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Policy B: New money financed budget deficits

Could it be? Surely not! An economist writing on VoxEU, Richard Wood has sussed the possibilities within the money system to solve Ireland’s problems.  Yet, this is what he seems to be saying using slightly different concepts than Modern Monetary Theory (MMT) supporters usually employ. If it is the case that the conventional economists citadel that is VoxEU has been breached by the infidels of MMT, we rejoice; – there is hope yet.  Link to full article entitled “Deflation, debt, and economic stimulus”.

Aha, we note Richard Wood hails from Australia, home of William Mitchell and Steve Keen.  That might explain his  independent thinking.  Still, that fact does not take from his achievement in getting published.  Let us hope he has breached the walls.

Here is the heart of his argument. ..

Policy B: New money financed budget deficits

The alternative approach involves the central bank printing new money to directly finance fiscal stimulus. This neglected policy option – apparently largely overlooked by officials during the global economic crisis – is likely to be appropriatefor countries where prices are falling (or inflation drops toward zero), private demand is deficient, interest rates are already too low and where public debt is excessive.

Policy B provides a capacity to:

  • finance budget deficits without raising public debt levels further;
  • simultaneously stimulate private demand; and
  • retreat from deflation.

In order for the central bank to expand the monetary base (the liability side of its balance sheet), there must be a matching expansion on the asset side. This would have to be matched by a liability on the central government’s balance sheet. This involves the central bank purchasing newly created bonds from the ministry of finance, thereby creating new intra-governmental debt, which, nevertheless, would normally need to be serviced and repaid.

The interest outflows to the central bank would, over time, be returned as budget revenue to the government, and taxpayers would, on that account, accumulate no liabilities.

In relation to the redemption value, the government could either refinance the debt in the market or else pay down the debt. Paying down the debt would create a liability for taxpayers when the redemption date is reached. In extraordinary times the government’s liability (the bond) could be issued as “perpetual” debt (i.e., it would provide no set maturity date). This approach would leave a long-term liability on the government’s balance sheet and a long-term asset on the balance sheet of the central bank. There is no effective increase in the overall net debt of the government (considered broadly), and taxpayers would not incur taxation liabilities to finance the deficit.

Policy B would be appropriate if domestic demand is deficient, excess productive capacity exists, unemployment is high, inflation is low or negative, and there is a desire to apply fiscal stimulus without raising the level of publicly-held debt. These prior conditions exist in different degrees in the US, Japan, and Ireland, and potentially in some other European countries.

Policy B directs new money creation to locations in the economy where the marginal propensities to consume, and to invest in real productive assets (as distinct from financial assets under quantitative easing), are the highest. Policy B, therefore, could be expected to impact relatively favourably on consumption and investment spending and provide the time, increased incomes, suitable inflation rates, confidence, and appropriate interest rates needed to work-out of liquidity traps.

Policy B would be wound-down as sustainable economic recovery is established.

Both Policy A and Policy B involve new money creation and, if taken too far, may eventually lead to rising inflation and excess liquidity that may, possibly, later need to be withdrawn by raising bank reserve requirements, asset and mortgage sales, or sales of government bonds.

The policy change and its implications

The application of Policy B to Ireland (a country without its own sovereign currency) could be challenging at the political level, but not necessarily precluded by policy design. The European Central Bank could conceivably directly finance budget deficits of selected small countries, addressing growing “debt” problems at their source. Attempting to resolve debt-crises, as is currently the case, by generating even more (relatively high interest) debt seems counter-intuitive and self-defeating – especially where early economic recovery is unlikely.

There are not endless shots left in the policy armoury. Great care needs to be taken so as not to fire-off the remaining monetary policy shot in the wrong direction. Each creation of new money is not costless, as eventually it could result in a higher rate of inflation than is desirable, and may, therefore, need to be withdrawn from the economy, reducing the scope for more constructively applied money creation in the interim.

If monetary policy is considered on its own then there could be a case for terminating current quantitative easing programmes. This would steer Japan and the US away from the shoals of triple jeopardy (Leijonhufvud 2011).

Quantitative easing could be replaced with a policy of printing new money with an explicit objective to assist in the financing of future budget deficits (see suggested money-financed tax cut: Bernanke 2002 and analysis by Corden 2010). The deployment of new money creation in this manner would take some pressure off the need for severe fiscal austerity measures (at a time when continued stimulus is still required); minimise further increases in public debt; provide clear signals of policy intent (in relation to interest rate objectives, the method of financing deficits and the approach to delivering economic stimulus); and be more effective, have fewer adverse side-effects, and deliver stronger economic stimulus than further quantitative easing.

Countries experiencing a deflationary tendency and deficient private demand that introduced laws in times of high inflation which preclude the printing of new money to finance budget deficits, and the ability of central banks to lend directly to Ministries of Finance, could consider repealing them.

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