Quantitative easing and the Keynesian free lunch

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).

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