The distributional implications of alternative ways of dealing with the Global Financial Crisis November 24, 2011
Posted by Peter Earl in Global Financial Crisis, Keynesian economics, Liquidity problem, Monetary policy, Solvency problem.add a comment
To understand what is going on in the current financial crisis, and to consider who would shoulders the burden of alternative solutions, it is necessary to have a basic understanding of banks’ balance sheets. The assets of a solvent bank – i.e., its loans – will be more than its liabilities, with the difference between its assets and liabilities consisting of its ‘reserves’ and shareholders’ funds. A bank’s reserves can be thought of simply as a deposit account that the bank has with itself, which grows when the bank makes profits and shrinks when the bank makes losses. Its profits normally come from charging borrowers more than the sum it pays out in operating costs and in interest on deposits. But it can also make profits if it enjoys capital gains on assets that it owns, such as shares, government securities, or foreign exchange.
When a bad loan is written off, or some other form of capital loss is suffered, the bank’s assets are written down by the amount of the loss, as are its reserves. A bank is insolvent when the losses that have to be written off are bigger than its reserves. The shortfall in reserves means that the bank can only pay its depositors a fraction of their deposits. If the depositors panic and try to withdraw their money en masse, the bank may then have a liquidity problem too, for it will not be able instantly to liquidate its loans and it may have trouble borrowing funds from elsewhere to repay its depositors. In the early phase of the Global Financial Crisis, the problem was more a liquidity problem than a solvency problem, for banks got nervous and became unwilling to lend to each other at a time when some institutions needed to pay out panicking depositors or simply refinance existing deposits. But increasingly the solvency issue is threatening to drive the financial system into meltdown.
When a bank is insolvent, writing down the value of deposits by the value of the shortfall does not fully solve the problem even if it does not cause further loan defaults due to depositors being unable to meet their financial obligations after having their deposits marked down. Such a writing-down of deposits will still leave the bank without any reserves, so it either needs an injection of new shareholder capital or a period of sustained profits to restore its reserve position. To the extent that banks in general are worried about growing insolvency risks, we may expect to see them increasing the ‘spread’ between their loan charges and rates of deposit interest and hence their retained profits. If this is going on, banks on the marginal of survival may likewise start to generate operating profits and start to accumulate new reserves. This way of staving off disaster involves the burden of adjustment being borne by the banks’ borrowers, not by their depositors. If bank margins are increased prior to loan defaults, shareholder capital may not be wiped out and depositors will not have their deposits written down. But pushing the burden of dealing with previous bad lending decisions on to the borrowers may increase the scale of defaults.
Because of this, policies aimed at preventing the collapse of banks have tended to involve the banks being provided with financial assistance or ensuring that their debtors do not default. If a government nationalizes a failing bank and recapitalizes it, the bank’s reserves are restored and a write-down of deposits is avoided. However, instead of having their deposits written down in value, members of the non-bank private sector still end up suffering a reduction in their wealth if the government borrows on financial markets to pay for bank recapitalization and then increases taxes to service and eventually repay these loans. In terms of the banks’ balance sheets, assets are reduced by the amount of the loan write offs as are reserves (to the extent that loans are indeed written off) but so, too, deposits. In essence what happens with deposits is that some deposits are used to buy government debt, with the money received by the government then ending up in bank reserves. As the loans to the government are serviced and repaid, the bank deposits of those who bought the government bonds are replenished and those of the rest of the public are reduced. The rest of the public’s bank deposits end up being lower than they otherwise would have been due to increases in taxation or cuts in public spending. This, in essence, is what has happened in Ireland. The masses end up paying for the incompetence and/or opportunism of the bankers.
From a Keynesian standpoint, the Irish solution looks crazy if implemented at the level of the world financial system as a whole. There is no need to impose burdens on ordinary people in order to revive the financial system, for governments can simply ‘print money’ (aka ‘engage in quantitative easing’) in order to buy up failed banks and recapitalize them. Under quantitative easing, government debt grows and the debt does not end up in the hands of the private sector but on the assets side of the reserve bank’s balance sheet.
The Keynesian solution is only open to governments in command of their own currencies, such as the US and the UK. It is not an option for Greece and Italy, since they are members of the Euro zone, and neither is their problem one of bank solvency within their countries. Rather, the problem is of Greece and Italy is their inability to service or refinance their own levels of borrowing, which threatens the solvency of banks in other countries. The governments of the latter, such as France and Germany, are addressing the problem by trying to prevent sovereign debt defaults – i.e., by agreeing partially to refinance the problem deficits so long as they are also partly reduced by austerity measures being imposed on the populations of the debtor countries. In this way, the populations of corrupt, poorly-managed economies are given a strong message that they had better elect better governments that will reform these economies to ensure such problems do not recur; they do not get off largely without penalty. Their fate is in sharp contrast to that of the least credit-worthy of the US sub-prime mortgage customers, who walked away with their new furnishings and cars after defaulting on negative equity home loans that they had used, while the market was rising, as if they were getting money out of an ATM.
If Greece or Italy were to leave the Euro and default on public sector debt obligations, their residents would still end up suffering reduced real incomes, for their new currencies would fall in value against the Euro and other currencies, raising the prices of imported goods. (Residents of these countries would therefore be wise to hold their current Euro wealth as cash rather than as electronic bank deposits for as long as the risk of exit from the Euro is present.) But they would have a bigger chance of avoiding unemployment and lost output, and part of the problem would then be pushed over to the banks and, ultimately, governments and residents of other countries. The remainder of the Euro zone, and other countries in which bank solvency was jeopardized by exposure to Greece, Italy and their like, would then face a choice between the Irish solution and a more Keynesian strategy based on quantitative easing and bank nationalization. If they were foolish enough not to go for the latter, Keynesians would surely hope that an Irish-style solution would be modified by ensuring that the burden of the austerity measures fell on the rich (especially bankers), whereas in the Irish case the bankers and elite public servants were insulated from the cuts and tax increases. If the less well-off have a higher marginal propensity to consumer than the rich, a more egalitarian version of the Irish solution may also have less adverse implications for aggregate demand.
Quantitative Easing and Foreign Debt: The Keynesian ‘Free Lunch’ Revisited April 6, 2011
Posted by Peter Earl in Global Financial Crisis, Keynesian economics, Monetary policy.1 comment so far
The Keynesian analysis of how to deal with a recession seems to entail a free lunch, as I noted in an earlier and frequently viewed post. If the government increases its net spending at a time of unemployment and funds its deficit by borrowing from its reserve bank (also known as ‘printing money’ or nowadays known euphemistically as ‘quantitative easing’), society gets more output without seeming to owe anything extra to the financial sector or other wealth-holders. The reserve bank increases the size of its balance sheet by the amount of extra government debt (an asset) and credits the government’s account with the same amount of funds (a liability). Recipients of payments from the government bank their cheques and their banks in turn present these cheques to the reserve bank, which then transfers funds from the government’s account to the banks’ reserve accounts held at the reserve bank. The banks’ balance sheets thus grow by the amount of the extra deposits (liabilities for the banks) and their increased reserve funds at the reserve banks (assets for the banks). Growth in the government’s debt seems to entail no growth in its burden, in contrast to what would be the case if stimulus packages were financed by selling bonds on the open market. Moreover, the growth in banks’ reserve asset holdings may stimulate bank lending if this has previously been constrained by any binding reserve asset ratio having to be met.
Unfortunately, there is a complication. Some of the income received from the stimulus packages will be spent on imported goods and services, creating a demand for foreign currency. This will tend to push down the value of the domestic currency. If this does happen, then residents of the country will face higher prices for imports, so some of the real income gains from the stimulus will be lost. The reserve bank could try to maintain the domestic currency’s value by running down the country’s foreign currency reserves by an equivalent amount – if so, the stimulus package has not been a ‘free lunch’. Alternatively, the rise in imports might not result in a fall in the domestic currency’s value if the overseas counties returned their earnings by spending on goods and services from the country that implemented the stimulus package or by buying that country’s financial assets such as government bonds or shares in the country’s firms. To the extent that the stimulus package results in the overseas sector buying up the country’s financial assets, the stimulus package does involve a cost to the economy, despite being financed by quantitative easing. It is a cost that will grow with time because of interest/dividend earnings on these securities, quite apart from any need to pay off the principal at some point. In short, the ‘free lunch’ story of Keynesian stimulus packages financed by quantitative easing works fine for a closed economy but runs into trouble in an open economy setting. Treasurers who try to reduce unemployment are likely to end up adding to their country’s foreign debt, which will eventually require servicing from greater export earnings and may, if the financial markets get nervous, lead to a collapse of confidence in the domestic currency. Treasurers thus will find themselves torn between the pain of unemployment today or the pain of a debt crisis further down the track. With employment affecting fewer voters than would be affected by a debt crisis, it is easy to see why they might end up, as in the UK, backing away from Keynesian policies.
The thing to notice about all this is that it is not that the Keynesian free lunch is not available in times of recession but that the world economy operates with a deflationary bias – something that was emphasized long ago by Joan Robinson (in her 1966 inaugural lecture in Cambridge, reprinted in 1973 in her Collected Economic Papers Volume IV, Oxford, Blackwell) and Michael Stewart (in his prescient 1983 book Controlling the Economic Future: Policy Dilemmas in a Shrinking World, Brighton, Wheatsheaf). The foreign debt problem arises because the countries with trade surpluses – most notably China – insiston having undervalued currencies and/or fail to engage in stimulus packages of their own to ensure that their demand for products from the rest of the world rises far enough to offset the trade deficits of the nations that try to pursue Keynesian policies. The financial markets punish the economies that do the right thing in Keynesian terms and end up with rising foreign debt (for example by downgrading their credit ratings), while those with seriously undervalued currencies end up being allowed to own an increasing share of the world’s financial assets.
Given this set of incentives it is not surprising that we have been witnessing both the non-Keynesian policies of spending cuts being undertaken in the UK but also beggar-my-neighbour attempts at competitive devaluation to reduce the need for stimulus packages. If the world is to get out of the Global Financial Crisis, measures will need to be implemented to remove the deflationary bias and coordinate expansionary policies so that they realize the Keynesian free lunch and do not exacerbate any nation’s foreign debt problems. Bodies such as the G20 could have a major role to play here; individual countries cannot deal with the problem unless the follow the kinds of import control policies advocated during the 1970s by Wynne Godley and his fellow Cambridge Economic Policy Group members. Such policies would be aimed at stopping a demand expansion from partially leaking out to the rest of the world, rather than at reflating domestic demand by cutting imports from the rest of the world. But it is hard to imagine them being adopted in the age of the WTO.
Quantitative easing and the Keynesian free lunch April 26, 2010
Posted by Peter Earl in Global Financial Crisis, Keynesian economics, Monetary policy.add a comment
The way that fiscal stimulus packages for combating the GFC have been financed often indicates that policy-makers have failed to grasp basic Keynesian insights about deflationary gaps. From a Keynesian perspective, these deficits should be financed purely by borrowing from state-owned central banks—in other words, by ‘printing money’ or, to use the modern euphemism, by ‘quantitative easing’. To finance stimulus packages wholly or partly by selling government bonds involves unnecessary opportunity costs for the inhabitants of the economy in question, in the form of a future stream of interest payments and, eventually, repayment of the principal.
The resource costs essentially involve a transfer to the financial and overseas sectors from the population of the country issuing the debt. If the bonds are sold domestically, this is essentially a matter of income distribution: taxes will need to be higher in future to facilitate transfers to the financial sector. Bankers and their shareholders will have more to consume at the expense of taxpayers in general. If the bonds are sold to the foreign sector, future foreign exchange earnings will be taken up servicing and repaying them, so domestic consumption of foreign goods and services will eventually have to be less.
There is no need for the community at large to incur such long-run costs of keeping recessions at bay. If effective demand is less than the full-employment level of aggregate demand, and if workers would prefer to have jobs rather than be involuntarily unemployed, there is no physical resource cost to increasing production to satisfy extra demand that is generated to fill the deflationary gap. To be sure, the demand for imports will, other things equal, be greater if a stimulus package is introduced, but this will not involve increased foreign currency repayments to the overseas sector if the exchange rate is allowed to depreciate to a level that ensures no net increase in imports and hence no increase in foreign borrowing. The expansion of output that results from a stimulus package thus can come at zero opportunity cost in foregone future consumption. In times of recession, this is the Keynesian free lunch.
In the face of an impending recession, plugging the deflationary gap via a stimulus package that is financed purely by monetary expansion will not cause inflationary pressures—though it may well help to prevent tendencies towards a damaging deflationary spiral of falling asset prices and bankruptcies. It is actually financially prudent for a government to finance a stimulus package by monetary expansion since it otherwise will be promoting a ‘twin deficits’ problem. If such a package is instead financed by selling bonds and the overseas sector is allowed to buy these bonds, the exchange rate will be pushed up, partly offsetting the stimulus and necessitating a bigger stimulus in order to achieve a given end result.
From this standpoint, we might wonder cynically whether the antipathy of bankers towards the use of quantitative easing to finance Keynesian stimulus packages actually arises not because of a genuine fear of inflation due to their failure to understand the Keynesian analysis of aggregate supply but because they stand to make money from deficits that are financed by bond sales. If they have become nervous about creating bank deposits to finance corporate and household spending, interest earnings on government bonds provide them with a safe alternative source of income. The banking sector in effect gives itself extra liabilities by writing out cheques to the government to buy government debt as offsetting assets. When the government spends the proceeds, consumers and firms deposit the cheques they have received from the government they thereby replenishing the banks’ newly added liabilities.
By contrast, if quantitative easing is the means by which the stimulus package is financed, the banks will receive additional deposits as firms and consumers deposit cheques from the government, but the banks’ holdings of deposits at the reserve bank will increase. This will improve the reserve asset ratios of the banks and if it makes them more willing to lend to the private sector, the stimulus package will not need to be so large. However, if the increase in the monetary base does not trigger a larger volume of bank lending and bank deposit creation, the banks will earn less under the quantitative easing strategy insofar as deposits at the reserve bank have a lower yield than government bonds.
Treasurers in countries that are members of currency zones (for example, Greece as a member of the Euro zone) unfortunately do not enjoy the ability to finance their deficits via quantitative easing in the manner of, say, the United Kingdom or Australia. Their positions are analogous to those of treasurers of a city, county council or state in a country with its own currency. From a Keynesian perspective, then, the United Kingdom was wise to stay out of the Euro zone, as the continuation of Sterling provides monetary independence for the Chancellor of the Exchequer provided that the Governor of the Bank of England is prepared to agree to a plan to use quantitative easing as the means by which a stimulus package is financed.
From a Keynesian perspective, it thus seems potentially unwise to make central banks free of government directives about how fiscal deficits should be financed. Such independence may help the credibility of anti-inflation policies. However, in times of recession it could prove costly to the citizens of a country whose reserve bank governor did not understand the essence of the Keynesian free lunch and the case for using quantitative easing as the sole means of financing deficits that were aimed at removing a deflationary gap.
There may be reasons to be nervous about the use of quantitative easing to finance stimulus packages in countries where governments do not have to account for themselves at the ballot box. In non-democratic systems, or in countires where governments can rig the results of general elections, those in power may succumb to temptations to use ‘printing money’ as a means to expropriate the economy’s resources for their own ends via a strategy that leads eventually to hyperinflation. In Western-style democracies, however, governments may be expected not to use quantitative easing in an irresponsible manner that ends up turning a deflationary gap into an inflationary gap. If they do get addicted to financing increasing volumes of spending via quantitative easing when there is no deflationary gap to fill, they will wreck their chances at subsequent elections. This is particularly so in today’s increasingly ‘grey’ economies where ageing baby-boomer voters will not tolerate their retirement savings being jeopardized by rising prices.
The question that remains is what happens to the monetary injection once confidence has returned to the economy and there is no need for the fiscal stimulus to continue. There might be concerns of an inflationary gap emerging unless monetary growth is reversed. A tradtional method of reducing bank deposits is to sell government bonds to the private sector (i.e., open market operations), but in this case there will be a transfer of interest payments from the population at large to those who purchase the government bonds. An alternative strategy is simply to use a tightening of fiscal policy (e.g., cutting back on the kinds of expenditure involved in the stimulus packages, or increasing taxes on the rich), taking the public sector back into surplus. As this happens, money will flow from the banks’ reserve deposits at the reserve bank, into government balances held there. The government can then use its balances to liquidate govenerment securities held by the reserve bank. What happens here is much the same as what happens when we pay off our credit cards: the reserve bank’s liabilities are reduced (government deposits go down) by the same amount as its assets are reduced (its holdings of government bonds go down).
