxes may be required to curb excessive profits and pay in the sector. “If you want to stop excessive pay in a swollen financial sector you have to reduce the size of that sector or apply special taxes to its pre-remuneration profit,” he says. Even if all these assertions are correct, they do not imply the need for a Tobin tax.

Continue reading “Forget Tobin tax: there is a better way to curb finance”

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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