Quantitative Easing and Foreign Debt: The Keynesian ‘Free Lunch’ Revisited

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.