Friday, July 25, 2014
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Rethinking the Monetization Taboo

LONDON – Now that the pace of the US Federal Reserve’s “tapering” of its asset-purchase program has been debated to death, attention will increasingly turn to prospects for interest-rate increases. But another question looms: How will central banks achieve a final “exit” from unconventional monetary policy and return balance sheets swollen by unconventional monetary policy to “normal” levels?

To many, a larger issue needs to be addressed. The Fed’s tapering merely slows the growth of its balance sheet. The authorities would still have to sell $3 trillion of bonds to return to the pre-crisis status quo.

The rarely admitted truth, however, is that there is no need for central banks’ balance sheets to shrink. They could stay permanently larger; and, for some countries, permanently bigger central-bank balance sheets will help reduce public-debt burdens.

As a recent IMF paper by Carmen Reinhart and Kenneth Rogoff illustrates, advanced economies face debt burdens that cannot be reduced simply through a mix of austerity, forbearance, and growth. But if a central bank owns the debt of its own government, no net public liability exists. The government owns the central bank, so the debt is to itself, and the interest expense comes back to the government as the central bank’s profit. If central bank holdings of government debt were converted into non-interest-bearing perpetual obligations, nothing substantive would change, but it would become obvious that some previously issued public debt did not need to be repaid.

This amounts to “helicopter money” after the fact. In 2003, then-Fed Chairman Ben Bernanke argued that Japan, facing deflation, should increase public expenditure or cut taxes, funding the operation by printing money rather than issuing bonds. This, he argued, was bound to increase national income, because the direct stimulative effect would not be offset by concern about future debt burdens.

His advice was not followed; large Japanese deficits were in fact bond-financed. But the debts held by the Bank of Japan (BoJ) could still be written off. In Japan’s case, this would reduce government debt by an amount equal to more than 40% of GDP today, and around 60% if implemented after the bond purchases planned for 2014.

Objections focus on two risks: central-bank losses and excessive inflation. But both of these outcomes can be avoided.

Central banks have bought government bonds with money on which they currently pay zero or very low interest rates. So, as interest rates rise, central banks might face costs exceeding their income. But central banks can choose to pay zero interest on a portion of the reserves that commercial banks hold with them, even when they increase the policy interest rate. And they can require commercial banks to hold zero-interest reserves at the central bank equal to a defined proportion of their loans, thus preventing inflationary growth of private credit and money.

Permanent monetization of government debts is undoubtedly technically possible. Whether it is desirable depends on the outlook for inflation. Where inflation is returning to target levels, debt monetization could be unnecessarily and dangerously stimulative. Central-bank bond sales, while certainly not inevitable, may be appropriate. But if deflation is the danger, permanent monetization may be the best policy.

I predict that Japan will, in effect, permanently monetize some government debt. After two decades of low growth and deflation, Japanese gross public debt is now above 240% of GDP (and above 140% of GDP on a net basis); and, with the fiscal deficit at 9.5% of GDP, the debt burden continues to increase. According to the IMF, to reduce its net public debt to 80% of GDP by 2030, Japan would have to turn today’s 8.6% primary budget deficit (the balance excluding interest payments) into a 6.7% primary surplus by 2020 and maintain such surpluses continuously until 2030.

That will not happen, and any attempt to reach that target would drive Japan into a severe depression. But the government does not need to repay the ¥140 trillion ($1.4 trillion) of its debt that the BoJ already owns.

The BoJ will continue to increase its balance sheet until it achieves its 2% inflation target. Thereafter, its balance sheet may stabilize in absolute yen terms and fall slowly as a percentage of GDP, but its absolute size will probably never decrease – a likelihood that should cause no concern. It is precisely what happened to the Fed’s balance sheet after its wartime and postwar buying of US government bonds came to an end in 1951.

Even as permanent monetization occurs, however, the truth may be obfuscated. If government bond repayments to the BoJ continued, but were always offset by new BoJ bond purchases, and if the BoJ kept the interest rate on reserves at zero, the net effect would be the same as a debt write-off, but the fiction of “normal” central-bank operations could be maintained.

Central banks can monetize debt while pretending not to. That pretense may reflect a useful taboo: if we overtly recognize that debt write-off/monetization is possible, politicians might want to do it all the time and in excess, not just in circumstances that make it appropriate. The historical experience of Weimar Germany, or that of Zimbabwe today, illustrates the danger.

As a result, even when permanent monetization occurs – as it almost certainly will in Japan and possibly elsewhere – it may remain forever the policy that dare not speak its name. Such reticence may serve a useful purpose. But it must not blind central banks and governments to the full range of policy tools available to address today’s severe debt overhangs.

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  1. CommentedLuis de Agustin

    According to David Ranson, head of research at Wainwright Economics, it's difficult to foresee any substantial change in the current yield curve. Under Janet Yellen, the Fed seems much more conscious of the poor state of the labor market despite the decline in the official unemployment rate. Tapering, Ranson says, will remain extremely gradual, this despite that quantitative easing inflates but does not stimulate.

    According to Ranson, the evidence to support the Federal Reserve’s stimulation of the economy by easy monetary policy is unfavorable. Artificially low interest rates inhibit saving and lending, leaving borrowers no better off than before. What borrowing does take place tilts towards the well to do or the politically connected.

    The Fed can print money and buy bonds, but it’s banks that generate money balances. The failure of money in circulation to grow is notorious in spite of enormous debt purchases in the course of the Fed’s quantitative easing initiatives. Wainwright’s analysis finds that the more money the Fed creates to buy up debt, the slower the economy grows.

    Creating money is inflationary, especially when inflationary forces are expressed in terms of a market-driven sensitive indicator like the price of gold. In fact according to Wainwright’s findings, no matter which kind of hoped-for stimulus the government relies on, the effect is the same. The research concludes that true stimulus comes from the incentivization of private capital and not from turbo-charged government activity.

    Luis de Agustin

  2. CommentedJason Gower

    Wow, it's that easy...who knew! Can really summarize this whole issue with the last sentence. What was the point of independent central banks in the first place? Call it whatever you want but keep playing with fire and the whole house will eventually burn down.

  3. CommentedProcyon Mukherjee

    Debt can be partially monetized by allowing inflation to increase (government debt vanishes, being replaced by inflation), this is the same subject on which Janet Yellen in September 2005 had been vocal that interest rates would rise quicker as a consequence (in fact she is still hinting that now).

  4. CommentedClaudio Migliore

    Let me dare interpret Mr. Turner's word, if I may.
    "The money has already hit the streets so, whichever way the governments' accountants choose to cook the books is irrelevant, except for the fact that we all like to save face. I cannot imagine why economic agents should care whether the pieces of paper stored in their central banks' vaults say one thing or the other or do not exist at all."
    I couldn't agree more. Zimbabwe, Weimar, Hungary or Venezuela differ from the US only in that beyond a certain degree, face cannot be saved and monetary illusion collapses. I remember the One Trillion note proposed by Mr. Krugman fondly, because if comes closer to admit reality, i.e. the government can inflate whenever they feel like and they are already doing it with gusto.
    That they are doing it in the "right" amount it is another story and that they will be equally willing to deflate when prices catch up is another. The real game is one of redistribution, as different degrees of inflation move wealth between their citizens' pockets.
    I hope one day societies are mature enough to live without the thin veil of this illusion.

  5. Commentededwin knouse

    So as a layman, what I'm seeing here is the root of all this is that if you make up money out of thin air. Then you can also make it disappear. Well I guess that's the reason the "Fed" is a private corp.,business whatever you want to call it, it certainly isn't our elected government Now why is that?. Oh that's right it's so we want have banking crisis, I almost forgot I was so worried about the banking crisis.

  6. CommentedTomas Kurian

    There is no way CB could reduce its balance sheets without inflation. State debt is an inevitable tool for keeping economy afloat which enables profits creation and its retention.

    To ask for state debt reduction one asks for reduction of personal savings.
    To ask for balanced budget means to ask for no increase in savings and profits.

    Methods of monetary reform:


  7. Commentedroberto martorana

    I wrote about this on "riodialogues during RIO20":I suppose a new rule for central bank: a model that integrates the concepts between von Hayek and J.M. Keynes,because it keeps the economic freedom of enterprise and market , creating resources that can be used by the government but to the extent that they are created and without increasing the tax burden... when one of the central bank(respectively of each country or through international agreements) have a new emission of money whith each rate the same bank print corrispective quantity of money of the rate ,off C.B. budget,and give this quantity ( to compense the monetary mass to solve the lack natural compensation previously provided by 'gold mining ..) at a pubblic commission that use for pubblic necessity etc etc...we resolve three problem :pubblic necessity,pubblic balance,and market crisis,;for example : the B.C. have a emission of hundred billion unit and fix a rate of 3% and give this money to commercial bank,at the same moment print 3 billion and give these to pubblic commission that spend for pubblic problem....
    (More on:Teoria della compensazione della massa monetaria this is my page about a new theory macroeconomic conception monetary system ,and any contribute are well accepted )

  8. CommentedYoshimichi Moriyama

    I do not have any good economics knowledge, so I would rather not make a comment on Mr. Turner's Rethinking.
    However, I am certain of one thing and it is that the Bank of Japan's monetization policy over the past year is right.

    If I may use this space and repeat what I said to Koichi Hamada/Japan's Tax-Hike Test, one major problem with Japan is the low intellectual level, at least in so far as enonomics is concerned, of the Japanese Ministry of Treasury (JMT). As Paul Samuelson said, most bureaucrats of JMT come from the Law Department of Tokyo University, not the Economics Department. They begin to learn economics after entering the office and so never arrive at an adequate or desired level; they cannot compete in discussing economic problems with top-class Japanese economists. They should come from at least a graduate master or doctor course of economics.

  9. CommentedRalph Musgrave

    Hurray. Someone in power is beginning to understand Modern Monetary Theory.

    Turner’s point could be taken a lot further: Milton Friedman, Warren Mosler and other economists have long pointed out that government debt is a farce, and that the only liability that should be issed by the government / central bank machine should be money (monetary base to be exact).

    That is, it would be perfectly feasible to continue with QE till all government debt had vanished. As to any inflationary effect of that, that can easily be dealt with (at least in principle) by raising taxes. There might be POLITICAL problems there. But there’s no strictly ECONOMIC problem.

      CommentedSergey Ivanovitch

      @ G.A. Pakela: How can taxes be inflationary under the profit-maximizing assumption? If the tax rate goes up and a firm raises prices to either keep profit constant or increase profit, that implies that the firm was not maximizing its profit in the first place. This is a problematic assumption.

      All else equal, increasing taxes should reduce the money supply which reduces inflation.

      CommentedIngolf Eide

      Looked at from certain angles, in an independent fiat system government debt is a farce. Or, more accurately, a sort of veil drawn over the underlying reality.

      Still, replacing government debt with freshly issued money would not be without real-world consequences. Consider Musgrave's suggestion of continuing with QE until "all government debt had vanished". In the case of the US, this would leave the Fed with a balance sheet of close to 100% of GDP and the banking system with the same level of reserves.

      Would that matter? Well, one thing immediately stands out: heavily influenced though that market may be, government bonds are still priced by the market, reserves are not, and so yet another signalling mechanism would effectively vanish. One that many see as the most important of all.

      And banks, how would they react to having reserves roughly equal to GDP? If the central bank pays no interest on them, or a rate substantially below market, the incentive for individual banks to try to get rid of reserves by purchasing securities and/or increasing lending would be irresistible. Mr Turner suggests any such problems can be dealt with by forcing banks to hold zero interest reserves in proportion to their loans (including securities, I assume). Maybe, for a while at least, but Lord isn't the whole contraption getting a little ramshackle at this point? And let's not forget the banking system as a whole can't get rid of reserves; they're wholly determined by central bank actions. Common sense suggests matters could well spin out of control as reserves replaced government debt. As we clearly saw in 2008, money and finance have a distinctly nonlinear nature lurking under their benign, rational exterior.

      Most of this radical monetary activity (both existing and proposed) is aimed at keeping creditors whole. This obsession has precluded sensible policy ever since the crisis hit, and indeed long before. Instead of fighting to keep an unsustainably overgeared system propped up, the focus could have been on debt conversions wherever debt was unsustainable. Backing away from the precipice, in other words, rather than trying to leap over it and effectively risking all.

      CommentedG. A. Pakela

      Raising taxes in the face of monetary expansion would increase, rather than decrease inflation as households and firms would demand higher wages and prices to compensate them for the higher tax rates. This scenario was in play in the 1970s when the highly progressive tax rates at all income levels were not indexed for inflation; this meant that tax payers were pushed into higher tax brackets each year. The inflation psychology fed on itself and even the brutal recession in the 1973-1974 only barely slowed the pace of inflation. Inflation returned with a vengeance in the subsequent recovery with effective taxes increasing in each of those years. The Reagan tax cuts only restored tax rates to their earlier levels for most tax brackets except at the top bracket. The Reagan tax policy indexed the subsequent rates and this may have been a factor in the multi-decade fall in inflation.